Part 2: Capital Budgeting Analysis Impressed by your answers in Part 1, you have been given...
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Part 2: Capital Budgeting Analysis Impressed by your answers in Part 1, you have been given the job offer and accepted the position. A few days later, your new boss, Michael Scott, stops by your cubicle, drops a consultant's report on your desk, and complains, "We owe these consultants a lot of money 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 and give me your opinion." You open the report and find the following estimates (in thousands of dollars) Project Year 1 2 9 10 Sales revenue 30,000 30,000 30,000 30,000 Cost of goods 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 O), which is what Kevin Malone in 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 your Finance 207 class and realize more work is needed! First, you note that the consultants have not factored in that the project will require $10 million in working capital upfront (year 0), which you add to the cost of the equipment, but this $10 million 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 th will be incurred even if the project is not accepted, so you deduct this amount. Finallyu know that accounting earnings are not the right thing to focus on, you know that free cash flow is the correct measure, and that can be obtained by calculating the new net income and adding back the depreciation. 1. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project? Create an Excel spreadsheet that shows how you derive your cash flows for the project. 2. If the weighted average cost of capital WACC for this project is 11%, what is your estimate of the new project's net present value (NPV)? Part 2: Capital Budgeting Analysis Impressed by your answers in Part 1, you have been given the job offer and accepted the position. A few days later, your new boss, Michael Scott, stops by your cubicle, drops a consultant's report on your desk, and complains, "We owe these consultants a lot of money 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 and give me your opinion." You open the report and find the following estimates (in thousands of dollars) Project Year 1 2 9 10 Sales revenue 30,000 30,000 30,000 30,000 Cost of goods 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 O), which is what Kevin Malone in 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 your Finance 207 class and realize more work is needed! First, you note that the consultants have not factored in that the project will require $10 million in working capital upfront (year 0), which you add to the cost of the equipment, but this $10 million 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 th will be incurred even if the project is not accepted, so you deduct this amount. Finallyu know that accounting earnings are not the right thing to focus on, you know that free cash flow is the correct measure, and that can be obtained by calculating the new net income and adding back the depreciation. 1. Given the available information, what are the free cash flows in years 0 through 10 that should be used to evaluate the proposed project? Create an Excel spreadsheet that shows how you derive your cash flows for the project. 2. If the weighted average cost of capital WACC for this project is 11%, what is your estimate of the new project's net present value (NPV)?
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