Question

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

$1.5

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

$25

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):

​(Click on the Icon located on the​ top-right corner of the data table below in order to copy its contents into a​ spreadsheet.)

	Project Year
Earnings Forecast​ ($ million)	1	2	. . .	9	10
Sales revenue	29.000	29.000		29.000	29.000
−Cost of goods sold	17.400	17.400		17.400	17.400
=Gross profit	11.600	11.600		11.600	11.600
−​Selling, ​general, and administrative expenses	2.000	2.000		2.000	2.000
−Depreciation	2.500	2.500		2.500	2.500
=Net operating income	7.100	7.100		7.100	7.100
−Income tax	2.485	2.485		2.485	2.485
=Net unlevered income	4.615	4.615		4.615	4.615

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. The report concludes that because the project will increase earnings by

$4.615

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

$46.15

million. You think back to your halcyon 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

$11

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

$2

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

$1

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?

b. If the cost of capital for this project is

16%​,

what is your estimate of the value of the new​ project?

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?

The free cash flow for year 0 is

​$nothing

million.

Answer 1

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