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 $ 1.1 million for this report, and I am not sure their analysis makes sense. Before we spend the $ 29 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 ($ million) 1 2 . . . 9 10 Sales revenue 28.00028.000 28.00028.000 28.00028.000 28.00028.000 minus−Cost of goods sold 16.80016.800 16.80016.800 16.80016.800 16.80016.800 equals=Gross profit 11.20011.200 11.20011.200 11.20011.200 11.20011.200 minus−Selling, general, and administrative expenses 2.3202.320 2.3202.320 2.3202.320 2.3202.320 minus−Depreciation 2.9002.900 2.9002.900 2.9002.900 2.9002.900 equals=Net operating income 5.9805.980 5.9805.980 5.9805.980 5.9805.980 minus−Income tax 1.1961.196 1.1961.196 1.1961.196 1.1961.196 equals=Net unlevered income 4.7844.784 4.7844.784 4.7844.784 4.7844.784 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 $ 4.784 million per year for ten years, the project is worth $ 47.84 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 $ 14 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $ 2.32 million of selling, general and administrative expenses to the project, but you know that $ 1.16 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 13 %, 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 $ 1.1 million for this report, and I am not sure their analysis makes sense. Before we spend the $ 29 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 ($ million) 1 2 . . . 9 10 Sales revenue 28.00028.000 28.00028.000 28.00028.000 28.00028.000 minus−Cost of goods sold 16.80016.800 16.80016.800 16.80016.800 16.80016.800 equals=Gross profit 11.20011.200 11.20011.200 11.20011.200 11.20011.200 minus−Selling, general, and administrative expenses 2.3202.320 2.3202.320 2.3202.320 2.3202.320 minus−Depreciation 2.9002.900 2.9002.900 2.9002.900 2.9002.900 equals=Net operating income 5.9805.980 5.9805.980 5.9805.980 5.9805.980 minus−Income tax 1.1961.196 1.1961.196 1.1961.196 1.1961.196 equals=Net unlevered income 4.7844.784 4.7844.784 4.7844.784 4.7844.784 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 $ 4.784 million per year for ten years, the project is worth $ 47.84 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 $ 14 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $ 2.32 million of selling, general and administrative expenses to the project, but you know that $ 1.16 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 13 %, what is your estimate of the value of the new project?

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Question

	Project Year
Earnings Forecast ($ million)	1	2	. . .	9	10
Sales revenue	28.00028.000	28.00028.000		28.00028.000	28.00028.000
minus−Cost of goods sold	16.80016.800	16.80016.800		16.80016.800	16.80016.800
equals=Gross profit	11.20011.200	11.20011.200		11.20011.200	11.20011.200
minus−Selling, general, and administrative expenses	2.3202.320	2.3202.320		2.3202.320	2.3202.320
minus−Depreciation	2.9002.900	2.9002.900		2.9002.900	2.9002.900
equals=Net operating income	5.9805.980	5.9805.980		5.9805.980	5.9805.980
minus−Income tax	1.1961.196	1.1961.196		1.1961.196	1.1961.196
equals=Net unlevered income	4.7844.784	4.7844.784		4.7844.784	4.7844.784

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 $ 4.784 million per year for ten years, the project is worth $ 47.84 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 $ 14 million in working capital upfront (year 0), which will be fully recovered in year 10. Next, you see they have attributed $ 2.32 million of selling, general and administrative expenses to the project, but you know that $ 1.16 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 13 %, what is your estimate of the value of the new project?

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