Question

THE YEARS 1-9 ARE NOT SUPPOSE TO BE THE SAME IN EACH YEAR'S FINAL CASH FLOW BECAUSE ITS INCORRECT. FOR INSTANCE, YEARS 1-9 ARE NOT SUPPOSE TO BE 7.227 EACH YEAR. RATHER, ITS SUPPOSE TO BE A DIFFERENT NUMBER EACH YEAR.

You are a manager at Northern​ 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 $1.9 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):

1 2 9 10 27.000 16.200 Sales revenue - Cost of goods sold = Gross profit - General, sales, and administrative expenses - Depreciation = Net operating income - Income tax = Net income 27.000 16.200 10.800 1.840 2.300 6.6600 2.331 4.329 10.800 1.840 2.300 6.6600 2.331 4.329 27.000 16.200 10.800 1.840 2.300 6.6600 2.331 4.329 27.000 16.200 10.800 1.840 2.300 6.6600 2.331 4.329

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. CRA allows a CCA rate of 30% on the equipment for tax purposes. The report concludes that because the project will increase earnings by $4.329 million per year for ten​ years, the project is worth $43.29 million. You think back to your glory 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 $11 million in working capital up front​ (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!

QUESTION

If the cost of capital for this project is 15%​, what is your estimate of the value of the new​ project?

Value of Project= $ ______ million (Round your answer to three decimal places.)

Answer 1

Solution:

	0 (million)	1 (million)	2 (million)	3 (million)	4 (million)	5 (million)	6 (million)	7 (million)	8 (million)	9 (million)	10 (million)
Initial investment	( 24.9)
Working capital	( 11)
After tax cashflow		1.742	1.742	1.742	1.742	1.742	1.742	1.742	1.742	1.742	1.742
Depreciation tax shield		1.077	1.077	1.077	1.077	1.077	1.077	1.077	1.077	1.077	1.077
Recovery of working capital											11
Total cashflow	(35.9)	2.819	2.819	2.819	2.819	2.819	2.819	2.819	2.819	2.819	13.819

Cost of capital =15%

cost of capital 15% present factor =

year 1 2 3 4 5 6 7 8 9 10

.869 .756 .657 .571 .497 .432 .375 .326 .284 .247

Value of the project = 39.19 - 35.9 = 3.29 million