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QUESTION 1 You are a manager at Delta Electronics, which is considering expanding its operations in LED TV manufacturing. Your boss comes into your office,
QUESTION 1 You are a manager at Delta Electronics, which is considering expanding its operations in LED TV manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, "We owe these consultants 1.25 million for this report, and I am not sure their analysis makes sense. Before we spend the 10 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 ): 1 2 3 4 5 30,000 30,000 30,000 30,000 30,000 17,500 17,500 17,500 17,500 17,500 12,500 12,500 12,500 12,500 12,500 Sales Revenue -Cost of Goods sold Gross Profit -General, Sales and admin Expenses - Depreciation Net Operating Income -Income Tax Net Income 1,430 1,430 2,000 2,000 9,070 9,070 3628 3628 5,442 5,442 1,430 1,430 2,000 2,000 9,070 9,070 3628 3628 5,442 5,442 1,430 2,000 9,070 3628 5,442 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 O). However, the tax authorities require you to use 18% reducing balance method and you have estimated that the residual value of the equipment after 5 years is 20,000. The report concludes that because the project will increase earnings by 5.442 million per year for 5 years, the project is worth 54.42 million. You think back to your finance 1 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 5. Next, you see they have attributed 1.34 million of selling, general and administrative expenses to the project, but you know that 0.75 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! REQUIRED: a) Given the available information, what are the free cash flows in years 0 through 5 that should be used to evaluate the proposed project? (8%) b) If the cost of capital for this project is 10%, what is your estimate of the value of the new project? (3%) c) The board of directors have never been on a finance course and do not understand any of the finance jargon. However, they have asked you to persuade them that the appraisal method you have used in part b above can be relied on. Prepare a report for the board of directors explaining the reasoning and justification for using your chosen project appraisal 3 Continued Overleaf
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