Capital Budgetting of Caledonia Products - Research Paper Example

A- Caledonia Products should focus on free cash flows for evaluation of the project investment as compare to accounting profit in capital budgeting decision. Free cash flows provide the real picture of the amount that would be available to company from the project as the results are arrived with incorporating elements of time and risks in evaluation. Accounting profits, on other hand, are more like figures on paper only and due to ignorance of mentioned factors. There is every opportunity that accounting profits of the project shows an investment profitable, but it might be possible that the investment might not yield any returns to the company.

Another reason to focus on cash flow results than accounting profits is accounting profits include all expenditure and incomes be it result in cash in-flow or outflow. For instance, depreciation does not actually cause any cash out-flow but it is included in the accounting profits. However, cash flow accounts only consider those that affect the movement in cash inwards or outwards. So, free cash flows should be used to evaluate any project. Since the report is evaluate new project and take decision to undergo or not, therefore, company should focus on incremental cash flows from the projects.

There may be the case when overall company making positive cash flows whereas flow from the said project is otherwise. Incremental cash flows form the project provides marginal benefit firm can reap by taking this investment decisions. Same goes for the total and incremental profits. Incremental profits provide evaluation of benefit particular project will add to the firm’s value in addition to the total profits firm will be making. Therefore incremental profits should be used. B- DEPRECIATION EXPENSE AND FREECASH FLOW Depreciation is a non cash expense and although it is recorded in accounting statements as expense, but it does not actually incur any cash outflows (Gitman, 2003).

However, overall project cash flow receives impact from depreciation expense over a period of projects life. Depreciation expense reduces the amount of tax accrued on company which is a cash flow item; therefore, it impacts cash flow positively. C- SUNK COST AND ITS IMPACT ON CASH FLOWS Corporate finance theory suggests that while making investment decisions using capital budgeting techniques no consideration should be given to the sunk cost as this cost has already been incurred (Khan, 1993) whether the project is conducted or not and therefore it has no relevancy to future incremental cash flows that determines the acceptance or rejection of cash flows.

Only the concerned element is the after tax incremental cash flows as this is the amount which is available to the shareholder. Hence, evaluation of project using NPV and IRR shall ignore sunk cost item. D- INITIAL OUTLAY OF THE PORJECT Initial outlay of any project refers to amount of investment that will be required to undertake a project or the cost incurred for beginning the project. It includes basic plant and installation cost along with any shipping or transportation cost incurred to take plant to production point.

It further includes any change working capital due to this project. Initial cost incurred for this project is: $ $8,100,000.00 which includes: Plant and equipment cost is $7,900,000 the installation and shipping cost is $100,000 increased working capital is $100,000 E- DIFFERENTIAL CASH FLOWS OVER THE PROJECT'S LIFE Differential cash flow refers to incremental after tax