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 $1.8 million for this report, and I am not sure their analysis makes sense. Before we spend the $17 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​ ($ million)                1                   2                      9                   10

Sales revenue                                       30,000          30,000             30,000         30,000

-cost of goods sold                               18,000          same                same           same

= gross profit                                         12,000          same                same           same

-Selling, General & Adm expenses      1.360          same                 same           same

- depreciation                                         1.70            same                  same          same

=net operating income                         8.940           same                 same          same

-income tax                                             3.129            same                same          same

= net unlevered income                        5.811           same                 same          same

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 $5.811 million per year for ten​ years, the project is worth $58.11 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 $8 million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $1.36 million of​ selling, general and administrative expenses to the​ project, but you know that $0.68 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 8%​, what is your estimate of the value of the new​ project?

Answer 1

a).

Formula	Earnings Forecast​ ($ million)	Year 1-10
	Sales revenue	30.00
	-cost of goods sold	18.00
	= gross profit	12.00
Excluding the sunk cost of 0.68 million	-Selling, General & Adm expenses	0.68
	- depreciation	1.70
	=net operating income	9.62
35%* net operating income	-income tax (@ 35%)	3.37
	= net unlevered income	6.25
	Add: depreciation	1.70
	= Operating cash flows	7.953

Free Cash Flows:

Formula	Year (n)	0	1-9	10
	Initial investment (I)	-17.00
	Operating cash flow (OCF)		7.953	7.953
(Working capital spent in Year 0 and recovered in Year 10)	Working capital (WC)	-8.00		8.00
(I+OCF+WC)	Total cash flows	-25.00	7.953	15.953

b).

NPV calculation:

NPV Year 0 = -25.0

NPV Years 1-9: PMT = 7.953, I = 8%; N = 9, solve for PV. NPV = 49.681

NPV Year 10: FV = 15.953; I = 8%; N = 10, solve for PV. NPV = 7.389

Total NPV = -25 + 49.681 + 7.389 = 32.07

Value of the new project is $32.07 million.