It's been 2 months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your assignment follows:

We are considering the introduction of a new product. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project: Cost of new plant and equipment $7,900,000   Shipping and installation costs $ 100,000 Unit sales       YEAR UNITS SOLD            1 70,000          2 120,000          3 140,000          4 80,000          5 60,000    Sales price per unit $300/unit in years 1 through 4, $260/unit in year 5 Variable cost per unit $180/unit Annual fixed costs $200,000 Working-capital requirements There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5. The depreciation method Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years. a. Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits? b. How does depreciation affect free cash flows? c. How do sunk costs affect the determination of cash flows? d. What is the project's initial outlay? e. What are the differential cash flows over the project's life? f. What is the terminal cash flow? g. Draw a cash flow diagram for this project. h. What is its net present value? i. What is its internal rate of return? j. Should the project be accepted? Why or why not? k. In capital budgeting, risk can be measured from three perspectives. What are those three measures of a project's risk? l. According to the CAPM, which measurement of a project's risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that mean for our view of the relevant measure of a project's risk? m. Explain how simulation works. What is the value in using a simulation approach? n. What is sensitivity analysis and what is its purpose? (Keown. Foundations of Finance: The Logic and Practice of Financial Management, 6th Edition. Pearson Learning Solutions 14.15).

a. We focus on free cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest.  Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost.  Also, we are only interested in these cash flows on an after-tax basis as only those flows are available to the shareholder.  In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project.

b. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project's life because of its effect on taxes.  Depreciation is an expense item and, the more depreciation incurred, the larger are expenses.  Thus, accounting profits become lower and in turn, so do taxes which are a cash flow item.

c. When evaluating a capital budgeting proposal, sunk costs are ignored.  We are interested in only the incremental after-tax cash flows, or free cash flows, to the company as a whole.  Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows.  Hence, they are irrelevant.

Section I. Calculate the change in EBIT, Taxes, and Depreciation (this become an input in the calculation of Operating Cash Flow in Section II).