You are a manager at Percolated Fiber, which is considering expanding its operat
ID: 2812339 • 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 a consultant's report on your desk, and complains, "We owe these consultants $1.3 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):
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 $5.278 million per year for tenyears, the project is worth $52.78 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 $15 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 proposedproject?
b. If the cost of capital for this project is 16%, what is your estimate of the value of the new project?
Project Year Earnings Forecast ($000,000s) 1 2 . . . 9 10 Sales revenue 32 32 32 32 - Cost of goods sold 19.2 19.2 19.2 19.2 =Gross profit 12.8 12.8 12.8 12.8 - Selling, general, and administrative expenses 2.08 2.08 2.08 2.08 - Depreciation 2.6 2.6 2.6 2.6 = Net operating income 8.12 8.12 8.12 8.12 - Income tax 2.842 2.842 2.842 2.842 = Net unlevered income 5.278 5.278 5.278 5.278All 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 $5.278 million per year for tenyears, the project is worth $52.78 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 $15 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 proposedproject?
b. If the cost of capital for this project is 16%, what is your estimate of the value of the new project?
Explanation / Answer
year
0
1
2
3
4
5
6
7
8
9
10
cost of machine
-26
investment in working capital
-15
sales
32
32
32
32
32
32
32
32
32
32
less cost of goods sold
19.2
19.2
19.2
19.2
19.2
19.2
19.2
19.2
19.2
19.2
less depreciation
2.6
2.6
2.6
2.6
2.6
2.6
2.6
2.6
2.6
2.6
less selling expense
1.04
1.04
1.04
1.04
1.04
1.04
1.04
1.04
1.04
1.04
operating profit
9.16
9.16
9.16
9.16
9.16
9.16
9.16
9.16
9.16
9.16
after tax profit = operating profit*(1-tax rate)
5.954
5.954
5.954
5.954
5.954
5.954
5.954
5.954
5.954
5.954
operating cash flow = profit after tax+ depreciation
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
net operating cash flow =operating cash flow + recovery of working capital in year 10
-41
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
23.554
present value of cash flow = cash flow/(1+r)^n r= 16%
-41
7.374138
6.357015
5.480185739
4.724298051
4.072671
3.510923
3.026658
2.609188
2.2493
5.339306
NPV = sum of present value of cash flow
3.74368
year
0
1
2
3
4
5
6
7
8
9
10
cost of machine
-26
investment in working capital
-15
sales
32
32
32
32
32
32
32
32
32
32
less cost of goods sold
19.2
19.2
19.2
19.2
19.2
19.2
19.2
19.2
19.2
19.2
less depreciation
2.6
2.6
2.6
2.6
2.6
2.6
2.6
2.6
2.6
2.6
less selling expense
1.04
1.04
1.04
1.04
1.04
1.04
1.04
1.04
1.04
1.04
operating profit
9.16
9.16
9.16
9.16
9.16
9.16
9.16
9.16
9.16
9.16
after tax profit = operating profit*(1-tax rate)
5.954
5.954
5.954
5.954
5.954
5.954
5.954
5.954
5.954
5.954
operating cash flow = profit after tax+ depreciation
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
net operating cash flow =operating cash flow + recovery of working capital in year 10
-41
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
8.554
23.554
present value of cash flow = cash flow/(1+r)^n r= 16%
-41
7.374138
6.357015
5.480185739
4.724298051
4.072671
3.510923
3.026658
2.609188
2.2493
5.339306
NPV = sum of present value of cash flow
3.74368
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