Question

You are a manager at Percolated​ Fibre, which is considering expanding its operations in synthetic fibre 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 $ 15.1 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):

Earnings forecast	1	2	. . .	9	10
Sales revenue33.000	33.000	33.000	33.000	33.000	33.000
minus−Cost of goods sold	19.800	19.800	19.800	19.800	19.800
equals=Gross profit	13.200	13.200	13.200	13.200	13.200
minus−​General, sales and administrative expenses	1.208	1.208	1.208	1.208	1.208
minus−Depreciation	1.510	1.510	1.510	1.510	1.510
equals=Net operating profit	10.482	10.482	10.482	10.482	10.482
minus−Income tax	3.145	3.145	3.145	3.145	3.145
equals=Net profit	7.337	7.337	7.337	7.337	7.337

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, which is the​ company's assumption in this case. The report concludes that because the project will increase earnings by $ 7.337 million per year for ten​ years, the project is worth $ 73.37 million. You think back to your glory days in finance class and realise there is more work to be​ done! ​First, you note that the consultants have not factored in the fact that the project will require $ 12.7 million in net working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 1.208 million of​ selling, general and administrative expenses to the​ project, but you know that $ 0.604 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 to 10 that should be used to evaluate the proposed​ project? (year 0,year1-9, year 10)  ​(Round to three decimal​ places.)

b. If the cost of capital for this project is 13 %​, what is your estimate of the value of the new​ project?  ​(Round to three decimal​ places.) should you accept it or should not?

Answer 1

TAX RATE = TAX/NET OPERATING PROFIT =3.145/10.482 = 30%