MINI CASE It’s been 2 months since you took a position as an assistant financial

Question

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 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% 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 the present value?
i) What is the 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?

This is what I have so far.

DATA






Coxt of plant and equipment
7,900,000




Shipping and installation
100,000




Tax rate
34%




Required rate of return
15%




Sales Price per unit (yrs 1-4)
300




Sales Price per unit (yr 5)
260




Variable cost per unit
180




Annual fixed cost
200,000




Depreciation life
5












Section 1: Calculate EBIT






Year

1 2 3 4 5 Units Sold

70,000 120,000 140,000 80,000 60,000







Sales Revenue

21,000,000 36,000,000 42,000,000 24,000,000 15,600,000 Less: Variable Costs

12,600,000 21,600,000 25,200,000 14,400,000 10,800,000 Less: Fixed Costs

200,000 200,000 200,000 200,000 200,000 Equals: EBDIT

8,200,000 14,200,000 16,600,000 9,400,000 4,600,000 Less: Depreciation

1,600,000 1,600,000 1,600,000 1,600,000 1,600,000 Equals: EBIT

6,600,000 12,600,000 15,000,000 7,800,000 3,000,000 Taxes

2,244,000 4,284,000 5,100,000 2,652,000 1,020,000







Section 2: Calculate Operating Cash Flow




EBIT

6,600,000 12,600,000 15,000,000 7,800,000 3,000,000 Less: Taxes

2,244,000 4,284,000 5,100,000 2,652,000 1,020,000 Plus: Depreciation

1,600,000 1,600,000 1,600,000 1,600,000 1,600,000 Operating Cash Flow

5,956,000 9,916,000 11,500,000 6,748,000 3,580,000







Section 3: Calculate Net Working Capital




Revenue:

21,000,000 36,000,000 42,000,000 24,000,000 15,600,000 Initial Working Capital Requirement
100,000 100,000 100,000 100,000 100,000 Net Working Capital Needs:

2,100,000 3,600,000 4,200,000 2,400,000 1,560,000 Liquidation of Working Capital





1,560,000 Change in Working Capital:
100,000 2,000,000 1,500,000 600,000 (1,800,000) (2,400,000)







Section 4: Calculate Free Cash Flow





Operating Cash Flow

5,956,000 9,916,000 11,500,000 6,748,000 3,580,000 Minus: Change in Net Working Capital 100,000 2,000,000 1,500,000 600,000 (1,800,000) (2,400,000) Minus: Change in Capital Spending 8,000,000 0 0 0 0 0 Free Cash Flow:
(8,100,000) 3,956,000 8,416,000 10,900,000 8,548,000 5,980,000







PV =

3,440,000 6,363,705 7,166,927 4,887,347 2,973,117 NPV





IRR =
77%

Explanation / Answer

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