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

$ 1.2 million for this​ report, and I am not sure their analysis makes sense. Before we spend the

$ 15.9 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):

	Project Year
Earnings Forecast	1	2	. . .	9	10
Sales Revenue	26.000	26.000		26.000	26.000
minus−Cost of Goods Sold	15.600	15.600		15.600	15.600
equals=Gross Profit	10.400	10.400		10.400	10.400
minus−​General, Sales and Administrative Expenses	1.272	1.272		1.272	1.272
minus−Depreciation	1.590	1.590		1.590	1.590
equals=Net Operating Income	7.538	7.538		7.538	7.538
minus−Income Tax	2.638	2.638		2.638	2.638
equals=Net Income	4.900	4.900		4.900	4.900

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. They also calculated the depreciation assuming no salvage value for the equipment. The report concludes that because the project will increase earnings by$ 4.900 million per year for 10​ years, the project is worth $ 49.00 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 included the fact that the project will require $ 12.6 million in working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 1.272 million of​ selling, general, and administrative expenses to the​ project, but you know that $0.636 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?

The free cash flow for year 0 is

The free cash flow for years 1 to 9 is

​The free cash flow for year 10 is

B.

If the cost of capital for this project is 12%​, the value of the project is?

you should or not accept the project?

Answer 1

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