Caledonia Products Analysis

Caledonia Products Analysis

Capital Budgeting Decision Focus

Capital Budgeting decision should be focused over cash flows than accounting profits. As, in cash flow it gives actual invest received and for which they can re-invest further. Also, through cash flows we are able to analyze the timing of cost and benefit. In accounting profits, it is derived from result of revenues and expenses. Caledonia should focus on cash flows while making capital budgeting decision because cash flow are adjusted for the time value of money and enable to evaluate project worth in present after implication of time factor. In comparison to cash flow, accounting principle does not provide true project worth as they are not adjusted for the time value of money. Considering the project from company point of view, company should be interested into incremental cash flows because incremental cash flows are the ones which consider being the additional value to the firm in result of accepting the project.

Effect of Depreciation on Free Cash Flows

Depreciation affect amount of free cash flows indirectly as increase in depreciation expenses decreases accounting profits and as a result it affects taxes. Due to changing taxes impact Cash flow Statement as it is a cash flow item. As, a result though depreciation is not regarded as cash flow item but it do effect taxes and generate different cash flows over the project life.

Sunk Cost Affect Cash Flows Determination

Sunk costs are not of any relevance into cash flow determination. They are totally ignored while evaluating a capital budget proposal. Here for evaluating the proposal only concern is on incremental after-tax cash flows, or actual cash flow which is left after every expenses to be distributed to shareholders, to the company overall. Sunk costs are past event to be occurring already in the pasts which are not incremental cash flows.

Project Initial Outlay

Project Initial Outlay is calculated as follows:

Initial Cash Outlay

Description

Amount

 

$

Cost of Plant

$7,900,000.00

Installation and Shipping Cost

$100,000.00

Increment in Working Capital

$100,000.00

Total

$8,100,000.00

Project Initial Outlay is $8,100,000.00

Differential cash flows over the project's life

It is shown as follows:

Differential Cash Flow

 

Year 1

Year 2

Year 3

Year 4

Year 5

 

$

$

$

$

$

Net Income before tax

6600000

12600000

15000000

7800000

3000000

Add: Depreciation

1600000

1600000

1600000

1600000

1600000

Less: Taxes @ 34%

2244000

4284000

5100000

2652000

1020000

Cash Flow from Operating Activities

5956000

9916000

11500000

6748000

3580000

Terminal cash flow

It can be calculated as follows:

Terminal cash flow

Free Cash Flow

 

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

 

$

$

$

$

$

$

Cash Flow from Operating Activities

0

5956000

9916000

11500000

6748000

3580000

Less: Capital Spending (Change)

8000000

0

0

0

0

0

Less: Net Working Capital (Change)

100000

2000000

1500000

600000

-1800000

-2400000

 

Free Cash Flows

-8100000

3956000

8416000

10900000

8548000

5980000

Cash flow diagram for this project

Cash flow stream for this project can be shown as follows:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(8100000) 3956000 8416000 10900000 8548000 5980000

Net Present Value

Its net present value is shown as follows:

Project Net Present Value

 

 

 

 

 

 

 

Discount rate

15%

 

 

 

 

 

 

 

 

 

 

 

 

Year

0

1

2

3

4

5

Free Cash flow

-$8,100,000

$3,956,000

$8,416,000

$10,900,000

$8,548,000

$5,980,000

Discount Factor

1

1.15

1.3225

1.520875

1.74900625

2.011357188

Discounted CF

-$8,100,000

$3,440,000

$6,363,705

$7,166,927

$4,887,347

$2,973,117

 

 

 

 

 

 

 

 

Investment Measures

 

 

 

 

 

NPV =

$16,788,071.36

 

 

 

 

Its Net Present Value is $16,788,071.36.

Internal Rate of Return

Its internal rate of return is shown as follows:

Project Internal Rate of Return

 

 

 

 

 

 

 

Discount rate

15%

 

 

 

 

 

 

 

 

 

 

 

 

Year

0

1

2

3

4

5

Free Cash flow

-$8,100,000

$3,956,000

$8,416,000

$10,900,000

$8,548,000

$5,980,000

Discount Factor

1

1.15

1.3225

1.520875

1.74900625

2.011357188

Discounted CF

-$8,100,000

$3,440,000

$6,363,705

$7,166,927

$4,887,347

$2,973,117

 

 

 

 

 

 

 

 

Investment Measures

 

 

 

 

 

IRR =

77.02%

 

 

 

 

Its Internal Rate of Return is 77.02%

Project Decision

This project stand into criteria of acceptance as it shows positive Net Present value and greater than ...