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 project:
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 through 4, $260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000 per year in years 1–5
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 3, then decrease in year 4.
Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The 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 its net present value?
i. What is its 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?
(Foundations of Finance for Ashford University, 7th Edition. Pearson Learning Solutions pp. 333 - 335).
Please complete in Excel showing calculations(mini case chapter 11):
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 project:
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 through 4, $260/unit in year 5
Variable
cost per unit $180/unit.
Annual Fixed cost $200,000 per year in years 1-5
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 year
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.
The 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 the company focus on cash flow or accounting profits in making it
capital budgeting decisions?
b. How does depreciation affect the determination of
cash flows?
c. How do sunk cost affect the determination of cash
flows?
d. What is the project’s initial outlay?
e. What are the differential cash flows over the
projects life?
f. What is the terminal cash flow?
g. Cash flow diagram
h.
What is its net present value?
j.
Should the project be accepted? Why or why not?
k)
What are the three measures of a project’s risk in capital budgeting?
n)
What is sensitivity analysis and its purpose?
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 project:
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 through 4, $260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000 per year in years 1–5
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 3, then decrease in year 4.
Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The 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 its net present value?
i. What is its 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?
(Foundations of Finance for Ashford University, 7th Edition. Pearson Learning Solutions pp. 333 - 335).
Please complete in Excel showing calculations(mini case chapter 11):
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 project:
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 through 4, $260/unit in year 5
Variable
cost per unit $180/unit.
Annual Fixed cost $200,000 per year in years 1-5
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 year
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.
The 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 the company focus on cash flow or accounting profits in making it
capital budgeting decisions?
b. How does depreciation affect the determination of
cash flows?
c. How do sunk cost affect the determination of cash
flows?
d. What is the project’s initial outlay?
e. What are the differential cash flows over the
projects life?
f. What is the terminal cash flow?
g. Cash flow diagram
h.
What is its net present value?
j.
Should the project be accepted? Why or why not?
k)
What are the three measures of a project’s risk in capital budgeting?
n)
What is sensitivity analysis and its purpose?
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