Principles of Finance for Caledonia - Essay Example

?Part A: Caledonia needs to focus on the free cash flows of the project instead of focusing on the accounting profits of the project because free cash flows of the project will reflect the amount of money the company will receive from the project whereas the accounting profits of the project will reflect the profits on paper from the project rather than the amount of cash that the company has received from the project. By focusing on the free cash flows, Caledonia would be able to better analyze the cash flows and the timings of the cash flows. Another reason for focusing on cash flows is that the company might be showing positive accounting profits but it might not be having positive cash flows and therefore it is more important to use the cash flows instead of accounting profits in making the capital budgeting decisions. The company should be more interested in incremental cash flows in comparison to the total cash flows because incremental cash flows would reflect the increase in the cash flows from the project whereas the company could still be showing positive total profits even if the project is having a loss. Therefore it is more important to use the incremental cash flows as by using this method, the company would be able to analyze the marginal benefits that the project would give to the company and if the incremental cash flows are positive then the project should be accepted. The company should not use the incremental profits because it would also reflect the increase in the accounting profits from the project rather than showing the cash flows. Also the total profits or incremental cash flows should not be used to take capital budgeting decision because a firm can still be in positive total profits or positive incremental profits even if it is suffering from negative cash flows. Therefore, using the incremental cash flows would be the best technique for the firm. Part B: Depreciation And Free Cash Flows Depreciation is a non-cash item and even if the company records in its accounting book as depreciation expense, the company does not have to pay this expense to anyone (Gitman, 2003). However depreciation expense influences the differential cash flows of the project throughout its life because depreciation expenses influence the tax of the company. As depreciation is an expense, and therefore the higher the value of the depreciation expense, the lower would be the accounting profits of the company and therefore the lower amount of tax the company has to pay therefore depreciation would influence the cash flows in this manner. Part C: Sunk Costs and its Affect On Cash Flows When capital budgeting techniques are used to evaluate the feasibility of the project, sunk costs are ignored. The main focus in on the incremental cash flows particularly the incremental cash flows after deduction of taxes as they mainly reflect the cash flows at the end the company would receive. No matter what the decision has been made on the acceptance or rejection of the project, the sunk costs would still occur (Khan, 1993) and this would mean that sunk costs are not to be considered as incremental cash flows. Therefore incorporating the sunk cost in the capital budgeting technique would be irrelevant. Part D: Initial Project Outlay Initial project outlay is the amount of investment that would be required for the project. The initial outlay for this would be: Initial Project Outlay = All costs related to the Plant and equipment including shipping and installation costs + increment in the working capital because of the project Here, the installation and shipping cost is $100,000 Plant and equipment cost is $7,900,000 Increment in working capital is $100,000 So, Initial Project Outlay = $8,100,000 Part E: Differential Cash Flows Over The Project's Life Operating Cash Flow:  1  2  3  4  5 Revenue 21,000,000 36,000,000 42000000 24000000 15600000 Variable Cost 12600000 21600000 25200000 14400000 10800000   8,400,000 14,400,000 16,800,000 9,600,000 4,800,000 Depreciation expense $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000             Fixed Cost 200,000 200,000 200,000 200,000 200,000 Earnings before interest and taxes (EBIT) 6,600,000 12,600,000 15,000,000 7,800,000 3,000,000 Taxes $2,244,000 $4,284,000 $5,100,000 $2,652,000 $1,020,000 Re-add: Depreciation (Non-cash flow exp) $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000 Operating Cash Flow $5,956,000 $9,916,000 $11,500,000 $6,748,000 $3,580,000 Part F: Terminal cash flows Terminal cash flows can be defined as the cash flow that is occurred at the end of the project life and this considers the value or the money the company receives as the project is completed or liquidated. For instance, the amount that would be received after selling of assets would be included in the terminal cash flows as the company would receive it at the end of the project. Terminal cash flows of the project is calculated below: Operating Cash Flow: 0 1 2 3 4 5 Revenue   21,000,000 36,000,000 42000000 24000000 15600000 Variable Cost   12600000 21600000 25200000 14400000 10800000     8,400,000 14,400,000 16,800,000 9,600,000 4,800,000 Depreciation expense   $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000               Fixed Cost   200,000 200,000 200,000 200,000 200,000 Earnings before interest and taxes (EBIT)   6,600,000 12,600,000 15,000,000 7,800,000 3,000,000               Taxes   $2,244,000 $4,284,000 $5,100,000 $2,652,000 $1,020,000 Re-add: Depreciation (Non-cash flow exp)   $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000 Operating Cash Flow   $5,956,000 $9,916,000 $11,500,000 $6,748,000 $3,580,000 Changes in Working Capital $100,000 $2,000,000 $1,500,000 $600,000 ($1,800,000) ($2,400,000) Change in Capital Spending $8,000,000 0 $0 0 0 0 Free Cash Flow: ($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000 Part G: Cash flow diagram of the project $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,400 Year 1 Year 2 Year 3 Year 4 Year 5 ($8,100,000) Initial Project Outlay Part H: Net present Value: Net present value is the value of the future cash flows discounted at present value (Lohmanna, & Bakshb, 1993). Free Cash Flow: ($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000  NPV at 15%   $14,548,778.83 Part I: Internal rate of return Free Cash Flow: ($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000 IRR  77.02% Part J: Decision To Accept Or Reject The Project The project should be accepted as the NPV of the project is positive as and the internal rate of return of the project is greater than the required rate of return of the project. Part K: Risks and its three perspectives Risk is defined as the variations in the projected cash flows. Risk can alter the management decision to accept or reject the project. There are three main perspectives to measure the risk: Stand Alone risk: Stand Alone risk of the Project is the risk of the project and this kind of risk is because of the project only. If the project is not accepted or started then stand alone risk will not be considered or impact the company’s performance. This risk will be diversified as the company will be involved in several projects rather than only one project. Contribution To The Firm Risk The other perspective to measure the risk is the contribution to the firm risk which reflects the risk that the firm will have after the project is accepted or the amount of risk that the company will have to face as the project is accepted. If a risky project is accepted and the firm is involved in different projects, then the risk will be diversified to a certain extent but still it could influence the cash flows of the company. However, the contribution of the project’s risk would be high in the total risk of the company. Systematic Risk The other perspective to measure the risk is the systematic risk which is the risk that the company would face because of market or external conditions. This kind of risk is also considered as un-diversifiable risk. Part L: According to the capital asset pricing model (CAPM), the only relevant risk is the systematic risk for capital budgeting purpose, however there are certain complications in real world. There can be many instances where the company would have undiversified shareholders and therefore they would analyze the project from the risk that the project would contribute to the firm. In addition to this, there is another risk which is of bankruptcy. If the project has higher amount of risk or it has higher contribution of risk, then it could increase the chances of bankruptcy and therefore this can be considered as an important measure of risk considering the cost related to the bankruptcy. Part M: Simulation Simulation is the technique that is used to evaluate the performance of different projects that are being evaluated by the management or company before they are being accepted. It allows the company to analyze whether the project would be feasible or not. Simulation can be done by taking different random observations from different factors that could influence the final result or profit of the project and after combining these observations a simulated outcome or a project outcome of the project can be determined. Techniques such as probability distribution of different occurrences of events can be used and then net present value or internal rate of return or some other project appraisal techniques can be used to determine whether the project should be accepted or not. Part N: Sensitivity analysis Sensitivity analysis is used to analyze and determine how the values of net present value as well as internal rate of return are changed of the project if one of the input variables is changed (Keown, Martin, & Petty, 2011). As the value of input variables change, it would influence the values of profits and thus it would influence the profits of the company and therefore would influence the resulting values or the output values. References Gitman, L. (2003). Principles of Managerial Finance. Boston: Addison-Wesley Publishing. Keown, A., Martin, J., & Petty, J. (2011). Foundations of finance (7th ed.). Boston, MA: Prentice Hall Khan, M. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill Higher Education. Lohmanna, J., & Bakshb, S. (1993). The IRR,NPV And Payback Period And Their Relative Performance In Common Capitial Budgeting Decision Procedures For Dealing With Risk. The Engineering Economist: A Journal Devoted to the Problems of Capital Investment, 39(1), 17-47. Read More