It’s been two 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 capitalbudgeting
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 five years and then, because this is somewhat of a fad project, to 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 1–4, $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 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 five years. It is assumed that the plant and
equipment will have no salvage value after five years.
1. Should Caledonia focus on cash flows or accounting profits in making our capital-budgeting
decisions? Should we be interested in incremental cash flows, incremental profits, total free
cash flows, or total profits?
2. How does depreciation affect free cash flows?
3. How do sunk costs affect the determination of cash flows?
4. What is the project’s initial outlay?
I N T E G R AT I V E P R O B L E M
Prentice Hall. Copyright © 2005 by Pearson Education, Inc.
Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J. William Petty, and David F. Scott, Jr. Published by Pearson
ISBN: 0-536-18213-2
CHAPTER 10 CASH FLOWS AND OTHER T O P I C S I N C A P I TAL BUDGETING 363
5. What are the differential cash flows over the project’s life?
6. What is the terminal cash flow?
7. Draw a cash flow diagram for this project.
8. What is its net present value?
9. What is its internal rate of return?
10. Should the project be accepted? Why or why not?
What is the firm’s weighted-average cost of capital at various combinations of
debt and equity,
It’s been 2 months since you took a position as an assistant 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 projects. Given your lack of tenure at Caledonia, you have 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 record 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 plant and equipment $7,900,000
Shipping and installation costs $10,000
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 requirement 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 flows?
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?
_________________________________________________________________________________
12. Caledonia is considering two additional mutually exclusive projects. The cash flows associated with these projects are as follows:
YEAR PROJECT A PROJECT B
0 −$100,000 −$100,000
1 32,000 0
2 32,000 0
3 32,000 0
4 32,000 0
5 32,000 $200,000
The required rate of return on these projects is 11 percent.
a. What is each project's payback period?
b. What is each project's net present value?
c. What is each project's internal rate of return?
d. What has caused the ranking conflict?
e. Which project should be accepted? Why?
To effectively answer the questions posed in the assignment, we need to understand the concepts and calculations involved in capital budgeting. Let's go through each question step by step:
1. Should Caledonia focus on cash flows or accounting profits in making our capital-budgeting decisions? Should we be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?
In capital budgeting decisions, it is generally recommended to focus on cash flows rather than accounting profits. Cash flows represent the actual cash inflows and outflows generated by a project, whereas accounting profits can be influenced by non-cash items such as depreciation. Incremental cash flows are relevant in decision-making as they reflect the additional cash flows attributable to the project. Total free cash flows, which represent the remaining cash flows after accounting for all relevant expenses, are particularly important as they show the potential for returns to investors.
2. How does depreciation affect free cash flows?
Depreciation is a non-cash expense that reduces taxable income and, consequently, the taxes payable. Since taxes reduce free cash flows, depreciation helps to increase free cash flows by reducing the tax burden. When calculating cash flows, the depreciation expense should be added back to the net income to arrive at the operating cash flow.
3. How do sunk costs affect the determination of cash flows?
Sunk costs are costs that have already been incurred and cannot be recovered. They are not relevant to the determination of future cash flows since they are not incremental and do not represent additional costs or benefits associated with the project. Therefore, sunk costs should be ignored when evaluating cash flows for a new project.
4. What is the project’s initial outlay?
The initial outlay represents the total cash outflow required to start a project. It includes the cost of new plant and equipment, shipping and installation costs, and the initial working capital requirement. To calculate the initial outlay, you would sum up these costs.
5. What are the differential cash flows over the project’s life?
Differential cash flows refer to the change in cash flows between two mutually exclusive projects or between doing and not doing a particular project. In this case, the differential cash flows would represent the difference in cash flows between undertaking the new project and not doing it. To calculate the differential cash flows, you would subtract the cash flows associated with an alternative project or the status quo from the cash flows of the new project.
6. What is the terminal cash flow?
The terminal cash flow represents the net cash flow at the end of a project's life, including any cash inflows or outflows associated with the termination or liquidation of the project. It usually includes the salvage value of the project's assets and any recaptured working capital. In this case, the terminal cash flow would be the salvage value of the plant and equipment minus the working capital released.
7. Draw a cash flow diagram for this project.
To create a cash flow diagram, you would plot the cash inflows and outflows over time. In this case, you would plot the initial outlay, operating cash flows for each year, and the terminal cash flow on a timeline.
8. What is its net present value?
The net present value (NPV) is a measure used to assess the profitability of an investment project. It represents the difference between the present value of cash inflows and the present value of cash outflows. To calculate the NPV, you would discount each cash flow to the present using the required rate of return and sum them up. A positive NPV indicates that the project is expected to generate more value than its cost, while a negative NPV suggests the opposite.
9. What is its internal rate of return?
The internal rate of return (IRR) is the discount rate at which the NPV of a project becomes zero. It represents the project's return on investment. To calculate the IRR, you would find the discount rate that makes the sum of the present values of all cash flows equal to zero. If the IRR is higher than the required rate of return, the project is considered acceptable.
10. Should the project be accepted? Why or why not?
To determine whether the project should be accepted, you would evaluate its NPV and IRR. If the NPV is positive and the IRR is higher than the required rate of return, it indicates that the project is expected to generate value and meet the desired return. In this case, you would recommend accepting the project. However, if the NPV is negative or the IRR is lower than the required rate of return, the project should be rejected as it is not expected to meet the predetermined criteria.
By applying these concepts and calculations to the given information in the assignment, you can provide a thorough analysis and recommendation based on the capital-budgeting process.