Question

In: Accounting

You are a manager at Northern​ Fibre, which is considering expanding its operations in synthetic fibre...

You are a manager at Northern​ Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your​ office, drops a​consultant's report on your​ desk, and​ complains, "We owe these consultants

$1.3

million for this​ report, and I am not sure their analysis makes sense. Before we spend the

$17

million on new equipment needed for this​ project, look it over and give me your​ opinion." You open the report and find the following estimates​ (in millions of​dollars):

1

2

. . .

9

10

Sales revenue

35.000

35.000

35.000

35.000

−Cost

of goods sold

21.000

21.000

21.000

21.000

=Gross

profit

14.000

14.000

14.000

14.000

−​General,

​sales, and administrative expenses

1.360

1.360

1.360

1.360

−Depreciation

1.700

1.700

1.700

1.700

=Net

operating income

10.940

10.940

10.940

10.940

−Income

tax

3.829

3.829

3.829

3.829

=Net

income

7.111

7.111

7.111

7.111

All of the estimates in the report seem correct. You note that the consultants used​ straight-line depreciation for the new equipment that will be purchased today​ (year 0), which is what the accounting department recommended for financial reporting purposes. CRA allows a CCA rate of

30%

on the equipment for tax purposes. The report concludes that because the project will increase earnings by

$7.111

million per year for 10​ years, the project is worth

$71.11

million. You think back to your glory days in finance class and realize there is more work to be​ done!  

First you note that the consultants have not factored in the fact that the project will require

$9

million in working capital up front​ (year 0), which will be fully recovered in year 10. Next you see they have attributed

$1.36

million of​ selling, general and administrative expenses to the​ project, but you know that

$0.68

million of this amount is overhead that will be incurred even if the project is not accepted.​ Finally, you know that accounting earnings are not the right thing to focus​ on!

a. Given the available​ information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed​ project?

Solutions

Expert Solution

INFORMATION GIVEN IN QUESTION:

Estimates of the new project for 10 years is given. It generates a Net income after tax of $ 7.111M every year for 10 years. Some items need reconsideration to arrive at every year cash flow through out the life of Project.

ANSWER:

(in millions of​ dollars)

SR.NO PARTICULARS 0 1 2 3 4 5 6 7 8 9 10 NOTES
1 NEW EQUIPMENT COST ( 17 ) Outflow in 0 year
2 WORKING CAPITAL ( 9 ) 9 Outflow in 0 year & Inflow in last year
3 GROSS PROFIT 14 14 14 14 14 14 14 14 14 14 Inflow every year
4

(-) GENERAL SELLING & ADMIN EXPS

(EXCLUDING FIXED COST)

(0.68) (0.68) (0.68) (0.68) (0.68) (0.68) (0.68) (0.68) (0.68) (0.68) Fixed cost is excluded as it will not affect the project cash flow.
5 = 3-4 NET PROFIT BEFORE TAX 13.32 13.32 13.32 13.32 13.32 13.32 13.32 13.32 13.32 13.32
6 = 5x35% TAX @ 35% (4.662) (4.662) (4.662) (4.662) (4.662) (4.662) (4.662) (4.662) (4.662) (4.662)
7 = 5 - 6 NET PROFIT AFTER TAX 8.658 8.658 8.658 8.658 8.658 8.658 8.658 8.658 8.658 8.658
8 TAX SAVING ON DEPRECIATION (refer working) 1.79 1.25 0.87 0.61 0.43 0.30 0.21 0.15 0.10 0.07 CCA IS 30% decreasing balance method & TAX RATE IS 35%
1+2+7+8 NET CASH FLOW (26) 10.448 9.908 9.528 9.268 9.088 8.958 8.868 8.808 8.758 17.728

HENCE, TOTAL OF FREE CASH FLOWS = $ 75.36 M

WORKING OF TAX SAVING ON DEPRECIATION

YEAR
OPENING DEP 30% TAX @ 35%
1 17 5.10 1.79
2 11.90 3.57 1.25
3 8.33 2.50 0.87
4 5.83 1.75 0.61
5 4.08 1.22 0.43
6 2.86 0.86 0.30
7 2.00 0.60 0.21
8 1.40 0.42 0.15
9 0.98 0.29 0.10
10 0.69 0.21 0.07

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