Question

	Project Year
Earnings Forecast ($000,000s)	1	2	. . .	9	10
Sales revenue	28	28		28	28
- Cost of goods sold	16.8	16.8		16.8	16.8
Error: Error evaluating expression: Gross profit	11.2	11.2		11.2	11.2
- Selling, general, and administrative expenses	1.2	1.2		1.2	1.2
- Depreciation	1.5	1.5		1.5	1.5
Error: Error evaluating expression: Net operating income	8.5	8.5		8.5	8.5
- Income tax	1.7	1.7		1.7	1.7
Error: Error evaluating expression: Net unlevered income	6.8	6.8		6.8	6.8

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

$1.4

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

$15

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):

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

$6.800

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

$68 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

$7 million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed

$1.2 million of​ selling, general and administrative expenses to the​ project, but you know that

$0.6 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

13%​,

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

Answer 1

Part (a)

Please see the table below. All financials are in $ million. Please see the second row / column to understand the mathematics. The last row colored in yellow contains your answer. Adjacent cell in blue shows the excel formula used to get the answer.

Earnings Forecast ($000,000s)	Linkage	-	1	2	3	4	5	6	7	8	9	10
Sales revenue	A		28.00	28.00	28.00	28.00	28.00	28.00	28.00	28.00	28.00	28.00
- Cost of goods sold	B		16.80	16.80	16.80	16.80	16.80	16.80	16.80	16.80	16.80	16.80
Gross profit	C = A - B		11.20	11.20	11.20	11.20	11.20	11.20	11.20	11.20	11.20	11.20
- Selling, general, and administrative expenses	D		0.60	0.60	0.60	0.60	0.60	0.60	0.60	0.60	0.60	0.60
- Depreciation	E		1.50	1.50	1.50	1.50	1.50	1.50	1.50	1.50	1.50	1.50
Net operating income	F = C - D - E		9.10	9.10	9.10	9.10	9.10	9.10	9.10	9.10	9.10	9.10
- Income tax	G = 20% x F		1.82	1.82	1.82	1.82	1.82	1.82	1.82	1.82	1.82	1.82
Net unlevered income	H = F - G		7.28	7.28	7.28	7.28	7.28	7.28	7.28	7.28	7.28	7.28
Free Cash flows
Net income	H		7.28	7.28	7.28	7.28	7.28	7.28	7.28	7.28	7.28	7.28
[+] Depreciation	E		1.50	1.50	1.50	1.50	1.50	1.50	1.50	1.50	1.50	1.50
[-] Initial investment	I	15.00
[-] Working capital investment	J	7.00										-7.00
Free cash flows	K = H + E - I - J	-22.00	8.78	8.78	8.78	8.78	8.78	8.78	8.78	8.78	8.78	15.78

Part (b)

hence, estimate of the value of the new​ project = $ 27.70 million