Question

Chapter 11 Mini Case, Capital Budgeting, Capital Rationing, and Cash Flow 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 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? NEW QUESTION 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. 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? Please delete this question. 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.

Profits are different from cash flows. Profits may not always result in positive cash flows to the firm. Hence, cash flows are more important than accounting profits for capital budgeting.

Incremental cash flows are more important than total free cash flows. This is because in evaluating a particular project, the increase/decrease in the firm's cash flows attributable to that project are the most relevant in evaluating the accept/reject decision for that project

b]

Depreciation is a non-cash expense, and therefore does not involve a cash outflow. However, it is a tax deductible expense, and therefore reduces the tax outgo. It thus provides a "tax shield". When calculating free cash flow, depreciation is added back to net income.

c]

Sunk costs are past costs that are already incurred and cannot be recovered. They are not incremental to the accept/reject decision. Hence, they are irrelevant to the incremental cash flows analysis, and should not be included in the calculation of incremental cash flows

d]

Initial outlay = cost of new plant + shipping costs + initial working capital = $7,900,000 + $100,000 + $100,000 = $8,100,000