Couls some help please - need to check my figures ! MINI CASE It’s been 2 months
ID: 2779927 • Letter: C
Question
Couls some help please - need to check my figures !
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 30 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?
h) What is the net present value?
i) What is the internal rate of return?
k) In capital budgeting, risk can be measured from three perspectives. What are those three measures of a project’s risk?
Explanation / Answer
A) In making capital budgeting decision one should consider cash flow instead of accounting profit , The use of cash basis data to evaluate investment projects provides a verifiable measure with which to delineate the costs and benefits of each capital project, which can then be used to prioritize and select projects on the basis of the greater expected returns. The identification of cash inflows and outflows is a means of making the impact of a capital investment project readily apparent to interested parties. In addition, the capital budgeting process is appropriate for many different types of spending -- from outlays for physical assets to spending for the renovation of facilities. Cash inflows can incorporate depreciation effects on corporate profits. Cash budgeting is also used to determine if project goals are realistic and realizable in light of allotted resources.
company should be looking for incremental cash flow and profits
B) Tax paid is an cash out flow, Tax is calculated on EBT. To derieve EBT depreciation is deducted from the profit. hence depreciation indirectly reduces cash out flow. Thus it provides tax shield.
C) Sunk cost are those cost which are already incurred hence they does not affect capital budgeting decision nor cash flow
D) Statement showing project's initial outlay
Particulars Amount Cost of new plant and equipment 7900000 Shipping and installation cost 100000 WC requirement 100000 Initial outflow 8100000