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 $1.9 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $16 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 ($000,000s)	1	2	. . .	9	10
Sales revenue	33	33		33	33
- Cost of goods sold	19.8	19.8		19.8	19.8
Gross profit	13.2	13.2		13.2	13.2
- Selling, general, and administrative expenses	1.28	1.28		1.28	1.28
- Depreciation	1.6	1.6		1.6	1.6
Net operating income	10.32	10.32		10.32	10.32
- Income tax	3.612	3.612		3.612	3.612
Net unlevered income	6.708	6.708		6.708	6.708

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 $ 6.708 million per year for ten​ years, the project is worth $67.08 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 $12 million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $1.28 million of​ selling, general and administrative expenses to the​ project, but you know that $0.64 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

a). Free cash flows from year 1 to year 10 are calculated in the free cash flows line in the table above.

b). At a cost of capital of 14%, the project has an NPV of $20.742 million so the project can be accepted as NPV is positive.