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# Caledonia Products Mini Case Capital Budgeting

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Caledonia Products. Round any dollar amounts to the nearest dollar (\$1,500,074) and any percentages to two decimals (9.56%).

Mini Case

It's been 2 months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both 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 years 1 through 4, \$260/unit in year 5
Variable cost per unit \$180/unit
Annual fixed costs \$200,000 per year in years 1-5
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?

##### Solution Summary

Your tutorial is 766 words plus schedules in Excel showing the after tax cash flows, NPV, IRR and cash flow diagram.

##### Solution Preview

Caledonia Capital Budgeting

I have analyzed the case, including creating some schedules in Excel (attached). In addition, I will explain some basic concepts about capital budgeting for your view. Each concept has a heading to make it easier to follow.

A. Cash flows vs. accounting profits

Cash is available to put to work. You cannot pay for things with profits, you need cash. Profits are transactions that may or may not yet be settled in cash. It may take time before they turn into cash and so cash flow is the best measure of what is spendable in the current period. Operating cash flows and profits can be very similar, but cash flows included non-profit related items such as working capital, long term purchases, and proceeds from selling assets.

B. Depreciation's impact on free cash flows

Depreciation is a non-cash expense. So, it is not a cash outflow. However the depreciation deduction does shelter taxable income and so the tax benefit of depreciation does increase free cash flows by reducing the check to the taxing authorities.

C. Sunk costs

Sunk costs are past or committed funds that will be paid out regardless of the investment decision. These are ...

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• BSc, University of Virginia
• MSc, University of Virginia
• PhD, Georgia State University
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