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

$1.1million for this​ report, and I am not sure their analysis makes sense. Before we spend the$20million 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):

	Project Year
Earnings Forecast ($000,000s)	1	2	. . .	9	10
Sales revenue	34	34		34	34
- Cost of goods sold	20.4	20.4		20.4	20.4
= Gross profit	13.6	13.6		13.6	13.6
- Selling, general, and administrative expenses	1.6	1.6		1.6	1.6
- Depreciation	2	2		2	2
= Net operating income	10	10		10	10
- Income tax	3.5	3.5		3.5	3.5
= Net unlevered income	6.5	6.5		6.5	6.5

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

$6.005million per year for ten​years, the project is worth

$65million. 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

$11million in working capital upfront​ (year 0), which will be fully recovered in year 10.​ Next, you see they have attributed

$1.6million of​ selling, general and administrative expenses to the​ project, but you know that

$0.8million 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 is8%​,what is your estimate of the value of the new​ project?

Answer 1