Question

You are a manager at Northern​ 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

$1.3

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):

​(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​ ($000,000s)	1	2	. . .	9	10
Sales revenue	27.000	27.000		27.000	27.000
−Cost of goods sold	16.200	16.200		16.200	16.200
=Gross profit	10.800	10.800		10.800	10.800
−​Selling, ​general, and administrative expenses	1.360	1.360		1.360	1.360
−Depreciation	1.700	1.700		1.700	1.700
=Net operating income	7.7400	7.7400		7.7400	7.7400
−Income tax	2.709	2.709		2.709	2.709
=Net income	5.031	5.031		5.031	5.031

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 for financial reporting purposes. Canada Revenue Agency allows a CCA rate of

30%

on the equipment for tax purposes. The report concludes that because the project will increase earnings by

$5.031

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

$50.31

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

$10

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?

a. Given the available​ information, what are the free cash flows in years 0 through 10 that should be used to evaluate the p

Answer 1

CCA schedule (with the half-rule):

Tax rate = 35% (as calculated using the given net operating income and income tax)

For free cash flow, instead of straight-line depreciation, we need to use CCA tax shield directly, remove 0.68 million p.a. of SG&A cost as that is sunk cost amd include increase in NWC.

Free cash flows calculation: