8. You are a manager at Percolated Fiber, which is considering expanding its ope

Question

8. 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 $1.0 million for this report, and I am not sure their analysis makes sense. Before we spend the $25.0 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 Sales Revenue - Cost of Goods Sold 2 Gross Profit - General, Sales and Administrative Expenses - Depreciation -Net Operating Income - Income Tax 30.000 30.000 18.000 18.000 12.000 12.000 2.000 2.000 2.500 2.500 7.500 7.500 2.625 2.625 4.875 4.875 30.000 30.000 18.00018.000 12.000 2.000 2.000 2.500 7.500 2.625 4.875 2.000 2.500 7.500 2.625 4.875 Net Income 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 $4.875 million per year for 10 years the project is worth $48.75 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 $10.0 million in working capital up front (year 0), which will be fully recovered in year 10. Next, you see they have attributed $2.000 million of selling, general, and administrative expenses to the project, but you know that $1.000 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 14%, what is your estimate of the value of the new project? 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 $ The free cash flow for years 1 to 9 is $ The free cash flow for year 10 is $ b. If the cost of capital for this project is 14%, what is your estimate of the value of the new project? If the cost of capital for this project is 14%, the value of the project is $ million. (Round to three decimal places.) million. (Round to three decimal places.) million. (Round to three decimal places.) million. (Round to three decimal places.) You (1) accept the project. (Choose from the drop-down menu.) (1) O should O should not

Explanation / Answer

To properly derive the answer we need to make following steps to cashflows being presented:

1) Caluclate tax rate , which is easy, = 2.625/7.5 = 35%

2) Rectify SG&A expenses from 2 Million to 1 Million

3) Year 0 cashflows = -25 (Machine cost) and -10 (Working capital) = -35 Million (outflow in year 0)

4)Finally calculate dicsount factors at given rate of 14% to calucalte PV all cashflows and calculate NPV (formula = 1/(1+r)^T where r = dicsount factor and T = year

Results are below:

Using above table now we can answer all the questions

a) Free cash flow of year zero is -35
Cahsflows from year 1 to 9 is 5.525 Million (column titled 'h' in above table
FCF for year 10 is also 5.525 Million (since there is no salvage value of machine)

b)Value of the project or NPV is -6.181 (see value against NPV in above table)

Since NPV is less than zero, we should not acccept the project

Year Upfront Sales Revenue (a) Cogs (b) Gross profit (c=a-b) SGA (d) Depreciation (e) NOI (f = c-d-e) Income Tax (g) Net Income (h = f-g) Discount factor Discounted CF 0 -35 1 -35 1 30 18 12 1 2.5 8.5 2.975 5.525 0.877193 4.846491 2 30 18 12 1 2.5 8.5 2.975 5.525 0.769468 4.251308 3 30 18 12 1 2.5 8.5 2.975 5.525 0.674972 3.729218 4 30 18 12 1 2.5 8.5 2.975 5.525 0.59208 3.271244 5 30 18 12 1 2.5 8.5 2.975 5.525 0.519369 2.869512 6 30 18 12 1 2.5 8.5 2.975 5.525 0.455587 2.517116 7 30 18 12 1 2.5 8.5 2.975 5.525 0.399637 2.207996 8 30 18 12 1 2.5 8.5 2.975 5.525 0.350559 1.936839 9 30 18 12 1 2.5 8.5 2.975 5.525 0.307508 1.698981 10 30 18 12 1 2.5 8.5 2.975 5.525 0.269744 1.490335 NPV -6.18096

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