Caledonia should focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project because cash flows formulas focus on the project itself. Free cash flow formula determines whether an investment adds value to the firm, which important to Caledonia’s management. Since one of a firm’s primary goal is to gain profits for its stakeholders, using free cash flow formula would offer the most valuable information in the decision of proceeding with a new investment.
Incremental Cash Flows Years 1-5
| YEAR 1 | YEAR 2 | YEAR 3 | YEAR 4 | YEAR 5 |
Project Revenues (sales price/unit * # units) | 21,000,000 | 36,000,000 | 42,000,000 | 24,000,000 | ...view middle of the document...
Profits indicate how much money is left after the company has sold its good and service from a performance standpoint. A company needs to be profitable, but it also needs to ensure there is cash available when needed. The cash flow statement allows the company to plan for purchasing raw materials and paying off taxes, debt and any other expenses. A company can be profitable, but can still go bankrupt because it does not have money to pay the bills or purchase raw materials.
Expenses needed to start business:
Cost of new plant $7,900,000
Shipping and installation costs $100,000
Sales (60,000 units x sales price per unit $300) $18,000,000 x 34%= $6,120,000
Working capital requirement $100,000
Total Initial Outlay $14,220,000
Cash flow diagram
Positive cash flows
$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000
Negative cash flows
NPV = 45,900,000(Cash inflows from investment) – 29,168,000(cash outflows or costs of investment)= $16,731,096
The project should be accepted because of a strong Net Present Value as well as a High Internal Rate of Return. Using NPV and IRR as your benchmarks to evaluate your projects are the two most common used measures. A higher NPV and IRR will show a stronger investment opportunity.