Question

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 $1.9 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):Project Year Earnings Forecast ($000,000s) Sales revenue - Cost of goods sold 2 10 35.000 35.000 21.000 21.000 14.000 14.000 2.240 2.240 2.800 2.800 8.9600 8.9600 3.136 3.136 5.824 5.824 35.000 35.000 21.000 21.000 14.000 4.000 2.240 2.800 8.9600 8.9600 3.136 5.824 Gross profit 2.240 2.800 - General, sales, and administrative expenses Depreciation Net operating income 3.136 - Income tax -Net income 5.824All 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. Canada Revenue Agency allows a CCA rate of 45 % on the equipment for tax purposes. The report concludes that because the project will increase earnings by $ 5.824 million per year for ten years, the project is worth$ 58.24million. 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 $ 7 million in working capital upfront (year 0), 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!

Answer 1

To assess the project's viability, consider the total economic profit by adjusting the earnings forecast with relevant costs, not just accounting earnings, including $7 million of working capital and subtracting implicit expenses such as overhead.

Step-by-step explanation:

When evaluating the consultant's report on Northern Fibre's expansion project, it is crucial to consider not only the accounting earnings but also the true economic profit of the project. The analysis should consider the upfront $7 million working capital, recoverable at the end of the project, and only the portion of selling, general, and administrative expenses directly attributable to the project ($1.12 million being fixed overhead costs).

To arrive at the true economic profit, you need to adjust the earnings forecast by subtracting both explicit and implicit costs: the total revenues minus the explicit costs (that is directly related to the project) and the implicit costs (like the overhead costs that will occur regardless of the project's acceptance). This will offer a clearer picture of the project's viability.