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

$ 1.5

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

$ 24

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):

​(Click on the Icon located on the​ top-right corner of the data table below in order to copy its contents into a​ spreadsheet.)

	Project Year
Earnings Forecast​ ($ million)	1	2	. . .	9	10
Sales revenue	31.000	31.000		31.000	31.000
minus−Cost of goods sold	18.600	18.600		18.600	18.600
equals=Gross profit	12.400	12.400		12.400	12.400
minus−​Selling, ​general, and administrative expenses	1.920	1.920		1.920	1.920
minus−Depreciation	2.400	2.400		2.400	2.400
equals=Net operating income	8.080	8.080		8.080	8.080
minus−Income tax	2.828	2.828		2.828	2.828
equals=Net unlevered income	5.252	5.252		5.252	5.252

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

$ 5.252

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

$ 52.52

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

$ 1.92

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

$ 0.96

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