Caledonia Products Assignment

Caledonia Products: Calculating Free Cash Flow and Project Valuation Team Members FIN/370 Date Instructor

Caledonia Products Assignment 1) Why should Caledonia focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project? Free cash flow represents the cash a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows Caledonia to pursue opportunities (such as this one) that enhance shareholder value. Without this cash, it would be hard for Caledonia to develop new products, do new projects, and reduce their debt. The primary advantage Caledonia has to consider with using cash flows over accounting profits is that the time value of money is taken into considerations with cash flows and ignored when calculating accounting profits. It also is the money they have on hand now, and it will eventually cause it to grow. Accounting profits earned by the project are based off where they see themselves and what they expect to get in return. They are expecting to succeed regardless.

2) What are the incremental cash flows for the project in years 1 through 5 and how do these cash flows differ from accounting profits or earnings? Free Cash Flow Data Cash Flow ($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000

Year 0 1 2 3 4 5

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 flow formulas focus on the project itself. The free cash flow formula determines whether an

Caledonia Products Assignment investment adds value to the firm's primary goal, which is to gain profits for its shareholders. Using the free cash flow formula would offer the most valuable information in the decision of proceeding with a new investment. These cash flows differ from accounting profits or earnings because they identify how much is left after the company has sold its goods and services from a performance standpoint. A company needs to be profitable, but it also needs to ensure there is cash available when needed

3) What is the projects initial outlay? The initial outlay is equal to the increase in capital expenditures plus the increase in net operating working capital. Increase in Capital Expenditures= $7,900,000 + $100,000 = $8,000,000 Increase in Net Operating Working Capital = $100,000 Initial Outlay = $8,100,000

Caledonia Products Assignment 4) Sketch out a cash flow diagram for this project.
Year 0 Project Revenues (-) Costs of Goods Sold (=) Gross Profit (-) Cash Operating Expenses ($200k/yr) (-) Depreciation ($8,000,000/5) (=) Net Operating Income (-) Taxes at 34% (=) Net Operating Profit after Taxes (NOPAT) (+) Depreciation (=) Operating Cash Flow less: Increase in CAPEX less: Increase in operating working capital Free Cash Flow $ $ $ (8,000,000) (100,000) (8,100,000) $ (2,000,000) $ 3,956,000 $ (1,500,000) $ 8,416,000 $ (600,000) $ 1,800,000 $ 8,548,000 Year 1 $ 21,000,000 $ (12,600,000) $ 8,400,000 $ (200,000) Year 2 $ 36,000,000 $ (21,600,000) $ 14,400,000 $ (200,000) Year 3 $ 42,000,000 $ (25,200,000) $ 16,800,000 $ (200,000) Year 4 $ 24,000,000 $ (14,400,000) $ 9,600,000 $ (200,000)

Year 5 $ 15,600,000 $ (10,800,000) $ 4,800,000 $ (200,000)

$ (1,600,000) $ 6,600,000 $ (2,244,000) $ 4,356,000 $ 1,600,000 $ 5,956,000

$ (1,600,000) $ 12,600,000 $ (4,284,000) $ 8,316,000 $ 1,600,000 $ 9,916,000

$ (1,600,000) $ 15,000,000 $ (5,100,000) $ 9,900,000 $ 1,600,000 $ 11,500,000

$ (1,600,000) $ 7,800,000 $ (2,652,000) $ 5,148,000 $ 1,600,000 $ 6,748,000

$ (1,600,000) $ 3,000,000 $ (1,020,000) $ 1,980,000 $ 1,600,000 $ 3,580,000

$ 2,400,000 $ 5,980,000

$ 10,900,000

Caledonia Products Assignment 5) What is the projects net present value? NPV = $16,731,097.15

6) What is its internal rate of return? IRR = 77.02%

7) Should the project be accepted? Why or why not? Yes, the project should be accepted and represents a solid business case for Caledonia. The present value of the additional cash inflows exceeds the cost of making the new product. This project provides a positive NPV and has an IRR that far exceeds the companys discount rate of 15%.

Describe factors Caledonia must consider if it were to lease versus buying. The decision to lease or buy comes from the pros and cons for each particular path. One must take into account the costs of purchasing a property to include property taxes, inspections, and interest expense to name a few, this should compares against the costs of a lease and any future increases of lease costs. A purchase may have tax incentives, but these must outweigh any property tax or depreciation costs. One shall also consider if the amount of capital required is even available for a purchase. A lease may be the only option if the appropriate capital is not available.

Caledonia Products Assignment Working Data

Year 1 Units Sold Rev/Unit Rev (Unit * Rev/Unit) Cost/Unit Cost (Unit * Cost/Unit) $ $ $ $ 70000 300 21,000,000 180 12,600,000 $ $ Year 2 120000 300 180 $ $ $ 36,000,000 $ 21,600,000 Year 3 140000 300 180 $ $ $ 42,000,000 $ 25,200,000 Year 4 80000 300 180

Year 5 60000 $ $ 260 180 $ 15,600,000 $ 10,800,000

$ 24,000,000 $ 14,400,000

Year 0 Sales NOWC Change NOWC Increase NOWC $ (100,000) $ 100,000

Year 1 $ 21,000,000 $ 2,100,000 $ (2,000,000) $ (2,000,000)

Year 2 $ 36,000,000 $ 3,600,000 $ (1,500,000) $ (1,500,000)

Year 3 $ 42,000,000 $ 4,200,000 $ $ (600,000) (600,000)

Year 4 $ 24,000,000 $ 2,400,000 $ 1,800,000 $ 1,800,000

Year 5 $ 15,600,000 $ 1,560,000 $ 840,000 $ 2,400,000

NPV IRR

$16,731,097.15 77.02%

Caledonia Products Assignment References Robertson, Tonya. Accounting Profits vs. Firm Cash Flow. (Hearst Communications. 2013). Retrieved From: http://smallbusiness.chron.com/accounting-profits-vs-firm-cash-flow26289.html Titman, S., Keown, A. J., & Martin, J. D. (2011). Financial management: Principles and applications (11th ed.). Upper Saddle River, NJ: Pearson/Prentice Hall.