You are a Manager at Percolated Fiber, which is considering expanding its operations in synthetic fiber manufacturing. With your Group team accompanying you, your Boss, Mr. Moneypockets, asks you to come to his office, where he gives you a consultant's report and complains, "We owe these consultants $1 million for this report, and I am not sure their analysis makes sense. Before we spend the $25 million on new equipment needed for this project, look it over with your team and give me your opinion." You open the report and find the estimates Project Year
1 2 9 10
Sales revenue 30,000 30,000 30,000 30,000 – Cost of good sold 18,000 18,000 18,000 18,000 = Gross profit 12,000 12,000 12,000 12,000 – General, sales, and administrative expenses 2,000 2,000 2,000 2,000 – Depreciation 2,500 2,500 2,500 2,500 = Net operating income 7,500 7,500 7,500 7,500 – Income tax 2,625 2,625 2,625 2,625 = Net income 4,875 4,875 4,875 4,875
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 $4.875 million per year for 10 years, the project is worth $48.75 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 $10 million in working capital upfront (year 0), which will be fully recovered in year 10.
Next, you see they have attributed $2 million of selling, general and administrative expenses to the project, but you know that $1 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 project?
b) if the cost of capital for the project (that is, the WACC) is 13%, what is your estimate of the NPV for the new project? How does the IRR compare to the required WACC? Would you recommend to Mr. Moneypockets that this project be undertaken, and why?
c) what are some uncertainties in the FCFs that your team might see in these (presumed to be 100% correct) NPV and IRR metrics, that could cause them to not be as deterministic as you and your team are basically assuming in your presentation to Mr. Moneypocket