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FIN 370 WEEK 4 TEAM ASSIGNMENT - CALEDONIA PRODUCTS INTEGRATIVE PROBLEM

Caledonia Products Integrative Problem
Based on your Week Three readings, prepare a response to the Caledonia Products Integrative Problem located in
Chapter 10 of the Financial Management: Principles and Applications text by Keown.
In your response, be sure to address the following:
Formulate answers to questions 1 through 10.
Include a spreadsheet similar to Table 10-7.
Formulate answers to questions 12a-12e.
Describe the factors that Caledonia would have to consider if they were making a lease versus buy decision for the
two projects.

Formulate answers to questions 1 through 10.

It has 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 and 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 capitalbudgeting process. The memorandum you received outlining your assignment follows: To: The Assistant
Financial Analyst From: Mr. V. Morrison, CEO, Caledonia Products Re: Cash Flow Analysis and Capital
Rationing 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 1: Units sold: 70,000 Year 2: Units sold: 120,000 Year 3:
Units sold: 140,000 Year 4: Units sold 80,000 Year 5: Units sold 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 new 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.
1.) 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?
2.) How does depreciation affect free cash flows or total profits?
3.) How do sunk costs affect the determination of cash flows?
4.) What is the projects initial outlay?
5.) What are the differential cash flows over the projects life?
6.) What is the terminal cash flow?
7.) Draw a cash flow diagram for this project
8.) What is its net present value?
9.) What is its internal rate of return?
10.) Should the project be accepted? Why or why not?
A.) In capital budgeting, risk can be measured from three perspectives. What are those three
measures of a projects risk?
B.) According to CAPM, which measurement of a projects 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 projects risk?
C.) Explain how simulation works. What is the value in using a simulation approach?
D.) What is sensitivity analysis and what is its purpose? Please provide answers in excel showing the
work for each answer.
Answers
1.

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.

2.

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.

3.

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.

Answers from 4-6

7.

Cash flow diagram

$3,956,000

$8,416,000

($8,100,000)

8.

NPV

= $16,731,096

9.

IRR

77%

$10,900,000

$8,548,000

$5,980,400

10.

Yes. This project should be accepted because the NPV 0. and the IRR required rate of return.

A. In capital budgeting, risk can be measured from three perspectives. What are those three measures
of a projects risk?
First, there is the total project risk also called project standing alone risk, which is a projects risk
ignoring the fact that much of this risk will be diversified away as the project is combined with the
firms other projects and assets. Second, we have the projects contribution to firm risk, which is the
amount of risk that the project contributes to the firm as a whole; this measure considers the fact
that some of the projects risk will be diversified away as the project is combined with the firms
other projects and assets, but ignores the effects of diversification of the firms shareholders.
Finally, there is systematic risk, which is the risk of the project from the viewpoint of a welldiversified shareholder; this measure considers the fact that some of a projects risk will be
diversified away as the project is combined with the firms other projects, and, in addition, some of
the remaining risk will be diversified away by the shareholders as they combine this stock with other
stocks in their portfolio.
B. According to CAPM, which measurement of a projects 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 projects risk?

According to the CAPM, systematic risk is the only relevant risk for capital-budgeting purposes;
however, reality complicates this somewhat. In many instances, a firm will have undiversified
shareholders; for them, the relevant measure of risk is the projects contribution to firm risk.
The possibility of bankruptcy also affects our view of what measure of risk is relevant. Because
the projects contribution to firm risk can affect the possibility of bankruptcy, this may be an
appropriate measure of risk since there are costs associated with bankruptcy.
C. Explain how simulation works. What is the value in using a simulation approach?
The idea behind simulation is to imitate the performance of the project being evaluated. This is
done by randomly selecting observations from each of the distributions that affect the outcome
of the project, combining each of those observations and determining the final outcome of the
project, continuing with this process until a representative record of the projects probable
outcome is assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then bases his
decision on the full range of possible outcomes.
D. What is sensitivity analysis and what is its purpose? Please provide answers in excel showing the
work for each answer.

Sensitivity analysis involves determining how the distribution of possible net present values or
internal rates of return for a particular project is affected by a change in one particular input
variable. This is done by changing the value of one input variable while holding all other input
variables constant.

Formulate answers to questions 12a-12e.

The required rate of return on these projects is 11 percent.

a. What is each projects payback period?
Payback A = 3.125 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.

b. What is each projects net present value?

NPVA =

NPVB

$32,000

t 1

(1 0.11)t

- $100,000

$32,000 (3.696) - $100,000

$118,272 - $100,000

$18,272

$200 ,000
(1 0.11)5

- $100,000

$200,000 (0.593) - $100,000

$118,600 - $100,000

$18,600

c. What is each projects internal rate of return?

$100,000

$32,000 [PVIFAIRR %,5 yrs]

A

3.125

PVIFAIRR %,5 yrs

A

Thus, IRRA

18.03%

$100,000

$200,000 [PVIFIRR %,5 yrs]

B

.50

PVIFIRR %,5 yrs

B

Thus IRRB is just under 15% (14.87%).

d. What has caused the ranking conflict?

The conflicting rankings are caused by the differing reinvestment assumptions made by the NPV and IRR
decision criteria. The NPV criterion assume that cash flows over the life of the project can be reinvested
at the required rate of return or cost of capital, while the IRR criterion implicitly assumes that the cash
flows over the life of the project can be reinvested at the internal rate of return.

e. Which project should be accepted? Why?

Project B should be taken because it has the largest NPV. The NPV criterion is preferred because it

makes the most acceptable assumption for the wealth maximizing firm.

Describe factors Caledonia must consider if they were doing a lease versus buy.
As noted in the text, There are times when it might be advantageous to lease an asset, even when the
NPV for its purchase is negative. The cost savings of a lease may more than offset the negative NPV of
purchase.
Therefore, one of the most important factors to consider is the net advantage of leasing, or NAL. In
the Net Advantage of Leasing analysis, we calculate the net present value of the lease option and
compare it to the net present value of purchasing. If the net advantage to leasing is positive, then the
leasing alternative would be preferred. If the net alternative to leasing is negative, then the purchase
option should be selected.
Caledonia, therefore should consider the net advantage to leasing and in that it should compare the
expenses and revenues associated with each option; for example at the end of the project, the firm
might be able to sell the equipment receiving a cash inflow while this is not available under the lease
option, yet at the same time under the purchase option Caledonia does not have to make the initial
capital outlay. Another factor to consider is that there might be operating expenses associated with the
purchase option while such expenses would not be incurred under the lease option.