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You are a manager at Northern Fibre, which is considering expanding its operations in synthetic fibre manufacturing.
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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 $ 1.6 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 and give me your​ opinion." You open the report and find the following estimates​ (in millions of​ dollars):

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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 for financial reporting purposes. CRA allows a CCA rate of 30 % on the equipment for tax purposes. The report concludes that because the project will increase earnings by $ 4.095 million per year for ten​ years, the project is worth $ 40.95 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 $ 15 million in working capital up front​ (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!

b. If the cost of capital for this project is 16 %​, what is your estimate of the value of the new​ project?

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Subject: Business, Finance

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