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Principles of Finance - Essay Example

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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…
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Principles of Finance
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Principles of Finance

Download file to see previous pages... 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. ...
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 ...Download file to see next pagesRead More
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