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 consultant $ 1.1 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $23 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 ($000,000s) 1 2 10 Sales revenue 29.000 29.000 29.000 29.000 -Cost of goods sold = Gross profit -Selling, general, and administrative expenses -Depreciation = Net operating income 17.400 17.400 17.400 17.400 11.600 11.600 11.600 11.600 1.840 1.840 1.840 1.840 2.300 2.300 2.300 2.300 7.4600 7.4600 7.4600 7.4600 2.611 -Income tax 2.611 2.611 2.611 = Net income 4.849 4.849 4.849 4.849

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 45% on the equipment for tax purposes. The report concludes that because the project will increase earnings by $4.849 million per year for ten​ years, the project is worth $48.49 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 $1.84 million of​ selling, general and administrative expenses to the​ project, but you know that $0.92 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?

Answer 1

							0.35
			Cash Flow in Year 0
		A	Cost of new equipment	($23.00)	million
		B	Net Working Capital	($7.00)	million
		C=A+B	Total Initial Cash Flow	($30.00)	million
		N	Year	0	1	2	3	4	5	6	7	8	9	10
		a	Initial Cash Flow	-$30,000,000
			Annual Cash Flows:
		b	Gross Profit		$11,600,000	$11,600,000	$11,600,000	$11,600,000	$11,600,000	$11,600,000	$11,600,000	$11,600,000	$11,600,000	$11,600,000
		c	Selling , General and Admin. Expenses		($920,000)	($920,000)	($920,000)	($920,000)	($920,000)	($920,000)	($920,000)	($920,000)	($920,000)	($920,000)
		d	Book Value of equipment in the beginning		$23,000,000	$12,650,000	$6,957,500	$3,826,625	$2,104,644	$1,157,554	$636,655	$350,160	$192,588	$105,923
		e	CCA Rate		45%	45%	45%	45%	45%	45%	45%	45%	45%	45%
		f=-d*e	Depreciation Expense		($10,350,000)	($5,692,500)	($3,130,875)	($1,721,981)	($947,090)	($520,899)	($286,495)	($157,572)	($86,665)	($47,666)
		g=d+f	Book Value of equipment at the end		$12,650,000	$6,957,500	$3,826,625	$2,104,644	$1,157,554	$636,655	$350,160	$192,588	$105,923	$58,258
		h=b+c+f	Operating Income before tax		$330,000	$4,987,500	$7,549,125	$8,958,019	$9,732,910	$10,159,101	$10,393,505	$10,522,428	$10,593,335	$10,632,334
		i=h*35%	Income tax		($115,500)	($1,745,625)	($2,642,194)	($3,135,307)	($3,406,519)	($3,555,685)	($3,637,727)	($3,682,850)	($3,707,667)	($3,721,317)
		j=h+i	After tax Operating Income		$214,500	$3,241,875	$4,906,931	$5,822,712	$6,326,392	$6,603,415	$6,755,778	$6,839,578	$6,885,668	$6,911,017
		k	Add: Depreciation(Non cash Expense)		$10,350,000	$5,692,500	$3,130,875	$1,721,981	$947,090	$520,899	$286,495	$157,572	$86,665	$47,666
		l=j+k	Operating Cash Flow		$10,564,500	$8,934,375	$8,037,806	$7,544,693	$7,273,481	$7,124,315	$7,042,273	$6,997,150	$6,972,333	$6,958,683
		m	Terminal release working Caipital											$7,000,000
		CF=a+l+m	Net Cash Flow	($30,000,000)	$10,564,500	$8,934,375	$8,037,806	$7,544,693	$7,273,481	$7,124,315	$7,042,273	$6,997,150	$6,972,333	$13,958,683
			Net Cash Flow(Million Dollars)	($30.000)	$10.565	$8.934	$8.038	$7.545	$7.273	$7.124	$7.042	$6.997	$6.972	$13.959