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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:
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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 & equipment: $7,900,000
Shipping & installation costs: $ 100,000
Year Units Sold
Sales price per unit : $300/unit in years 1-4 &
$260/unit in year 5.
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.
Depreciation method: 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):
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.