Problem:
You are a manger at Percolated Fiber, which is considering expanding its operation 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 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 and give me your opinion. "You open the report and find the following estimates (in thousand of dollars):
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|
|
|
|
Project Year |
|
|
| |
|
|
|
1 |
2 |
*** |
9 |
10 |
| Sales revenue |
|
|
|
30,000 |
30,000 |
|
30,000 |
30,000 |
| -cost of goods sold |
|
|
|
18,000 |
18,000 |
|
18,000 |
18,000 |
| =gross profit |
|
|
|
12,000 |
12,000 |
|
12,000 |
12,000 |
| -general, sales, and administrative expenses |
|
2,000 |
2,000 |
|
2,000 |
2,000 |
| -depreciation |
|
|
|
2,500 |
2,500 |
|
2,500 |
2,500 |
| =net operating 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 |
|
4,875 |
4,875 |
All of the estimates in the report seem correct. You note that the consultants used straingt-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 ten years, the project is worth $48.75 million.
You think back to your halcyon days in finance class and realize ther eis 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 $2million of selling, general and administrative expenses to the project but you know that $1million 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.
Q1. What are the free cash flows in years 2 and 10 that should be used to evaluate the proposed project?
Free cash flow for the following years:
Year 2 =
Year 10 =
Q2. If the cost of capital for this project is 14%, what is your estimate of the value of the new project?