You are a manager at Percolated Fiber, which is considering expanding its operat
ID: 2795212 • Letter: Y
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 aconsultant's report on your desk, and complains, "We owe these consultants $ 1.1 million for this report, and I am not sure their analysis makes sense. Before we spend the $ 27 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 ofdollars):
(Click on the Icon located on the top-right corner of the data table below in order to copy its contents into a spreadsheet.)
(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 ($ million)
1
2
. . .
9
10
Sales revenue
33.000
33.000
33.000
33.000
minusCost
19.800
19.800
19.800
19.800
equals=Gross
13.200
13.200
13.200
13.200
minusSelling,
2.160
2.160
2.160
2.160
minusDepreciation
2.700
2.700
2.700
2.700
equals=Net
8.340
8.340
8.340
8.340
minusIncome
2.919
2.919
2.919
2.919
equals=Net
5.421
5.421
5.421
5.421
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 $ 5.421 million per year for ten years, the project is worth $ 54.21 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 $ 9 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $ 2.16 million of selling, general and administrative expenses to the project, but you know that $ 1.08 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 8%
what is your estimate of the value of the new project?
______________________________________________________________________________________________________________
Project Year
Earnings Forecast ($ million)
1
2
. . .
9
10
Sales revenue
33.000
33.000
33.000
33.000
minusCost
of goods sold19.800
19.800
19.800
19.800
equals=Gross
profit13.200
13.200
13.200
13.200
minusSelling,
general, and administrative expenses2.160
2.160
2.160
2.160
minusDepreciation
2.700
2.700
2.700
2.700
equals=Net
operating income8.340
8.340
8.340
8.340
minusIncome
tax2.919
2.919
2.919
2.919
equals=Net
unlevered income5.421
5.421
5.421
5.421
Explanation / Answer
a) FCF: 0 1 2 3 4 5 6 7 8 9 10 Sales 33.000 33.000 33.000 33.000 33.000 33.000 33.000 33.000 33.000 33.000 Cost of goods sold 19.800 19.800 19.800 19.800 19.800 19.800 19.800 19.800 19.800 19.800 SG&A 1.080 1.080 1.080 1.080 1.080 1.080 1.080 1.080 1.080 1.080 Depreciation 2.700 2.700 2.700 2.700 2.700 2.700 2.700 2.700 2.700 2.700 Net operating income 9.420 9.420 9.420 9.420 9.420 9.420 9.420 9.420 9.420 9.420 Tax at 35% 3.297 3.297 3.297 3.297 3.297 3.297 3.297 3.297 3.297 3.297 NOPAT 6.123 6.123 6.123 6.123 6.123 6.123 6.123 6.123 6.123 6.123 Add: Depreciation 2.700 2.700 2.700 2.700 2.700 2.700 2.700 2.700 2.700 2.700 Operating cash flow 8.823 8.823 8.823 8.823 8.823 8.823 8.823 8.823 8.823 8.823 Capital spending 27.000 Change in NWC 9.000 -9.000 FCF -36.000 8.823 8.823 8.823 8.823 8.823 8.823 8.823 8.823 8.823 17.823 b) NPV: PVIFA at 8% 1 0.92593 0.85734 0.79383 0.73503 0.68058 0.63017 0.58349 0.54027 0.50025 0.46319 PV at 8% -36.000 8.169 7.564 7.004 6.485 6.005 5.560 5.148 4.767 4.414 8.255 NPV (Value of the new project) $ 27.372 million
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