Caledonia Focus on Project Free Cash Flows

¶ … 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 | 3000000 |

Taxes | | 2244000 | 4284000 | 5100000 | 2652000 | 1020000 |

Net operating profit after taxes | | 4356000 | 8316000 | 9900000 | 5148000 | 1980000 |

Depreciation | 1600000 | 1600000 | 1600000 | 1600000 | 1600000 |

less increase in CAPEX | -8000000 | | | | | |

less Increase in working capital | -100000 | -2000000 | -1500000 | -600000 | 1800000 | 2200000 |

Free Cash flow | -8100000 | 3956000 | 8416000 | 10900000 | 8548000 | 5780000 |

5 & 6) What is the project's net present value? What is its internal rate of return?

Caledonia Products | | | |

Year | Team I | Team II | |

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

1 | $32,000 | $0 | |

2 | $32,000 | $0 | |

3 | $32,000 | $0 | |

4 | $32,000 | $0 | |

5 | $32,000 | $200,000 | |

a) | | | |

Payback Schedule -- Team I | | | |

Year | Beginning Unrecovered

Investment | Cash Inflow | Ending Unrecovered

Investment |

0 | $100,000 | $0 | $100,000 |

1 | $100,000 | $32,000 | $68,000 |

2 | $68,000 | $32,000 | $36,000 |

3 | $36,000 | $32,000 | $4,000 |

4 | $4,000 | $32,000 | ($28,000) |

Payback Period | 3.13 | | |

b) | | | |

Team I - NPV | | | |

Year | Cash Flow | PV Factor @ 11% | PV |

0 | ($100,000) | 1 | ($100,000) |

1 | $32,000 | 0.9009 | $28,829 |

2 | $32,000 | 0.8116 | $25,972 |

3 | $32,000 | 0.7312 | $23,398 |

4 | $32,000 | 0.6587 | $21,079 |

5 | $32,000 | 0.5935 | $18,990 |

Team I - NPV | $18,268.70 | | |

c) IRR | | | |

Year | Team I | Team II | |

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

1 | $32,000 | $0 | |

2 | $32,000 | $0 | |

3 | $32,000 | $0 | |

4 | $32,000 | $0 | |

5 | $32,000 | $200,000 | |

IRR | 18.03% | 14.87% | |

| Payback Schedule -- Team II | | | |

| Year | Beginning Unrecovered

Investment | Cash Inflow | Ending Unrecovered

Investment |

| 0 | $100,000 | $0 | $100,000 |

| 1 | $100,000 | $0 | $100,000 |

| 2 | $100,000 | $0 | $100,000 |

| 3 | $100,000 | $0 | $100,000 |

| 4 | $100,000 | $0 | $100,000 |

| 5 | $100,000 | $200,000 | |

| Payback Period | 4.5 | | |

| Team II - NPV | | | |

| Year | Cash Flow | PV Factor @ 11% | PV |

| 0 | ($100,000) | 1 | ($100,000) |

| 1 | $0 | 0.9009 | $0 |

| 2 | $0 | 0.8116 | $0 |

| 3 | $0 | 0.7312 | $0 |

| 4 | $0 | 0.6587 | $0 |

| 5 | $200,000 | 0.5935 | $118,690 |

| Team II - NPV | $18,690.27 | | |

7.) Should the project be accepted? Why or why not?

Based solely on the numerical facts, Caledonia should proceed with the project. The leasing would create enough revenue to justify investing in it. There would be a new version coming out in five years, long enough to justify using the product and then purchasing the newer version. In short, yes invest.

Describe factors Caledonia must consider if it were to lease vs. buying?

There are several questions that must be answered in order to side with leasing or buying. Do I have enough revenue to lease or buy? Do enough employees have the skills and knowledge to operate on a short-term lease or would it cost more to educate them on the lease system and then on the new purchased product? Will I have to alter my building, equipment or staff for both or either the lease or the buy? In the long run which would make me more money?