You are a manager at PercolatedFiber, which is considering expanding its operations in synthetic fiber manufacturing. Your boss comes into youroffice, drops aconsultant's report on yourdesk, andcomplains, "We owe these consultants $1.2 million for thisreport, and I am not sure their analysis makes sense. Before we spend the $30 million on new equipment needed for thisproject, look it over and give me youropinion." You open the report and find the following estimates(in millions ofdollars):

(Click on the Icon located on thetop-right corner of the data table below in order to copy its contents into aspreadsheet.)

Project Year

Earnings Forecast($ million)

1

2

. . .

9

10

Sales revenue

34.000

34.000

34.000

34.000

Cost of goods sold

20.400

20.400

20.400

20.400

=Gross profit

13.600

13.600

13.600

13.600

Selling, general, and administrative expenses

2.400

2.400

2.400

2.400

Depreciation

3.000

3.000

3.000

3.000

=Net operating income

8.200

8.200

8.200

8.200

Income tax

2.87

2.87

2.87

2.87

=Net unlevered income

5.330

5.330

5.330

5.330

All of the estimates in the report seem correct. You note that the consultants usedstraight-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 $5.330 million per year for tenyears, the project is worth $53.3 million. You think back to your halcyon days in finance class and realize there is more work to bedone!

First, you note that the consultants have not factored in the fact that the project will require $13 million in working capital upfront(year 0), which will be fully recovered in year 10.Next, you see they have attributed $2.4 million ofselling, general and administrative expenses to theproject, but you know that $1.2 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 focuson!

a. Given the availableinformation, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposedproject?

b. If the cost of capital for this project is 16%, what is your estimate of the value of the newproject?