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
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 $1.5million for this report, and I am not sure their analysis makes sense. Before we spend the$23.1million 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):
Earnings Forecast 1 2 . . . 9 10 Sales Revenue 35.000 35.000 35.000 35.000 - Cost of Goods Sold 21.000 21.000 21.000 21.000 Gross Profit 14.000 14.000 14.000 14.000 - General, Sales and Administrative expenses 1.848 1.848 1.848 1.848 - Depreciation 2.310 2.310 2.310 2.310 Net Operating Income 9.842 9.842 9.842 9.842 - Income Tax 3.445 3.445 3.445 3.445 Net Income 6.397 6.397 6.397 6.397
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. They also calculated the depreciation assuming no salvage value for the equipment. The report concludes that because the project will increase earnings by$6.397 million per year for 10 years, the project is worth $63.97 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 included the fact that the project will require $10.2 million in working capital up front (year 0), which will be fully recovered in year 10. Next, you see they have attributed $1.848 million of selling, general, and administrative expenses to the project, but you know that $0.924 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!
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 is15%,what is your estimate of the value of the new project?
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 $1.5 million for this report, and I am not sure their analysis makes sense. Before we spend the $23.1 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): Project Year Earnings Forecast 1. 2 9 10 Sales Revenue 35.000 35.000 35.000 35.000 - Cost of Goods Sold 21.000 21.000 21.000 21.000 = Gross Profit 14.000 14.000 14.000 14.000 - General, Sales and Administrative Expenses 1.848 1.848 1.848 1.848 - Depreciation 2.310 2.310 2.310 2.310 = Net Operating Income 9.842 9.842 9.842 9.842 - Income Tax 3.445 3.445 3.445 3.445 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? The free cash flow for year 0 is $ million. (Round to three decimal places.) 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), which is what the accounting department recommended. They also calculated the depreciation assuming no salvage value for the equipment. The report concludes that because the project will increase earnings by $6.397 million per year for 10 years, the project is worth $63.97 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 included the fact that the project will require $10.2 million in working capital up front (year O), which will be fully recovered in year 10. Next, you see they have attributed $1.848 million of selling, general, and administrative expenses to the project, but you know that $0.924 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! 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 15%, what is your estimate of the value of the new projectStep by Step Solution
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