Caledonia Mini Case
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?
Caledonia should focus on cash flows, not accounting profits. Free cash flows are able to be reinvested, whereas accounting profits are shown when they are earned, not when the cash is actually received.
The company should be interested in incremental after-tax cash flows. The incremental cash flow will allow Caledonia to see the profits or losses of a project by comparing cash flows with and without the project on an after tax basis.
b. How does depreciation affect free cash flows?
Depreciation lowers profits and in turn also lowers the taxes that are paid.
c. How do sunk costs affect the determination of cash flows?
Sunk costs do not affect cash flows. They are cash flows that have already occurred and won’t be considered in the incremental cash flows.
d. What is the project’s initial outlay?
Cost of new asset + shipping and installation costs + working capital increase = Initial outlay
$7,900,000 + $100,000 + $100,000 = $8,100,000
e. What are the differential cash flows over the project’s life? Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,800,000
Less: Taxes ($2,788,000) ($4,828,000) ($5,644,000) ($3,196,000) ($1,632,000)
Plus: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Equals: Operating Cash Flow $7,012,000 $10,972,000 $12,556,000 $7,804,000 $4,768,000
f. What is the terminal cash flow?
Terminal Cash Flow is $3,208,000 Initial Outlay Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,800,000
Less: Taxes ($2,788,000) ($4,828,000) ($5,644,000) ($3,196,000) ($1,632,000)
Plus: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Operating Cash Flow $7,012,000
Caledonia should focus on cash flows, not accounting profits. Free cash flows are able to be reinvested, whereas accounting profits are shown when they are earned, not when the cash is actually received.
The company should be interested in incremental after-tax cash flows. The incremental cash flow will allow Caledonia to see the profits or losses of a project by comparing cash flows with and without the project on an after tax basis.
b. How does depreciation affect free cash flows?
Depreciation lowers profits and in turn also lowers the taxes that are paid.
c. How do sunk costs affect the determination of cash flows?
Sunk costs do not affect cash flows. They are cash flows that have already occurred and won’t be considered in the incremental cash flows.
d. What is the project’s initial outlay?
Cost of new asset + shipping and installation costs + working capital increase = Initial outlay
$7,900,000 + $100,000 + $100,000 = $8,100,000
e. What are the differential cash flows over the project’s life? Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,800,000
Less: Taxes ($2,788,000) ($4,828,000) ($5,644,000) ($3,196,000) ($1,632,000)
Plus: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Equals: Operating Cash Flow $7,012,000 $10,972,000 $12,556,000 $7,804,000 $4,768,000
f. What is the terminal cash flow?
Terminal Cash Flow is $3,208,000 Initial Outlay Year 1 Year 2 Year 3 Year 4 Year 5
EBIT $8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,800,000
Less: Taxes ($2,788,000) ($4,828,000) ($5,644,000) ($3,196,000) ($1,632,000)
Plus: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Operating Cash Flow $7,012,000