All of the estimates in the report seem correct. You note that the consultants usedstraight-line depreciation for
Question:
All of the estimates in the report seem correct. You note that the consultants usedstraight-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 $ 5.886
$5.886 million per year for 10years, the project is worth $ 58.86
$58.86 million. You think back to your glory days in finance class and realize there is more work to bedone!
First, you note that the consultants have not included the fact that the project will require $ 7.5
$7.5 million in working capital up front(year 0), which will be fully recovered in year 10.Next, you see they have attributed $ 1.664
$1.664 million ofselling, general, and administrative expenses to theproject, but you know that $ 0.832
$0.832 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 focuson!
a. Given the availableinformation, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposedproject?
b. If the cost of capital for this project is 9 %
9%, what is your estimate of the value of the newproject?