Capital-Budgeting Decisions of Caledonia Products - Case Study Example

? Finance and Accounting – Mini Case Finance and Accounting – Mini Case a. In making its capital-budgeting decisions, Caledonia Products focuses more on cash flows than its accounting profits. The cash flows are what the firm receives and what it can reinvest. The examination of the cash flows of the business enables the management to correctly asses the timing of the benefit or cost. Cash flows must be assessed on an after tax basis because these are the available flows to the shareholder. Furthermore, the firm must focus on the incremental cash flows rather than incremental profits as the company looks at the project as a whole. The incremental cash flows constitute the marginal benefit from the project. Therefore, the incremental cash flows are the increased value to the firm from accepting the project. It is suitable to take the total free cash flow into account rather than taking the total profits. b. Cash flow items do not include depreciation. However, depreciation affects the cash flows at various levels on the life of the project as it has effects on taxes, which in turn impacts the cash flows (Business Accounting Guide). Depreciation comes under the expenses items and when the amount of depreciation incurred increases, the expenses also increase in proportion. On such a situation, the accounting profits get diminished. c. The sunk costs are ignored while assessing the capital budgeting proposal. The company as a whole concentrates only on the incremental after-tax cash flows, or free cash flows. The decision made on the investment at hand is not regarded as the sunk cost that would have already incurred. They are irrelevant and are not incremental cash flows and so they do not affect the determination of cash flows. d. The project’s initial cash outlay can be calculated by using the following formulae. Initial Cash Outlay = Cost of new plant & equipment + Cost of shipping & installation + Increase in working capital = $7,900,000+ $100,000+$100,000 = $8,100,000 e. The differential cash flows over the project’s life can be found out by adding Taxes to the amount of EBIT (Earning Before Interest and Taxes) and deducting the amount of Depreciation. The differential cash flows through the years are assessed as follows: Operating Cash Flow Statement Year 1 2 3 4 5 EBIT $6,500,000 $12,500,000 $14,900,000 $7,700,000 $2,900,000 Less: Taxes $2,210,000 $4,250,000 $5,066,000 $2,618,000 $986,000 Add: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000 Differential (Operating) Cash Flows $5,890,000 $9,850,000 $11,434,000 $6,682,000 $3,514,000 f. The Terminal Cash Flow means the cash flow that is accumulated at the end of the project life. It takes the net recovered value collected at the liquidation of the project into account. It consists of cash flow on account of the changes in net working capital but leaves out the operational cash flow from the previous year of the project. Usually, changes in the net working capital affect the cash inflow, which is the recovered amount of cash outflow taken into account at the starting of the project (Terminal Cash flow in capital budgeting decision, 2010). The Terminal Cash Flow is assessed using the following statement. Terminal Cash Flow = $5,914,000.00 Free Cash Flow Statement   1 2 3 4 5 Operating Cash Flow $ 5,890,000.00 $9,850,000.00 $11,434,000.00 $ 6,682,000.00 $ 3,514,000.00 Less: Change in Net Working Capital $ 2,000,000.00 $1,500,000.00 $ 600,000.00 $(1,800,000.00) $(2,400,000.00) Less: Change in Capital Spending $ - $ - $ - $ - $ - Free Cash Flow: $ 3,890,000.00 $8,350,000.00 $10,834,000.00 $ 8,482,000.00 $ 5,914,000.00 g. Cash Flow Diagram: Cash Flow Diagram       1 2 3 4 5 Operating Cash Flow   $ 5,890,000 $ 9,850,000 $ 11,434,000 $ 6,682,000 $ 3,514,000 Less: Change in Net Working Capital $ 100,000 $ 2,000,000 $ 1,500,000 $ 600,000 $ (1,800,000) $ (2,400,000) Less: Change in Capital Spending $ 8,000,000 $ - $ - $ - $ - $ - Free Cash Flow: $ (8,100,000) $ 3,890,000 $ 8,350,000 $ 10,834,000 $ 8,482,000 $ 5,914,000 $ (8,100,000) Read More