following incremental free cash flow projections B u s i n e s s F i n a n c e

1. 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 $1.4

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): (Open the attached file (data-10_12_2020-2_06 AM) in order to copy its contents into a spreadsheet.)

	Project Year
Earnings Forecast ($ million)	1	2	. . .	9	10
Sales revenue	35.000	35.000		35.000	35.000
−Cost of goods sold	21.000	21.000		21.000	21.000
=Gross profit	14.000	14.000		14.000	14.000
−Selling, general, and administrative expenses	2.320	2.320		2.320	2.320
−Depreciation	2.900	2.900		2.900	2.900
=Net operating income	8.780	8.780		8.780	8.780
−Income tax	1.756	1.756		1.756	1.756
=Net unlevered income	7.024	7.024		7.024	7.024

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 $7.024 million per year for ten years, the project is worth $70.24 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 $2.32 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?

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?

The free cash flow for year 0 is $ million. (Round to three decimal places and enter a decrease as a negative number.)

2. A bicycle manufacturer currently produces 294,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.40 per chain. The necessary machinery would cost $227,000 and would be obsolete after ten years. This investment could be depreciated to zero for tax purposes using a ten-year straight-line depreciation schedule. The plant manager estimates that the operation would require $24,000 of inventory and other working capital upfront (year 0), but argues that this sum can be ignored since it is recoverable at the end of the ten years. Expected proceeds from scrapping the machinery after ten years are $17,025. If the company pays tax at a rate of 20% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Project the annual free cash flows (FCF) of buying the chains.

The annual free cash flows for years 1 to 10 of buying the chains is $.(Round to the nearest dollar. Enter a free cash outflow as a negative number.)

3. Beryl’s Iced Tea currently rents a bottling machine for $54,000 per year, including all maintenance expenses. It is considering purchasing a machine instead, and is comparing two options:

a. Purchase the machine it is currently renting for $160,000. This machine will require $23,000 per year in ongoing maintenance expenses.

b. Purchase a new, more advanced machine for $260,000. This machine will require $15,000 per year in ongoing maintenance expenses and will lower bottling costs by $12,000 per year. Also, $37,000 will be spent upfront training the new operators of the machine.

Suppose the appropriate discount rate is 9%

per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the machine. Assume also that the machines will be depreciated via the straight-line method over seven years and that they have a ten-year life with a negligible salvage value. The corporate tax rate is 20%.
Should Beryl’s Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine? To make this decision, calculate the NPV of the FCF associated with each alternative.

Note: the NPV will be negative, and represents the PV of the costs of the machine in each case.

The NPV of renting the machine is $._________ (Round to the nearest dollar. Enter a negative NPV as a negative value.)

4. Arnold Inc. is considering a proposal to manufacture high-end protein bars used as food supplements by body builders. The project requires use of an existing warehouse, which the firm acquired three years ago for $1 million and which it currently rents out for $138,000. Rental rates are not expected to change going forward. In addition to using the warehouse, the project requires an upfront investment into machines and other equipment of $1.4 million. This investment can be fully depreciated straight-line over the next 10 years for tax purposes. However, Arnold Inc. expects to terminate the project at the end of eight years and to sell the machines and equipment for $585,000. Finally, the project requires an initial investment into net working capital equal to 10 percent of predicted first-year sales. Subsequently, net working capital is 10 percent of the predicted sales over the following year. Sales of protein bars are expected to be $4.7 million in the first year and to stay constant for eight years. Total manufacturing costs and operating expenses (excluding depreciation) are 80 percent of sales, and profits are taxed at 30 percent.

a. What are the free cash flows of the project?

b. If the cost of capital is 15%, what is the NPV of the project?

a. What are the free cash flows of the project?

The FCF for year 0 is $million. (Round to three decimal places.)

5. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12.2% to evaluate this project. Based on extensive research, it has prepared the following incremental free cash flow projections (in millions of dollars): I have attached a file (data-10_12_2020-2_23 AM) for solving this question.

a. For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?

b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the NPV of this project if revenues are 8% higher than forecast? What is the NPV if revenues are 8% lower than forecast?

c. Rather than assuming that cash flows for this project are constant, management would like to explore the sensitivity of its analysis to possible growth in revenues and operating expenses. Specifically, management would like to assume that revenues, manufacturing expenses, and marketing expenses are as given in the table for year 1 and grow by 2% per year every year starting in year 2. Management also plans to assume that the initial capital expenditures (and therefore depreciation), additions to working capital, and continuation value remain as initially specified in the table. What is the NPV of this project under these alternative assumptions? How does the NPV change if the revenues and operating expenses grow by 6% per year rather than by 2%?

d. To examine the sensitivity of this (base-case scenario) project to the discount rate, management would like to compute the NPV for different discount rates. Create a graph, with the discount rate on the x-axis and the NPV on the y-axis, for discount rates ranging from 5% to 30%.

For what ranges of discount rates does the project have a positive NPV?

a. For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?

The NPV of the estimated free cash flow is $ million. (Round to two decimal places.)