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 $ 1.1 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $ 16.3 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 revenue   26.000   26.000       26.000   26.000
- Cost of goods sold   15.600   15.600       15.600   15.600
Gross profit   10.400   10.400       10.400   10.400
- General, sales and administrative expenses   1.304   1.304       1.304   1.304
- Depreciation   1.630   1.630       1.630   1.630
Net operating profit   7.466   7.466       7.466   7.466
- Income tax   2.24   2.24       2.24   2.24
Net profit   5.226   5.226       5.226   5.226

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 $ 5.226 million per year for ten​ years, the project is worth $ 52.26 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 $ 9.2 million in net working capital up front​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed $ 1.304 million of​ selling, general and administrative expenses to the​ project, but you know that $ 0.652 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? b. If the cost of capital for this project is 15 %​, what is your estimate of the value of the new​ project?

a. The free cash flow for year 0 is ​$ nothing million. ​(Round to three decimal​ places.) The free cash flow for years 1 to 9 is ​$ nothing million. ​(Round to three decimal​ places.) The free cash flow for year 10 is ​$ nothing million. ​(Round to three decimal​ places.) b. If the cost of capital for this project is 15 %​, the value of project is ​$ nothing million. ​(Round to three decimal​ places.) You should not/should accept the project.​ (Choose the best answer from the drop down​ menu.)

Answer 1