Question

PLEASE ANSWER ALL THE QUESTIONS:

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:

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

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.

Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years.

Year                                    Units Sold

1                                    70,000

2                                    120,000

3                                    140,000

4                                    80,000

5                                     60,000

The purpose/risk classes and preassigned required rates of return are as follows:

• Replacement decision 12%
• Modification or expansion of existing product line 15%
• Project unrelated to current operations 18%
• Research and development operations 20%

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. What is its modified internal rate of return?

k. Should the project be accepted? Why or why not?

l. In capital budgeting, risk can be measured from three perspectives. What are those three measures 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?

Answer 1

a]

Caledonia should focus on cash flows in making its capital-budgeting decisions. The company should be interested in incremental cash flows.

This is because cash flows can vary significantly from accounting profits. Accounting profits are book figures are notional, whereas cash flows are real. In capital budgeting, cash flows are the most relevant for decision-making.

Incremental cash flows are the most relevant because they represent the change in cash flows if the project is accepted.

b]

Depreciation is a non-cash expense, and there is no cash outflow associated with depreciation. However, depreciation is a tax-deductible expense, and therefore results in a reduction in tax expense (depreciation tax shield). This reduction in tax expense due to depreciation is to be treated as a cash inflow since it reduces the cash outgo

c]

Sunk costs are past costs that are already incurred and cannot be recovered. They are irrelevant in determining incremental cash flows, and should not be considered in calculating cash flows. This is because they are not expenses that will be incurred only if the project is accepted, i.e. they are not incremental costs

d]

initial outlay = cost of new plant + shipping costs + investment in working capital

initial outlay = $7,900,000 + $100,000 + $100,000 = $8,100,000