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 & Installation Costs/Unit Sales $100,000
YEAR UNITS SOLD
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000
Sales Price Per Unit $300/units in years 1-4, $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 networking 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 1-3, then decrease in year 4. Finally, all working capital is liquidated at 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 practices 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. 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?
Read the Mini Case from the end of Chapter 11 about Caledonia Products and thoroughly respond to Parts a to n at the end of the case. Your paper should answer all of the questions of the Mini Case (without repeating the questions), as a concise management statement in six to eight pages. Where appropriate, properly cite the text or any other source. For questions requiring calculations, use formulas in Excel to calculate the ratios and format the cells to insert a comma if there are more than three numbers. Submit your work as a separate Excel document, in addition to your analysis. Round dollar amounts to the nearest whole number and percentages to two decimal places as a percentage. Clearly label your analysis and the sum of your conclusions for all parts of the case.
