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 $1.6 million for this? report, and I am not sure their analysis makes sense. Before we spend the $26 million on new equipment needed for this? project, look it over and give me your? opinion.” You open the report and find the following estimates? (in millions of? dollars): ?(Click on the following icon in order to copy its contents into a? spreadsheet.)
|
Project Year |
|||||
|
Earnings Forecast? ($ million) |
1 |
2 |
. . . |
9 |
10 |
|
Sales revenue |
33.000 |
33.000 |
33.000 |
33.000 |
|
|
-Cost of goods sold |
19.800 |
19.800 |
19.800 |
19.800 |
|
|
=Gross profit |
13.200 |
13.200 |
13.200 |
13.200 |
|
|
-?Selling, ?general, and administrative expenses |
2.080 |
2.080 |
2.080 |
2.080 |
|
|
-Depreciation |
2.600 |
2.600 |
2.600 |
2.600 |
|
|
=Net operating income |
8.520 |
8.520 |
8.520 |
8.520 |
|
|
-Income tax |
1.704 |
1.704 |
1.704 |
1.704 |
|
|
=Net unlevered income |
6.816 |
6.816 |
6.816 |
6.816 |
|
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 $6.816 million per year for ten? years, the project is worth $68.16 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 $14 million in working capital upfront? (year 0), which will be fully recovered in year 10.? Next, you see they have attributed $2.08 million of? selling, general and administrative expenses to the? project, but you know that $1.04 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 is12%?, what is your estimate of the value of the new? project?
