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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 outlining your assignment follows:
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:
new plant & equipment: $7,900,000
& installation costs: $ 100,000
price per unit : $300/unit in years 1-4 &
$260/unit in year
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, then
decrease in year 4. Finally, all working
capital is liquidated at the termination of the project at the end of year 5.
Straight-line over 5 years assuming the plant and equipment have no salvage value
after 5 years.
Prepare a response to the Caledonia Products Mini-Case as follows: (PLEASE REFER TO CHAPTER 12 FOR REFERENCE & INFO):
CHAP 12 - ANALYZING PROJECT CASH FLOWS
1. Introduction in general
2. Why should
Caledonia focus on project free cash flows as opposed to be accounting profits
earned by the project when analyzing whether to undertake the project?
3. What are
the incremental cash flows for the project in years 1 through 5 and how do
these cash flows differ from accounting profits or earnings?
4. Please include references.