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Relevant cash flows

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Your company currently sells oversized golf clubs. The Board of Directors wants you to look at replacing them with a line of super-sized clubs. Briefly explain whether the following are relevant cash flows to this analysis and if so, how those cash flows can affects any decision.
a. $300,000 drop in sales from terminating the oversized line of clubs
b. $750,000 in land you own that may be used for the project
c. $200,000 spent on Research and Development last year on oversized clubs
d. $350,000 you will pay to Fred Singles to promote your new clubs
e. $125,000 you will receive by selling the existing production equipment which must be replaced

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a. $300,000 drop in sales from terminating the oversized line of clubs

This is called as erosion and is relevant cash flow since the reduction in sales is due to the new project. We need to reduce the cash flows of the new project by the after tax loss of income due to drop in sales by terminating the line. The cash flows will reduce and this will ...

Solution Summary

The solution explains which cash flows are relevant to decision.

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See Also This Related BrainMass Solution

Should Caledonia focus on cash flows or accounting profits in making our capital-budgeting decisions? Should we be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?

I N T E G R AT I V E P R O B LEM

It's been two 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 five years and then, because this is somewhat of a fad project, to 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 1-4, $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 five years. It is assumed that the plant and equipment will have no salvage value after five years.

1. Should Caledonia focus on cash flows or accounting profits in making our capital-budgeting decisions? Should we be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?

2. How does depreciation affect free cash flows?

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

4. What is the project's initial outlay?

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