You are a Manager at Percolated Fiber, which is considering expanding its operat
ID: 2786219 • Letter: Y
Question
You are a Manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. With your Group team accompanying you, your Boss, Mr. Moneypockets, asks you to come to his office, where he gives you a consultant's report and complains, "We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over with your team and give me your opinion." You open the report and find the estimates
Project Year
1 2 -------------------------- 9 10
Sales Revenue 30,000 30,000 30,000 30,000
- COGS 18,000 18,000 18,000 18,000
= Gross profits 12,000 12,000 12,000 12,000
- General Sales 2,000 2,000 2,000 2,000
& admin expenses
- Depreciation 2,500 2,500 2,500 2,500
= Net income 7,500 7,500 7,500 7,500
- Income tax 2,625 2,625 2,625 2,625
Net income = 4,875 4,875 4875 4875
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 $4.875 million per year for 10 years, the project is worth $48.75 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 $2 million of selling, general and administrative expenses to the project, but you know that $1 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 project?
b) if the cost of capital for the project (that is, the WACC) is 13%, what is your estimate of the NPV for the new project? How does the IRR compare to the required WACC? Would you recommend to Mr. Moneypockets that this project be undertaken, and why?
c) what are some uncertainties in the FCFs that your team might see in these (presumed to be 100% correct) NPV and IRR metrics, that could cause them to not be as deterministic as you and your team are basically assuming in your presentation to Mr. Moneypocket
Explanation / Answer
Answer a.
The initial cash outlay = FCinv + WCinv
The investment in the project is $25million thus FCInv = 25 and workingcapital required is $10 million thus WCInv = 10
The initial cash outlay = FCinv + WCinv = 25+10 = 35 million
Year 0 FCF is -$35million.
After Tax non operating cashflow = (sales-cost-depreciation)(1-Tax) + Depreciation = Net income + depreciation
but as selling general and admin expenses includes sunk cost of $1million which will be incurred irrespective of the project taken or not, thus we will add $1million to the net income.
Tax rate = 2625/7500 = 35%
After Tax non operating cashflow = Net income + depreciation
= (7500+1000)*(1-0.35)+2500
=8500*0.65 + 2500
=5525 + 2500
=8025
Thus the FCF for year 1 to year 10 is 8.025 million per year
And terminal year cashflow = Salvage+WCinv-Tax*(salvage-Book value)
as salvage value is zero and the equipment is depreciation over 0 years using SLM to zero
Terminal year cashflow = 0+10-0.35(0-0)
=10million
and will add this to year 10 cashflow = 10+8.025=18.025
Answer b.
Using WACC of 13% NPV and IRR of the project are below in the spreadsheet:
year
FCF
0
-35
1
8.025
2
8.025
3
8.025
4
8.025
5
8.025
6
8.025
7
8.025
8
8.025
9
8.025
10
18.025
NPV using 13% WACC
$10.17
IRR
20.205%
Answer C. The uncertainities associated with FCFs are:
The uncertainity with the cashflow projection is the most important one as the forecast increasing beyond a certain number of years the ability to project correctly diminishes. Also some analyst might use WACC as the discount rate whereas some might use hurdle rate thus creating different FCFs projections. Even a fixed growth rate wont be applicable in the real world as the growth rate for country's keep changing in the real world.
year
FCF
0
-35
1
8.025
2
8.025
3
8.025
4
8.025
5
8.025
6
8.025
7
8.025
8
8.025
9
8.025
10
18.025
NPV using 13% WACC
$10.17
IRR
20.205%
IRR is the rate which makes the NPV of the project equal to zero whereas discount rate (WACC) is the cost of funds. As the IRR calculated of 20.205% is greater than the WACC of 13%, the project should be undertaken as also the NPV of the project is positive.Related Questions
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