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 $ 1.2 million for this​ report, and I am not sure their analysis makes sense. Before we spend the $ 19 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): ​ 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 $ 4.277 million per year for ten​ years, the project is worth $ 42.77 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 $ 1.52 million of​ selling, general and administrative expenses to the​ project, but you know that $ 0.76 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 9 %​, what is your estimate of the value of the new​ project?

(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 (S million) Sales revenue - Cost of goods sold 2 10 25.000 25.000 15.000 15.000 10.000 10.000 520 1.520 1.900 1.900 6.580 6.580 2.303 2.303 4.277 4.277 25.000 25.000 15.000 10.000 1.520 1.900 6.580 2.303 4.277 15.000 10.000 1.520 1.900 6.580 2.303 4.277 Gross profit - Selling, general, and administrative expenses - Depreciation Net operating income - Income tax Net unlevered income

Answer 1

Answer (a):

Since $ 0.76 million of selling, general and administrative overhead will be incurred even if the project is not accepted, relevant amount of .selling, general and administrative overhead is = 1.520 - 0.76 = $0.76 million

Income tax rate = Income tax / Net Operating income = 2.303 / 6.580 = 35%

Year 0 Working capital amount required = $10 million

Year 10 recovery of working capital= $10 million

To get free cash flow, we have to add back depreciation to net unlevered income

Free cash flows in years 0 through 10 that should be used to evaluate the proposed​ project are as follows:

Answer (b)

Estimate of the value of the new​ project = $37,036,302.59 = $37.04 million

NPV workings are as below: