$7.99 Only
Mini Case:
It’s been 2 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 percent marginal tax bracket with a 15 percent
required rate of return or cost of capital. This project is expected to last 5
years and then, because this is somewhat of a fad product, be terminated. The
following information describes the new product:
------------------------------------------------------------------------------------------------------------
Cost of new plant and equipment $7,900,000
Shipping and Installation Costs $ 100,000
Unit Sales
Year Units Sold
1
70,000
2
120,000
3
140,000
4
80,000
5
60,000
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
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 percent of the
dollar value of sales for that year. Thus, the investment in working capital
will increase during years 1 through year 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 Use the simplified
straight-line method over 5 years. Assume that the plant and equipment will
have no salvage value after 5 years.
-----------------------------------------------------------------------------------------------------------
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?
b.) How
does depreciation affect free cash flows?
c.) How
do sunk costs affect the determination of cash flows?
d.) What
is the project’s initial outlay?
e.) What
are the differential cash flows over the project’s life?
f.) What
is the terminal cash flow?
g.) Draw
a cash flow diagram for this project.
h.) What
is the present value?
i.) What
is the internal rate of return?
j.) Should
the project be accepted? Why or why not?
k.) In
capital budgeting, risk can be measured from three perspectives. What are those
three measures of a project’s risk?
l.) According
to the CAPM, which measurement of a project’s risk is relevant? What
complications does reality introduce into the CAPM view of risk, and what does
that mean for our view of the relevant measure of a project’s risk?
m.) Explain how
simulation works. What is the value in using a simulation approach?
n.) What
is sensitivity analysis and what is its purpose?
No comments:
Post a Comment