Hello Mr. Morrison. After reviewing everything in the assignment for the new project and considering that we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital, I have put together the following answers to the questions that were included in my assignment. Please review the answers to the questions.
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 definitely focus on cash flows. We want to make the most money we can and cash flows can be reinvested into the company to make more money.
B. ...view middle of the document...
Simply put, They do not affect the determination of cash flows. The costs have already occurred, regardless of the decision made about the investment. You can call these cost a trial and error cost because they will occur pre investment and usually are used to base a decision on if they want the project or not.
Answers to question D though J can be found calculated on the attached Excel Spreadsheet.
D. The projects initial outlay is $8,100,000 . This is found by adding the Cost of the plant ($7,900,000) + Shipping and installation costs ($100,000) + Increase in working capital ($100,000). The total is the projects initial outlay.
E. In order to find the differential cash flows over the projects life, you must calculate the change in EBIT, taxes, and depreciation and this will give you the numbers you need to calculate the operating cash flow. Once the operating cash flow is calculate, you can figure the net working capital and then finally calculate the free cash flow.
F. The terminal cash flow is $5,980,000. This is the final number of free cash flow at the end of the project.
G. Please see my excel spreadsheet for the cash flow diagram for this project.
H. The net present value for this project is $16,731,096. This was calculated in excel using the NPV formula and inputing a 15% required rate of return and using the 5 years free cash flow numbers. Then we have to add the initial cash outlay to come up with the NPV.
I. What is the internal rate of return.
Again, this was figure through my attached excel spreadsheet. The IRR is 77.02%
In excel, we only need to select the IRR function and input all 5 years totals of free cash flow numbers.
J. Should the project be accepted?
Yes the NPV is greater than 0 and the IRR is greater than the required rate of return.
K. There are three risks. There is the project standing alone risk, a contribution to firm risk and the systematic risk.