You have just been hired as the CFO of super constructor, a large construction company. You receive the following profitability report for a new project which was made by the former CFO which left for a competing company (which competes for the same project).

At first look it seems that the former CFO has done a good job. You learned that the project will last 6 years and then it will be terminated. According to the technical department, the required initial investment in equipment for the project is $1.2 million, (which is required today). The required equipment has an expected life of 3 years, after which the firm would have to replace it with a new equipment (assume that the new equipment will be exactly the same as the old one). According to the accounting department the investment in the equipment will be depreciated in a straight line over 3 years (with no salvage value).

According to the former CFOs forecast, the first years revenues are expected to be $2,000 thousand and are expected to grow every year until the end of the project by 10%. The COGS are expected to be 70% of the revenues. You ran some tests regarding the revenues and COGS calculations and found that the reported revenues and COGS are in real figures. When you looked more closely at the forecast you saw that throughout the forecast, the former CFO did not pay attention to the effect of inflation.

In addition, the former CFO attributed $150,000 as G&A expenses. According to the accounting department this is a fixed tariff for every new project. However, you calculated and found that the incremental annual G&A expenses for this project should be $100,000. Also, you noticed that the former CFO did not take into consideration real working capital balance requirements (primary inventory) which are assumed to be 10% of annual gross real sales. The working capital is needed at the beginning of the project (time 0) and will be recovered when the project ends.

The former CFOs final conclusion was not to accept the project, He got to this conclusion by adding up the Net Operating Profit After Tax for each year and decreasing the investment (which equals to -$1,638.38).

You understand that a lot of work is needed in order to examine this project.

You found out that the companys nominal cost of capital is 15%, the annual expected inflation during the next 6 years is 2% and the tax rate is 40%.

Your CEO is asking you a simple question. Should the company undertake the project?

Guidance:

The former CFO who prepared the table above did not pay attention to the effect of inflation. You should. Think which figures in the table are given to you in real terms and which are nominal. Decide whether you want to do the analysis in real terms or in nominal terms and make the appropriate adjustments. For example, if you decide to work with real values, you dont need to adjust the sales figures because they are given in real term. On the other hand, you will have to adjust the discount rate because it is given as nominal.

year 1 2 year year 3 year 4 year 5 year 6 Revenues** 2,000 2,200 2,420 2,662 2,928 3,221 COGS 1,400 1,540 1,694 1,863 2,050 2,255 G&A expenses 150 150 150 150 150 150 Depreciation 400 400 400 400 400 400 EBIT 50 110 176 249 328 416 Interest expenses 10 10 10 10 10 10 Net Profit Before Tax 40 100 166 239 318 406 Tax 16 40 66 95 127 163 Net Profit After Tax 24 60 100 143 191 244 **revenues are in thousands of dollars and are calculated based on today's price (I.e. they are real, not nominal) year 1 2 year year 3 year 4 year 5 year 6 Revenues** 2,000 2,200 2,420 2,662 2,928 3,221 COGS 1,400 1,540 1,694 1,863 2,050 2,255 G&A expenses 150 150 150 150 150 150 Depreciation 400 400 400 400 400 400 EBIT 50 110 176 249 328 416 Interest expenses 10 10 10 10 10 10 Net Profit Before Tax 40 100 166 239 318 406 Tax 16 40 66 95 127 163 Net Profit After Tax 24 60 100 143 191 244 **revenues are in thousands of dollars and are calculated based on today's price (I.e. they are real, not nominal)