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Caledonia Products Financial Analysis

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Mini Case

Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves bIt's been 2 months since you took a position as an assistant financial analyst at Caledonia Products. oth the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your assignment follows:

To: The Assistant Financial Analyst

From: Mr. V. Morrison, CEO, Caledonia Products

Re: Cash Flow Analysis and Capital Rationing

We are considering the introduction of a new product. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project:

Cost of new plant and equipment

$7,900,000

Shipping and installation costs

$100,000

Unit sales

YEAR

UNITS SOLD

1
70,000 

2
120,000 

3
140,000

4
80,000

5
60,000

Sales price per unit

$300/unit in years 1 through 4, $260/unit in year 5

Variable cost per unit

$180/unit

Annual fixed costs

$200,000

Working-capital requirements

There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method

Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years.

a. Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?

b. How does depreciation affect free cash flows?

c. How do sunk costs affect the determination of cash flows?

d. What is the project's initial outlay?

e. What are the differential cash flows over the project's life?

f. What is the terminal cash flow?

g. Draw a cash flow diagram for this project.

h. What is its net present value?

i. What is its internal rate of return?

j. Should the project be accepted? Why or why not?

k. In capital budgeting, risk can be measured from three perspectives. What are those three measures of a project's risk?

l. According to the CAPM, which measurement of a project's risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that mean for our view of the relevant measure of a project's risk?

m. Explain how simulation works. What is the value in using a simulation approach?

n. What is sensitivity analysis and what is its purpose?

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Solution Preview

See the attached Excel file.

a. Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?

ANSWER: Caledonia should focus on free cash flows in making its capital budgeting decisions because these are the flows Caledonia receives and can reinvest. By examining the company's after tax-basis cash flows, it makes an analysis possible as to the timing of the associated benefit or cost. Cash flows are analyzed on an after-tax basis because it will be the amount that flows through to the shareholders, and because it is only the incremental cash flows that are pertinent, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project, and are the increased value to the firm from the accepted project.

b. How does depreciation affect free cash flows?

ANSWER: Depreciation affects the level of the differential cash flows over the life of the project, due to its effect on taxes, even though depreciation itself is not a cash flow item. Depreciation is an expense to the company, and, the more depreciation incurred, the larger are the expenses. The effect of this is that accounting profits become lower and in turn, so do taxes, which is a cash flow item.

c. How do sunk costs affect the determination of cash flows?

ANSWER: Sunk costs are ignored when analyzing a capital budgeting problem. The only point of ...

$2.19