How do i do A-N? CHAPTER 11.Cash Flows and Other Topics in Capita 9 403 We are c
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How do i do A-N?
CHAPTER 11.Cash Flows and Other Topics in Capita 9 403 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 some- what of a fad product, be terminated. The following information describes the new project: Cost of new plant and equipment Shipping and installation costs $7,900,000 100,000 UNIT SALES YEAR UNITS SOLD 70,000 120,000 140,000 80,000 60,000 Sales price per unit Variable cost per unit Annual fixed costs Working-capital requirements $300 unit in years 1 through 4, $260 unit in year 5 $180/unit $200,000 per year in years 1-5 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 capi- tal 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. 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? i. Should the project be accepted? Why or why k. In capital budgeting, risk can be measured from three perspectives. What are not? those three measures of a project's risk? 1. 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?Explanation / Answer
a. A capital budget project is a lumpsum investment, which leads to expend the resources currently in order to create future cash flows, thus it leads to loss in liquidity at present. The entire plan involves shelling out the liquidity of the company at present in order to purchase or create capital assets now, which can give a continuous future cash flows in the coming years. In order to make sure that the decision is right in favour of the organisation or not, we need to evaluate and compare the current cash outflows with future cash inflows. The investment proposals are evaluated in terms of the profits which are expected to be generated in future cash flows, with the current outflows of the investment. Moreover the company would be only interested in incremental cash flows, because incremental cashflows is what company would see as a growh in the value of the company over the period of time, so that the company be sure of earning growth in the future and value addition to the company by making the capital budgeting decision.
b. Depreciation is a non-cash item, it may not have direct effect on the cash flows, but since it has effect on the calculation of tax (tax advantage) and it is an expense, it reduces the net profit arising from the investment. Capital budgeting evaluation techniques take into consideration the net cash flows after taking into account the tax benefits and depreciation. So depreciation is an expense and it reduces the net cash inflows.
c. Since we are interested only in the incremental cash flows, we may not be interested in the initial sunk costs which might have already occured before the beginning of the project. Sunk cost is the cost incurred at the stage of making capital budgeting decision, no matter whatever be the result. It is not taken into consideration, because it has already been incurred, and has no relaltion to the future cash flows of the project.
d. Project's Initial Outlay: Is the total initial cash outflow of the project, which are incurred to begin or start the project. It includes total investment made to purchase the fixed assets as well as the total cash outlay in the working capital investments.
Initial Cash outlay = Equipment purchase price + Shipping and Installation + Changes in working capital
= 7900000 + 100000 + 100000 = $8,100,000
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