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¶ … Caledonia focus on project free cash flows as opposed to the accounting profits earned by the project when analyzing whether to undertake the project?
After studying the Caledonia case I came to the conclusion that the reason that Caledonia should focus on free cash flows is because the cash flows are where the firm receives and is able to reinvest. Also the firm is only interested in the free cash flows on an after-tax basis because they are the only ones available to the shareholder.
) 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?
Even though depreciation is not part of the company's cash flow, it has a major effect on the different levels of cash flow over the life of the project as well as the effect on taxes. Sincems.e, depreciation is considered as an expense, the more one has of it, the bigger the expense. Consequently, profits are lowered...
and so are the taxes which are cash flow it.
3.) What is the project's initial outlay?
The initial cash outlay for Caledonia is as follows:
Initial Cash Outlay= Cost of New Plant & Equipment+ Shipping & Installation Costs + Increase in Working Capital
4.) Sketch out a cash flow diagram for this project.
| Cash Flow Diagram | | | |
| 0 | 1 | 2 | 3 | 4 | 5 |
Unit Sales | 70000 | 120000 | 140000 | 80000 | 60000 |
Project Revenues | 21000000 | 36000000 | 42000000 | 24000000 | 15600000 |
Variable expense | | 12600000 | 21600000 | 25200000 | 14400000 | 10800000 |
Gross Profit | 8400000 | 14400000 | 16800000 | 9600000 | 4800000 |
Fixed Expenses | 200000 | 200000 | 200000 | 200000 | 200000 |
Depreciation | 1600000 | 1600000 | 1600000 | 1600000 | 1600000 |
Net operating income | | 6600000 | 12600000 | 15000000 | 7800000 |…
References
Financial Management: Principles and Applications, Eleventh Edition, by Sheridan Titman, John D. Martin, and Arthur J. Keown. Published by Prentice Hall.
Caledonia Products a) When making capital budgeting decisions, Caledonia should focus on cash flows rather than accounting profits. The argument in favor of cash flows is simple -- cash flows are what drive company value, more so than economic profit. Profit can be distorted by a number of considerations that do not impact on cash flows. For example, depreciation expense is not a cash flow, but a means of accounting for
This will also show the degree to which the project is vulnerable to potential changes on the market that would influence its main figures, including the volume of sales. Another useful tool that can be used is a simulation. A simulation would allows us, in this particular analysis, to change some of the variables in a mathematical model that we would create and analyze the consequences of those changes. The