Question

Your company is considering expanding its operations in shoe manufacturing. You owe your consultants $ 1.8 million for a​ report, but you are not sure their analysis makes sense. Before you spend the $ 21 million on new equipment needed for this​ project, you have to look it over and give it your​ opinion. You open the report and find the following estimates​ (in millions of​ dollars):

	1	2	. . .	9	10
Sales revenue	32,000	32,000		32,000	32,000
−Cost of goods sold	19,200	19,200		19,200	19,200
=Gross profit	12,800	12,800		12,800	12,800
−​General, ​sales, and administrative expenses	1,680	1,680		1,680	1,680
−Depreciation	2,100	2,100		2,100	2,100
=Net operating income	9,020	9,020		9,020	9,020
−Income tax	3,157	3,157		3,157	3,157
=Net income	5,863	5,863		5,863	5,863

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 $ 5.863 million per year for 10​ years, the project is worth $ 58.63 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 $ 13 million in working capital up front​ (year 0), which will be fully recovered in year 10.

Next you see they have attributed $ 1.68 million of​ selling, general and administrative expenses to the​ project, but you know that $0.84 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!

1. Given the available​ information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed​ project?
2. If the cost of capital for this project is 12%​, what is your estimate of the value of the new​ project?

Answer 1