It’s been 2 months since you took a position as an assistant financial analyst a
ID: 2674669 • Letter: I
Question
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 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?
Explanation / Answer
a. We focus on free cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after-tax basis as only those flows are available to the shareholder. In addition, it is only the incremental cash flows that interest us, 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, as such, are the increased value to the firm from accepting the project.
b. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. Thus, accounting profits become lower and in turn, so do taxes which are a cash flow item.
c. When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows, or free cash flows, to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are irrelevant.
Parts d, e and f:
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this become an input in the calculation of Operating Cash Flow in Section II).
Year
0
1
2
3
4
5
Units Sold
70,000
120,000
140,000
80,000
60,000
Sale Price
$300
$300
$300
$300
$260
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
$1,600,0000
$1,600,0000
$1,600,0000
$1,600,0000
Equals: EBIT
$6,600,000
$12,600,000
$15,000,000
$7,800,000
$3,000,000
Taxes (@34%)
$2,244,000
$4,284,000
$5,100,000
$2,652,000
$1,020,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT
$6,600,000
$12,600,000
$15,000,000
$7,800,000
$3,000,000
Minus: 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
Equals: Operating Cash Flow
$5,956,000
$9,916,000
$11,500,000
$6,748,000
$3,580,000
Section III. Calculate the Net Working Capital (This becomes an input in the calculation of Free Cash Flows in Section IV).
Change In 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
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 IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
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
NPV =
$16,731,096
IRR =
77%
g. Cash Flow Diagram:
$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,400
| | | | |
($8,100,000)
h. NPV = $16,731,096
i. IRR = 77%
j. Yes. This project should be accepted because the NPV 0. and the IRR required rate of return.
k. First, there is the total project risk also called project standing alone risk, which is a project’s risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm’s other projects and assets. Second, we have the project’s contribution to firm risk, which is the amount of risk that the project contributes to the firm as a whole; this measure considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets, but ignores the effects of diversification of the firm’s shareholders. Finally, there is systematic risk, which is the risk of the project from the viewpoint of a well-diversified shareholder; this measure considers the fact that some of a project’s risk will be diversified away as the project is combined with the firm’s other projects, and, in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolio.
l. According to the CAPM, systematic risk is the only relevant risk for capital-budgeting purposes; however, reality complicates this somewhat. In many instances, a firm will have undiversified shareholders; for them, the relevant measure of risk is the project’s contribution to firm risk. The possibility of bankruptcy also affects our view of what measure of risk is relevant. Because the project’s contribution to firm risk can affect the possibility of bankruptcy, this may be an appropriate measure of risk since there are costs associated with bankruptcy.
m. The idea behind simulation is to imitate the performance of the project being evaluated. This is done by randomly selecting observations from each of the distributions that affect the outcome of the project, combining each of those observations and determining the final outcome of the project, continuing with this process until a representative record of the project’s probable outcome is assembled. In effect, the output from a simulation is a probability distribution of net present values or internal rates of return for the project. The decision maker then bases his decision on the full range of possible outcomes.
n. Sensitivity analysis involves determining how the distribution of possible net present values or internal rates of return for a particular project is affected by a change in one particular input variable. This is done by changing the value of one input variable while holding all other input variables constant.
Year
0
1
2
3
4
5
Units Sold
70,000
120,000
140,000
80,000
60,000
Sale Price
$300
$300
$300
$300
$260
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
$1,600,0000
$1,600,0000
$1,600,0000
$1,600,0000
Equals: EBIT
$6,600,000
$12,600,000
$15,000,000
$7,800,000
$3,000,000
Taxes (@34%)
$2,244,000
$4,284,000
$5,100,000
$2,652,000
$1,020,000
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