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 capital-budgeting process. The memorandum you received outlined 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% tax bracket with a 15% discount rate. This project is expected to last five years and then, because this is somewhat of a fad project, it will 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 ears 1-4 and
$ 260/unit in year 5.
Variable cost per unit: $ 180/unit
Annual fixed costs: $ 200,000 per year
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, and thendecrease in year 4.
Finally, all working capital is liquidated at
the termination of the project at the end
of year 5.
Depreciation method: Straight-line over
5 years, assuming the plant and equipment
have no salvage value after the 5th year.
Questions

1. Why should Caledonia focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?
2. What are the incremental cash flows for the project in years 1 through 5 and how do these cash flows differ from accounting profits of earnings?
3. What is the project’s initial outlay?
4. Sketch out a cash flow diagram for this project.
5. What is the project’s net present value?
6. What is its internal rate of return?
6. Should the project be accepted? Why or why not?
7. What other investment criteria might the Assistant Financial Analyst use and how they can be applied?

help i need answer

1. Caledonia should focus on project free cash flows rather than accounting profits because free cash flows represent the actual cash generated by the project that is available to the company and its investors. Accounting profits, on the other hand, are calculated based on accounting principles and may include non-cash items such as depreciation. Free cash flows take into account the timing and magnitude of cash inflows and outflows, providing a more accurate measure of the project's profitability and potential return on investment.

To calculate the project's free cash flows, you need to subtract all cash outflows (cost of new plant and equipment, shipping and installation costs, working capital requirements) from the cash inflows (sales revenue, salvage value, if any). Accounting profits, on the other hand, are calculated by subtracting expenses from revenues without considering cash flows or timing.

2. The incremental cash flows for the project in years 1 through 5 are the additional cash flows generated by the project compared to the cash flows that would have been generated without the project. To calculate the incremental cash flows, you need to subtract the cash flows that would have occurred without the project (e.g., if the plant and equipment were not purchased) from the cash flows with the project.

In this case, the incremental cash flows would be calculated by subtracting the variable costs per unit, fixed costs, and working capital requirements from the sales revenue for each year. The incremental cash flows differ from accounting profits or earnings because they focus on the actual cash flows generated by the project, taking into account the timing and magnitude of cash inflows and outflows.

3. The project's initial outlay includes the cost of new plant and equipment ($7,900,000), shipping and installation costs ($100,000), and initial working capital requirement ($100,000). To calculate the project's initial outlay, you need to sum up these costs.

4. To sketch out a cash flow diagram for this project, you would typically use a timeline to represent the years from 0 to 5. On the timeline, you would show the cash inflows (sales revenue) and cash outflows (costs, expenses, working capital requirements) for each year. You can use arrows to indicate the direction and magnitude of the cash flows. Make sure to also include the initial outlay and any salvage value at the end of year 5, if applicable.

5. To calculate the project's net present value (NPV), you need to discount the project's cash flows to their present value using the discount rate. The discount rate is the company's required rate of return or cost of capital. You then subtract the initial outlay from the present value of the cash flows. If the NPV is positive, it indicates that the project is expected to generate more cash inflows than the initial outlay and is therefore potentially a good investment. If the NPV is negative, it indicates that the project is expected to generate less cash inflows than the initial outlay and may not be a good investment.

6. The internal rate of return (IRR) is the discount rate at which the present value of the project's cash inflows equals the initial outlay, resulting in an NPV of zero. The IRR represents the project's expected rate of return. If the IRR is higher than the discount rate, it indicates that the project is expected to generate a higher return than the company's required rate of return and is therefore potentially a good investment. If the IRR is lower than the discount rate, it indicates that the project is expected to generate a lower return than the company's required rate of return and may not be a good investment.

7. Whether the project should be accepted or not depends on the project's net present value (NPV) and internal rate of return (IRR). If the NPV is positive and higher than zero, it indicates that the project is expected to generate more cash inflows than the initial outlay and is therefore potentially a good investment. If the IRR is higher than the company's discount rate, it indicates that the project is expected to generate a higher return than the company's required rate of return and is therefore potentially a good investment. In this case, the assistant financial analyst should compare the project's NPV and IRR to the company's investment criteria and make a recommendation based on the results.

8. Other investment criteria that the assistant financial analyst might use include the payback period, profitability index, and modified internal rate of return (MIRR). The payback period is the time it takes for the project to recover its initial investment. The profitability index is the ratio of the present value of the project's cash inflows to the initial outlay. The MIRR adjusts the project's cash flows to account for the reinvestment rate of the cash inflows. These criteria can be used to assess the project's profitability and potential return on investment, in addition to the NPV and IRR.