BUS 401 Principles of Finance
Mini Case 11 Chapter 11
I am aware that this is my new position as assistant financial analyst at Caledonia Products and that I am asked to consider the introduction of a new product into the company. My job will be to analyze the information you require in depth with research regarding my answer. Let it be known that I will have put every ounce of my knowledge into this assignment to make this experience one for the record books as an assistant analyst. Here, I have answers to your inquiries that I have personally thought of as a professional at my job. 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?
On this particular take, I believe we should focus on free cash flows rather than profits because the company itself can receive cash flow and reinvest it. The benefit or cost of this can be determined in due time. We can analyze and come to the conclusion that we are only interested in the after tax basis of these cash flows because these are available to the shareholders. The next thing we are interested in is the incremental cash flows because for this project these incremental cash flows are the marginal benefits we are looking for as a whole. The increased value to the firm from these small effective opportunities are what we want in accepting this project. “Any incremental after-tax cash flow affecting the company as a whole is a relevant cash flow, whether it is flowing in or flowing out.” (Keown 305) How does depreciation affect free cash flows?
Since depreciation is not a positive cash flow item, it doesn’t effect us in a negative way. It only effects taxes to an extent. It is an expense that we can write off as we incur more depreciation. All in all, we will have profits become lower and at the same time taxes will be lower as well. How do sunk costs affect the determination of cash flows?
Sunk costs are essentially ignored when evaluation the capital budgeting proposal. Since we are only for free cash flows to the company, we make the decision based on the investment. Sunk costs will already have been occurred by that time and they are not incremental cash flows. So essentially they are neither here nor there.
What is the projects initial outlay?
Year| 0| 1| 2| 3| 4| 5|
Units Sold| | 70,000| 120,000| 140,000| 80,000| 60,000| Sale Price| | $300 | $300 | $300 | $300 | $260 |
| | | | | | |
Sales Revenue| | $21,000,000 | $36,000,000 | $42,000,000 | $24,000,000 | $15,600,000 | Less: Variable Costs| | 12,600,000| 21,600,000| 25,200,000| 14,400,000| 10,800,000| Less: Fixed Costs| | $200,000 | $200,000 | $200,000 | $200,000 | $200,000 | Equals: EBDIT| | $8,200,000 | $14,200,000 | $16,600,000 | $9,400,000 | $4,600,000 | Less: Depreciation| | $1,600,000 | $1,600,0000 | $1,600,0000 | $1,600,0000 | $1,600,0000 | Equals: EBIT| | $6,600,000 | $12,600,000 | $15,000,000 | $7,800,000 | $3,000,000 | Taxes (34%)| | $2,244,000 | $4,284,000 | $5,100,000 | $2,652,000 | $1,020,000 |
What are the differential cash flows over the project’s life? Operating Cash Flow:| | | | | | |
EBIT| | $6,600,000 | $12,600,000 | $15,000,000 | $7,800,000 | $3,000,000 | Minus: Taxes| | $2,244,000 | $4,284,000 | $5,100,000 | $2,652,000 | $1,020,000 | Plus: Depreciation| | $1,600,000 | $1,600,000 | $1,600,000 | $1,600,000 | $1,600,000 | Equals: Operating Cash Flo| | $5,956,000 | $9,916,000 | $11,500,000 | $6,748,000 | $3,580,000 |
What is the terminal cash flow?
Change In Net Working Capital:| | |
Revenue:| | $21,000,000| $36,000,000| $42,000,000| $24,000,000| $15,600,000| Initial Working Capital Requirement| $100,000| | | | | |...