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Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

Caledonia Products Integrative Problem


FIN/370

Project Cash Flows vs. Accounting Profits

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

If a company is determining if an investment will be undertaken, it must decide if it will


add or detract from company value. A critical factor would be for Caledonia to focus on free
cash flows as opposed to account profits earned because the cash flows that the company
receives can be reinvested. By examining cash flows Caledonia will be able to analyze the
timing of the benefit or the cost. It is important to focus on incremental cash flows because this
can create a developmental advantage. By Caledonia looking at the project as a whole,
incremental cash flows are benefits from the project that help increase value. Caledonia also
focuses more on project free cash flows over accounting profits on an after tax basis because
those flows are only available to shareholders. These reasons as well as accounting profits are
only shown when they are earned rather than when the money is in hand. Free cash flows allow
Caledonia to correctly reflect, when the money is received, when it can be reinvested, and when
it must be paid out (Titman, Keown, & Martin, 2011).
Incremental Cash Flows
The incremental cash flows for the project in years one through five are Net Initial
Investment Outlay, Net Operating Cash Flow, and Net Salvage Value. The Net Initial Investment
Outlay includes the cash expenditures, the changes in net working capital, net cash flow from the
sale of any existing or older equipment, and investment tax credit. The Net Operating Cash Flow
include the revenue net of expenses and tax liabilities for the period under review. The Net
Salvage Value includes the after-tax net cash flow for the termination, liquidation, or sale of
investments that no longer are financially sustainable or that the owner wanted to get rid of. The
incremental cash flows differ from account profits or earnings because of how Caledonia uses
their cash.

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

The difference between the incremental cash flows and accounting profits or earnings is
the purpose of each. Cash flow shows how cash moves in and out of the company and
accounting profits shows how the company is performing. Caledonias investment of a new
product is a cash outlay and is not expensed. The costs of the product are spread out over five
years.
The Projects Initial Outlay
Cost of new plant and equipment:

$7,900,000

Shipping and installation costs:

$100,000

Total initial outlay:

$8,000,000

Caledonia Products
Year
Units Sold
Price of

1
$70,000.00
$300.00

2
$120,000.00
$300.00

3
$140,000.00
$300.00

4
$80,000.00
$300.00

5
$60,000.00
$300.00

Units
Total Sales

$21,000,000.0

$36,000,000.0

$42,000,000.0

$24,000,000.0

$156,000,000.0

Cost
180/Unit

(12,600,000.0

(21,600,000.0

(25,200,000.0

(14,400,000.0

(108,000,000.0

Annual

0)
(200,000.00)

0)
(200,000.00)

0)
(200,000.00)

0)
(200,000.00)

0)
(200,000.00)

Fixed Cost
Total

$8,200,000.00

$14,200,000.0

$16,600,000.0

$9,400,000.00

$4,600,000.00

Variable

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

Depreciatio (1,600,000.00

(1,600,000.00

(1,600,000.00

(1,600,000.00

(1,600,000.00)

n
EBIT

)
$6,600,000.00

)
$12,600,000.0

)
$15,000,000.0

)
$7,800,000.00

$3,000,000.00

$2,244,000.00

0
$4,284,000.00

0
$5,100,000.00

$2,652,000.00

$1,020,000.00

Tax 34%

Sketch out a cash flow diagram for this project


Operating Cash Flow
EBIT

$6,600,00.00

$12,600,000.0

$15,000,000.0

$7,800,000.00 $3,000,000.00

(4,284,000.00)

(5,100,000.00)

(2,652,000.00

Taxes

(2,244,000.00

Depreciatio

)
$1,600,000.00 $1,600,000.00

$1,600,000.00

)
)
$1,600,000.00 $1,600,000.00

n
Operating

$5,956,000.00 $9,916,000.00

$11,500,000.0

$6,748,000.00 $3,580,000.00

Cash Flow

(1,020,000.00

Projects Net Present Value


I configured the net present value using a financial Calculator. I pulled the data to be
used from the cost of the project plus the $100,000 in initial working capital. The cash flows
were taken from the operating cash flow.
Cost of new plant and equipment:

$7,900,000

Shipping and installation costs:

$100,000

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

Initial working capital:

$100,000

Total:

$8,100,000

Discount Rate:

15%

CF; -8,100,000; Enter


; 5,956,000; Enter
; 1; Enter
; 9,916,000; Enter
; 1; Enter
; 11,500,000; Enter
; 1; Enter
; 6,748,000; Enter
; 1; Enter
; 3,580,000; Enter
; 1; Enter
NPV; 15; Enter
; CPT

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

Net Present Value is $17,776,571,33

Internal Rate of Return


Expected
Cash Flow

Year

Internal Rate of
Return

-8000000

5875600

6316000

7300000

4248000

3364000

69%

Should the project be accepted? Why or why not?


After reviewing the Caledonia Products Mini-Case located near the end of Chapter 12 in
Financial Management I have determined that this project should be accepted because the NPV
and the IRR required rate of return. In addition there was a steady increase in sales revenue
within the first three years even with the minor decrease in years four and five.
Lease vs. Buying Factors to Consider
While considering whether to lease or buy, Caledonia will want to calculate the benefits
that will come from each, such as comparing the expected returns. The Time Value of Money can
help determine the present value of the expected cash inflows from the investment. Currently

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM

Caledonia is in the 34% tax bracket with a 15% discount rate. The project is expected to only last
for five years. (Titman, Martin, & Keown, 2011).
If Caledonia were to lease, the company would not own the asset. Caledonia needs to
consider the costs to lease, if their credit is good enough to consider leasing and will bring an
acceptable lease rate, and if the company will have enough income to cover their lease payments.
Another factor Caledonia needs to consider is how much revenue the new product will bring and
if it will be enough to cover their expenses, including lease payments. If Caledonia were to buy,
they would own the asset and possibly increase their asset values. However, the depreciation of
the asset is also an important factor for Caledonia to consider. If the asset will only depreciate
and have no worth after five years, Caledonia may want to consider the lease option.

Reference
Titman, S., McAllister, W., Keown, A., Pamplin, R., Martin, J., & Collins, C. (2011). Financial
Management: Principles and Applications (11th ed.). Upper Saddle River, NJ: Pearson
Education.

Running head: CALEDONIA PRODUCTS INTEGRATIVE PROBELM