1 9 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 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 thousands of dollars): Project Year 2 10 Sales revenue $30,000 $30,000 $30.000 $30,000 - Cost of good 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 S4,875 $4,875 S4,875 All of the estimates in the report seem correct. You note that the consultants used straightline 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 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 milion 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 14%, what is your estimate of the value of the new project? Tax rate 35% 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? Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 0 -S25,000 -$10,000 $30,000 $18,000 $12,000 $30,000 $18,000 $12,000 $30,000 $18,000 $12,000 S30,000 $18,000 $12,000 $30,000 $18,000 $30,000 $18,000 $12,000 $30,000 $18,000 $12,000 $30,000 $18,000 $12,000 $30.000 $18,000 $12,000 $10.000 $30,000 $18,000 $12,000 $12,000 $2,000 S2,000 $2,000 S2,000 $2,000 $2,000 2,000 $2,000 $2,000 $2,000 Cost of machine Change in net working capital Sales revenue Minus cost of goods sold Equals gross profit Minus General, sales and administrative expense Plus overhead that would have occurred anyway Minus depreciation Equals net operating income Minus income tax Equals Net income Plus depreciation Cost of machine plus change in net working capital Equals cash flow $1,000 $2,500 $8,500 $2,975 $5,525 $2,500 $1,000 $2,500 8,500 $2,975 $5,525 $2,500 $1,000 $2,500 $8,500 $2,975 $5,525 $2,500 $1,000 $2,500 $8,500 $2,975 $5,525 $2,500 $1,000 $2,500 $8,500 $2,975 $5,525 $2,500 $1,000 $2,500 $8,500 $2,975 $5,525 $2,500 $1,000 $2,500 $8,500 $2,975 $5,525) $2,500 $1,000 $2,500 S8,500 $2,975 $5,525 $2,500 $1,000 $2,500 $8,500 $2,975 $5,525 $2,500 $1,000 $2.500 $8,500 $2,975 $5,525 $2,500 $10,000 -S35,000 -S35,000 SO $8,025 SO S8,025) SO $8,025 SO S8,025 SO $8,025 SO $8,025 sol $8,025 SO S8,025 SO $8,025 $1,975 b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project? Cost of capital NPV 14%