Calculating Free Cash Flow and Project Valuation
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:
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:
|Shipping and installation costs:
|Sales price per unit:
||$300/unit in years 1–4 and $260/unit in year 5.
|Variable cost per 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.
Depreciation method: Straight-line over 5 years assuming the plant and equipment have no salvage value after 5 years.
PLEASE HELP ME ANSWER THESE 2 QUESTIONS IN YOUR OWN WORDS:
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?
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?