Cal

Caledonia Products Integrative Problem

FIN

March 14, 2010

Caledonia Products Integrative Problem

Caledonia Products has assigned Team-C, as special assistants to conduct risk analysis on a new project in question and give a recommendation for purchase. In the writing below a response to several questions aimed at the understanding of the capital-budgeting process. Discussed are cash flows as opposed to accounting profits. Cash flow diagram, initial outlay, and incremental cash flows for the project in five years. The project??™s net value, internal rate of return and whether it should be accepted or not.

When Caledonia decides to purchase the plasma cutting tool for the metal works division, they anticipate the new venture will increase future cash flows. Free cash flows may be the better option more willingly than profits alone. In the long term the benefits in cost will prove to be greater and the company can use the revenue for additional purposes. Free cash flows are the net amounts of cash accumulated after expenses are paid. Caledonia should take in consideration the free cash flows option to measure the amount in value of the real cost of the new project. This approach the company can see revenue made while determining monthly expense. Free cash flows are calculated income from operations, minus taxes, plus depreciation, minus increase in capital expenditures. When spending on new projects, earnings from the venture should be sufficient for covering all cost of the entire project.

The additional cash flow from operations can be measured from incremental cash flows. Caledonia should invest resources, capital, and time if the new project in place will increase cash flow. If the project has negative incremental cash flows with the project in place it is not a good option. Taxes and depreciation also have an effect on cash flows when forecasting budget with a new project. Before and after tax cash flow is important because it changes the actual total profits made. Depreciation cost is factored in the cost of new projects as equipment loses value over time but maybe salvaged in calculation for profits. This marginal cost has an effect on productivity in the company and the long term cost may not balance with expenses of the new equipment. These factors are needed to determine if the new project damages or increases current sales.

Five Year Incremental Cash Flows

Years | 1 | 2 | 3 | 4 | 5 |

Units sold | 70,000 | 120,000 | 140,000 | 80,000 | 60,000 |

Unit Sale Price | $ 300.00 | $ 300.00 | $ 300.00 | $ 300.00 | $ 260.00 |

Revenue | $ 21,000,000.00 | $ 36,000,000.00 | $ 42,000,000.00 | $ 24,000,000.00 | $ 15,600,000.00 |

Fixed Cost | $ (200,000.00) | $ (200,000.00) | $ (200,000.00) | $ (200,000.00) | $ (200,000.00) |

Variable Cost | $ (12,600,000.00) | $ (21,600,000.00) | $ (25,200,000.00) | $ (14,400,000.00) | $ (10,800,000.00) |

Depreciation | $ 1,600,000.00 | $ 1,600,000.00 | $ 1,600,000.00 | $ 1,600,000.00 | $ 1,600,000.00 |

Taxes | $ (2,244,000.00) | $ (4,284,000.00) | $ (85,100,000.00) | $ (2,652,000.00) | $ (1,020,000.00) |

Accept or Reject the Project

Without Project | Base Year | Max With Project | High Year |

Units sold | 70,000 | Units sold | 140,000 |

Unit Sale Price | $ 300.00 | Unit Sale Price | $ 300.00 |

Revenue | $ 21,000,000.00 | Revenue | $ 42,000,000.00 |

Fixed Cost | $ (200,000.00) | Fixed Cost | $ (200,000.00) |

Variable Cost | $ (12,600,000.00) | Variable Cost | $ (25,200,000.00) |

Depreciation Cost | $ 1,600,000.00 | Depreciation Cost | $ 1,600,000.00 |

Taxes | $ (2,244,000.00) | Taxes | $ (85,100,000.00) |

In the above results each year has positive cash flows making the plasma cutting tool a profitable option for Caledonia. The total cost of conducting business is represented by accounting profits. If the company needed additional operating cash during the years evaluated, the new equipment purchase would change productivity cost, decreasing profits.

Question 5. What is the project??™s net present value

Solution/Answer: The project??™s net present value (NPV) evaluates the potential profitability. NPV will measure the amount that the investment in a project expects increase on the present value of potential cash flows and initial cost (Keown, Martin, & Titman, 2011).

Formula: NPV = – C0 + C1/1+r + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4 + C5/(1+r)5 + CT/(1+r)T

– Co = Initial Investment ($8,100,000)

C = Cash Flow (Zero through five $ values)

r = Discount Rate (15%)

T = Time (Zero through five years)

Year | Cash Flow | PV Factor @ 15% | Discounted Cash Flow |

0 | ($8,100,000) | 100.00% | ($8,100,000) |

1 | $3,956,000 | 86.96% | $3,440,000 |

2 | $8,416,000 | 75.61% | $6,363,705 |

3 | $10,900,000 | 65.75% | $7,166,927 |

4 | $8,548,000 | 57.18% | $4,887,347 |

5 | $5,980,400 | 49.72% | $2,973,316 |

| | | |

| | NPV = | $16,731,294.53 |

Question 6. What is its internal rate of return

Solution/Answer: The internal rate of return (IRR) is the discount rate used in capital budgeting for making the NPV of cash flows equal zero for the project. The IRR is the flipside of NPV. For example, the NPV consist of the discounted price of cash flow generated from the investment in the project (Keown, Martin, & Titman, 2011). Computing the IRR measure and compare the break even rate of the return showing the discount rate.

Formula:

IRR | | |

Year | Cash Flow | | |

0 | ($8,100,000) | | |

1 | $3,956,000 | | |

2 | $8,416,000 | | |

3 | $10,900,000 | | |

4 | $8,548,000 | | |

5 | $5,980,400 | IRR = | 77.02% |

Question 7. Should the project be accepted Why or why not

Solution/Answer: The more elevated a project??™s IRR is, the greater the rate of growth will generate maximum profits and shareholders??™ wealth (Keown, Martin, & Titman, 2011). Based on the resulting information of Caledonia??™ Products free cash flow budget, yes the project ought to receive acceptance because the NPV equal $16,731,294.53 ? zero and the IRR equal 77.02% ? the required rate of return.

Factors for leasing versus buying:

There are a number of factors that Caledonia must think about when acquiring assets through leasing or purchasing. Based on particular business circumstances, both options have advantages and disadvantages. Factors for leasing in opposition to buying may consist of the length of time required, financing options, tax profit, capital expenditures, budget constraints, and accounting for inflation (Accounting for Management, 2012). The short-term and long-term length of time necessities for assets use should establish if leasing is a better option than buying. Financing options should always think about cash flows and budget requirements. Purchasing assets requires large cash outlays up front and leasing allows reasonable monthly expenses. The tax benefits are the direct effects of financing options. Leasing payments offers lower after-tax operating costs for the time of use. The benefit of saving on capital expenditures for leasing is the consequences of no down payments, security deposits, or origination fees. When there are budget constraints, leasing allows the acquiring of assets from the existing operating budget for maintaining budgetary truthfulness. Leasing will account for price increases through fixed payment terms and the net cost of the lease will decrease at the same time gross revenues increase (Accounting for Management, 2012). Taking into consideration these factors in the organization decision-making procedure will prove fundamental to the success or collapse of Caledonia Products.

Recommendations:

Team C recommends that Caledonia Products initiate the new product and accept the project. The project will only last for five years, and the considered free cash flows in the capital-budgeting method reveals total working capital liquidation at the end of the fifth year project termination. Taking into consideration the factors of leasing against buying, it is recommend that for the short-term of the project the leasing option offers the best financial advantage.

References

Accounting For Management. (2012). The use of net present value (NPV) methodis capital budgeting decisions – discounted cash flows. Retrieved from http://www.accountingformanagement.com/net_present_value_method.htm

Keown, A., Martin, J., & Titman, S. (2011). Financial management: Principles and applications (11th ed.). Upper Saddle River, NJ: Pearson/Prentice Hall.