You are a manager at Northern$$ Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your$$ office, drops a$$ consultant's report on your$$ desk, and$$ complains, $"$We owe these consultants $$1\mathrm{.}1$ 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$$ straight$-$line depreciation for the new equipment that will be purchased today$($year $0),$ which is what the accounting department recommended for financial reporting purposes. CRA allows a CCA rate of $45\%$ on the equipment for tax purposes. The report concludes that because the project will increase earnings by $ $4\mathrm{.}498$ million per year for ten$$ years, the project is worth $ $44\mathrm{.}98$ million. You think back to your glory 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 $ $12$ million in working capital up front$($year $0),$ which will be fully recovered in year $10.$ Next you see they have attributed $ $2\mathrm{.}08$ million of$$ selling, general and administrative expenses to the$$ project, but you know that $ $1\mathrm{.}04$ 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$!$

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Part $1$

You are a manager at Northern$$ Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your$$ office, drops a$$ consultant's report on your$$ desk, and$$ complains, $"$We owe these consultants $ $1\mathrm{.}1$ million for this$$ 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$)$:

$1$

$2$

$...$

$9$

$10$

Sales revenue

$29\mathrm{.}000$

$29\mathrm{.}000$

$29\mathrm{.}000$

$29\mathrm{.}000$

minusCost of goods sold

$17\mathrm{.}400$

$17\mathrm{.}400$

$17\mathrm{.}400$

$17\mathrm{.}400$

equalsGross profit

$11\mathrm{.}600$

$11\mathrm{.}600$

$11\mathrm{.}600$

$11\mathrm{.}600$

minus$$General$,$sales$,$ and administrative expenses

$2\mathrm{.}080$

$2\mathrm{.}080$

$2\mathrm{.}080$

$2\mathrm{.}080$

minusDepreciation

$2\mathrm{.}600$

$2\mathrm{.}600$

$2\mathrm{.}600$

$2\mathrm{.}600$

equalsNet operating income

$6\mathrm{.}9200$

$6\mathrm{.}9200$

$6\mathrm{.}9200$

$6\mathrm{.}9200$

minusIncome tax

$2\mathrm{.}422$

$2\mathrm{.}422$

$2\mathrm{.}422$

$2\mathrm{.}422$

equalsNet income

$4\mathrm{.}498$

$4\mathrm{.}498$

$4\mathrm{.}498$

$4\mathrm{.}498$

All of the estimates in the report seem correct. You note that the consultants used$$ straight$-$line depreciation for the new equipment that will be purchased today$($year $0),$ which is what the accounting department recommended for financial reporting purposes. CRA allows a CCA rate of $45\%$ on the equipment for tax purposes. The report concludes that because the project will increase earnings by $ $4\mathrm{.}498$ million per year for ten$$ years, the project is worth $ $44\mathrm{.}98$ million. You think back to your glory 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 $ $12$ million in working capital up front$($year $0),$ which will be fully recovered in year $10.$ Next you see they have attributed $ $2\mathrm{.}08$ million of$$ selling, general and administrative expenses to the$$ project, but you know that $ $1\mathrm{.}04$ 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$!$

b$.$ If the cost of capital for this project is $9\%,$ what is your estimate of the value of the new$$ project?