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

$ 1.5m

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

$ 21m

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	27.000	27.000		27.000	27.000
minus−Cost of goods sold	16.200	16.200		16.200	16.200
equals=Gross profit	10.800	10.800		10.800	10.800
minus−​Selling, ​general, and administrative expenses	1.680	1.680		1.680	1.680
minus−Depreciation	2.10	2.10		2.100	2.100
equals=Net operating income	7.020	7.020		7.020	7.020
minus−Income tax	2.457	2.457		2.457	2.457
equals=Net unlevered income	4.563	4.563		4.563	4.563

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

$ 4.563m

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

$ 45.63m

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

$ 15m

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

$ 1.68m

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

$ 0.84m

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

14 %

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

Answer 1