Question

You are a Manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. With your Group team accompanying you, your Boss, Mr. Moneypockets, asks you to come to his office, where he gives you a consultant's report and complains, "We owe these consultants $1.2 million for this report, and I am not sure their analysis makes sense. Before we spend the $30 million on new equipment needed for this project, look it over with your team and give me your opinion." You open the report and find the estimates

Project Year

               1               2             --------------------------    9          10       

Sales Revenue            35,000        35,000                                    35,000     35,000

- COGS 21,000 21,000 21,000 21,000           

= Gross profits            14,000          14,000                                    14,000      14,000

- General Sales             2,400            2,400                                    2,400        2,400

    & admin expenses

- Depreciation 3,000 3,000 3,000 3,000

= Net income 8,600 8,600 8,600 8,600

- Income tax 3.01 3.01 3.01     3.01

Net income = 5.590    5.590    5.590    5.590

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 $5.590 million per year for 10 years, the project is worth $55.9 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 $2.4 million of selling, general and administrative expenses to the project, but you know that $1.2million 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 project?

b) if the cost of capital for the project (that is, the WACC) is 8%, what is your estimate of the NPV for the new project? How does the IRR compare to the required WACC? Would you recommend to Mr. Moneypockets that this project be undertaken, and why?

c) what are some uncertainties in the FCFs that your team might see in these (presumed to be 100% correct) NPV and IRR metrics, that could cause them to not be as deterministic as you and your team are basically assuming in your presentation to Mr. Mon

Answer 1

a]

The free cash flows are calculated as below :

selling, general and admin expenses for the project are those expenses which would be incurred if the project was accepted. Out of the accounting expenses of $2.4 million, 50% are overheads that would be incurred even if project is rejected. Hence only 50% of $2.4 million is attributed to this project

Tax rate for the company is computed as (income tax / net income) = 3,010,000 / 8,600,000 = 0.35, or 35%   

In the cash flow sheet below, the tax rate of 35% is applied.

Net cash flow = income after taxes + depreciation

Net cash flow in year 0 = initial investment + net working capital investment

Net cash flow in year 10 = income after taxes + depreciation + recovery of net working capital

b]

PV of each cash flow is calculated by discount each net cash flow back to the present using 8% discount rate. The sum of all these PVs is the NPV of the project

NPV of the project is $26,968,591

IRR is calculated using the IRR function in Excel, and inputting the array of cells containing the net cash flows. IRR is calculated to be 11%. As this is higher than the required WACC, the project should be accepted

c]

Possible uncertainties are that the given projections of sales and expenses are not the actual sales and expenses over the 10-year period. Although this could be the most likely scenario, there is possibility that in case of worst case or best case scenarios, the cash flows could be worse or better than this. Hence it is better to determine cash flows under each possibility, and not just the most likely scenario.