15. You are a manager at Northern Fibre, which is considering expanding its operations in synthetic fibre manufacturing. Your boss comes into your office, drops a consultant's report on your desk, and complains, "We owe these consultants $1.2 million for this report, and I am not sure their analysis makes sense. Before
we spend the $28 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):
1
2
9
10
Sales revenue
28.000 28.000
28.000 28.000
- Cost of goods sold
16.800 16.800
16.800 16.800
= Gross profit
11.200 11.200
11.200 11.200
- General, sales, and administrative expenses 2.240 2.240
2.240 2.240
- Depreciation
2.800 2.800
2.800 2.800
= Net operating income
6.1600 6.1600
6.1600 6.1600
- Income tax
2.156 2.156
2.156 2.156
= Net income
4.004 4.004
4.004 4.004
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 o), which is what the accounting department recommended for financial reporting purposes. CRA allows a CCA rate of 45% on the equipment for tax
purposes. The report concludes that because the project will increase earnings by $4.004 million per year for ten years, the project is worth $40.04 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 factored in the fact that the project will require S13 million in working capital up front (year o), which will be fully
recovered in year 10. Next you see they have attributed $2.24 million of selling, general and administrative expenses to the project, but you know that $1.12
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!
b. If the cost of capital for this project is 11%, what is your estimate of the value of the new project?
b. If the cost of capital for this project is 11%, what is your estimate of the value of the new project?
Value of project = 5
million (Round to three decimal places.)