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 $15$

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

$170,000$

$2120,000$

$3140,000$

$480,000$

$560,000$

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?

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$.$ Explain how simulation works. What is the value in using a simulation approach?

n$.$ What is sensitivity analysis and what is its purpose?