Foundations of Finance

¶ … Finance

In reply to the memo sent by Mr. V. Morrison, CEO of Caledonia Products, this paper aims to provide relevant feedback in terms of the opportunity to undertake a 5-year project. A financial analysis will make recommendations that will help in the decision making process. The financial analyst believes that the company should use total free cash flows as the primary method in this budgeting decision. The primary reason for this is that this method will take into account the time value of money, a significant fact given that the project lasts for 3 years. At the same time, it is the best method to accurately evaluate the outflows and inflows that this project will generate.

Another important element in making the decision to use total free cash flows is that depreciation, as a non-cash item, does not directly affect the cash flows. It does so indirectly, mainly because it affects the amount of taxes that the company will pay, but has no direct impact on the cash flow. At the same time, sunken costs are costs that have already occurred in the past and that are no longer recoverable. This type of costs has no impact on the cash flows.

The first step in this financial analysis is to determine the initial outlay. There are several steps to be undertaken

. First, one calculates the explicit initial outlay. This includes the cost of the new plant and equipment, as well as the shipping and installation cost, for a total of $8,000,000. The second phase is to calculate the working capital for the 5-year period. As mentioned in the case study, this is 10% of the dollar value of sales during the year, a total of $13,860,000.00 for the 5 years, plus the initial $100,000 to start the production, with a total working capital of $13,860,000. The third phase would be to evaluate the salvage value, however, the case study specifies that there is no salvage value. As such, the total initial outlay is $21,960,000, calculated by adding the explicit initial outlay to the working capital over the 5 years.

After calculating the initial outlay, this financial analysis will focus on calculating the differential cash flows over the project's life. This is done in several steps as well. First, the change in operating income before taxes is calculated by subtracting the change in operating expenses from the change in revenues.

Then, one calculates the change in operating income after taxes by subtracting from the operating income the taxes. To this, one adds the change in depreciation. As mentioned in the case study, the linear method is used. The depreciation is the same in all the years over the 5 years, with $1,580,000 each year. The final result is the differential cash flow, having the following values over the 5-year period (all results are shown in the Excel file): $7,124,000.00, $11,084,000.00, $12,668,000.00, $7,916,000.00, and $4,748,000.00.

A relevant element in the analysis is also the terminal cash flow, calculated as the salvage value + working capital recovered in the last year

. The salvage value, as shown, is 0 in this case, while the working capital in the last year is $1,560,000.00, which means that the terminal cash flow is also $1,560,000.

The drawing below shows the cash flow diagram, over the 5-year period that the plant is expected to run. A couple of observations: other than the initial investment (market as year 0), all cash flows are positive, with the values being shown above the arrows.

In order to be able to make a decision that takes into consideration the financial performance of the project, we need to determine to essential values: the net present value and the internal rate of return. The net present value will calculate the total value of the present values of all discounted cash flows. The initial cost of the plant, along with the shipping and installation costs, is the negative value at year 0. The required rate of return or the cost of capital will be used as the discount rate, so I = 0.15. With that in mind, the formula used is NPV = the sum of Rt / (1+i) t where t represents the years and goes from 1 to 5. In order to properly compute this in Excel, we will calculate the NPV from years 1 to 5 and then subtract from this value the value of the initial outlay, as previously calculated in a different paragraph.

The total value of the NPV is $7,831,888.48, which is a significantly positive value.

Under these conditions and using the initial outlay previously determined and the values of the differential cash flows from years 1 to 5, the internal rate of return for the given project is 30%.

With the calculation of the NPV and the IRR, the conclusion of the analysis is that the project is viable at least because of two reasons. First, the NPV for years 0 to 5, where year 0 is the initial outlay, is positive. Using a differential cash flow for these 5 years, the estimate is that the company is likely to have a positive net present value of $7,831,888.48, which makes the project viable using this methodology. The project should thus be accepted.

On the other hand, the internal rate of return is 30%, significantly bigger than the acceptable rate of return of 15% that the case study has proposed. This makes the yield of this investment very attractive for a potential investor and for our company as well, as the project thus appears as a very profitable investment.

Whenever analyzing a project and the opportunity to invest in it, the company should also consider the three perspectives from which risk can be evaluated. These are stand-alone risk, corporate risk and market risk. Each of these approaches should undertaken in the case of this project. The stand-alone risk is the risk that the project has by itself, if it were the only project in the organization's portfolio and there were no shareholders.

On the other hand, corporate risk is important because it will give a good idea on the potential impact that the project could have on the company's earnings. This type of measure will create a new perspective going beyond the NPV and IRR that have been previously discussed, including because it links the project with other projects in the company's portfolio, correlating its performance with the overall set.

Finally, the market risk will estimate the effect that the project is likely to have on a stock portfolio. In using all these different approaches, one will have the best evaluation as to the risk impact that the project is likely to have. According to CAPM, market risk is most relevant for a project's risk. This is measured as beta.

There are several potential problems and complications that arise with the CAPM. The model is market-based and includes several assumptions that are not true, including in this particular analysis. On one hand, the CAPM assumes that there are no taxes or transaction costs. At the same time, several of the assumptions are stock-related, while this particular analysis and model is less focused on the stock portfolio risk, since this discusses the risks of a project. With that in mind, the relevant measure of risk for this project appears to be not market risk, but rather stand-alone risk. The stand-alone risk is project-based, considering the risk of the project alone.