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 6$1 6 million for this report, and I am not sure their analysis makes sense Before we spend the $ 20$20 million on new equipment needed for this project, look it over and give me your opinion You open the report and find the following estimates (in millions of dollars) (Click on the following icon in order to copy its contents into a spreadsheet ) Project Year Earnings Forecast ($ million) 1 2 9 10 Sales revenue 25 00025 000 25 00025 000 25 00025 000 25 00025 000 minusCost of goods sold 15 00015 000 15 00015 000 15 00015 000 15 00015 000 equals Gross profit 10 00010 000 10 00010 000 10 00010 000 10 00010 000 minusSelling, general, and administrative expenses 1 6001 600 1 6001 600 1 6001 600 1 6001 600 minusDepreciation 2 0002 000 2 0002 000 2 0002 000 2 0002 000 equals Net operating income 6 4006 400 6 4006 400 6 4006 400 6 4006 400 minusIncome tax 1 281 28 1 281 28 1 281 28 1 281 28 equals Net unlevered income 5 1205 120 5 1205 120 5 1205 120 5 1205 120 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 $ 5 120$5 120 million per year for ten years, the project is worth $ 51 2$51 2 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 the fact that the project will require $ 11$11 million in working capital upfront (year 0), which will be fully recovered in year 10 Next, you see they have attributed $ 1 6$1 6 million of selling, general and administrative expenses to the project, but you know that $ 0 8$0 8 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 16 16 , what is your estimate of the value of the new project

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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

$ 1.6$1.6

million for this report, and I am not sure their analysis makes sense. Before we spend the

$ 20$20

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):(Click on the following icon

in order to copy its contents into a spreadsheet.)

	Project Year
Earnings Forecast ($ million)	1	2	. . .	9	10
Sales revenue	25.00025.000	25.00025.000		25.00025.000	25.00025.000
minusCost of goods sold	15.00015.000	15.00015.000		15.00015.000	15.00015.000
equals=Gross profit	10.00010.000	10.00010.000		10.00010.000	10.00010.000
minusSelling, general, and administrative expenses	1.6001.600	1.6001.600		1.6001.600	1.6001.600
minusDepreciation	2.0002.000	2.0002.000		2.0002.000	2.0002.000
equals=Net operating income	6.4006.400	6.4006.400		6.4006.400	6.4006.400
minusIncome tax	1.281.28	1.281.28		1.281.28	1.281.28
equals=Net unlevered income	5.1205.120	5.1205.120		5.1205.120	5.1205.120

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

$ 5.120$5.120

million per year for ten years, the project is worth

$ 51.2$51.2

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 the fact that the project will require

$ 11$11

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

$ 1.6$1.6

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

$ 0.8$0.8

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

16 %16%,

what is your estimate of the value of the new project?