It’s been two months since you took a position as an assistant financial analyst
ID: 2663467 • Letter: I
Question
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.
8. what is its net present value?
9. what is its internal rate of return?
Explanation / Answer
8. what is its net present value? Year Units Sold contribution fixed cost net income Cash flow Net present value (net of Tax) 1 70,000 8,400,000 200,000 8,200,000 5,412,000 4,706,113 2 120,000 14,400,000 200,000 14,200,000 9,372,000 7,086,544 3 140,000 16,800,000 200,000 16,600,000 10,956,000 7,203,789 4 80,000 6,400,000 200,000 6,200,000 4,092,000 2,339,601 5 60,000 4,800,000 200,000 4,600,000 3,036,000 1,509,438 TOTAL 22,845,485 Less: Capital investment 7,900,000 Net present value 14,945,485 IRR IS MORE THAN 15%
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