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What is the project’s initial outlay? What is the project’s net present value?

01 / 10 / 2021 Assignment

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Case 4.Calculating Free Cash
Flow and Project Valuation

It’s been two months
since you took a position as an assistant financial analyst at Caledonia
Products. Although your boss has been pleased with your work, he is still a bit
hesitant about unleashing you without supervision. Your next assignment
involves both the calculation of the cash flows associated with a new
investment under consideration and the evaluation of several mutually exclusive
projects. Given your lack of tenure at Caledonia, you have been asked not only
to provide a recommendation, but also to respond to a number of questions aimed
at judging your understanding of the capital-budgeting process.

The memorandum you
received outlining your assignment follows:

To: The Assistant
Financial Analyst

From: Mr. V. Morrison,
CEO, Caledonia Products

Re: Cash Flow Analysis
and Capital Rationing

We are considering the
introduction of a new product. Currently we are in the 34 percent tax bracket
with a 15 percent discount rate. This project is expected to last five years
and then, because this is somewhat of a fad project, it will be terminated. The
following information describes the new project:

Cost of new plant
and equipment:

$
7,900,000

FIN325/ Corporate
Finance, Assignment #2

Shipping and
installation costs:

$

100,000

Unit sales:










Year

Units Sold




1

70,000




2

120,000




3

140,000




4

80,000




5

60,000




Sales price per
unit:

$

300/unit
in Years 1–4 and




$

260/unit in Year 5

Variable cost per
unit:

$

180/unit

Annual fixed costs:

$

200,000 per year

Working capital
requirements: There will be an initial working capital requirement of $100,000
just to get production started. For each year, the total investment in net
working capital will be equal to 10 percent of the dollar value of sales for
that year. Thus, the investment in working capital will increase during Years 1
through 3, then decrease in Year 4. Finally, all working capital is liquidated
at the termination of the project at the end of Year 5.

Depreciation method:
Straight-line over five years assuming the plant and equipment have no salvage
value after five years.

a.
Why
should Caledonia focus on project free cash flows as opposed to the accounting
profits earned by the project when analyzing whether to undertake the project?

b.
What
are the incremental cash flows for the project in Years 1 through 5, and how do
these cash flows differ from accounting profits or earnings?

c.
What
is the project’s initial outlay?

d.
What
is the project’s net present value?

e.
Should
the project be accepted? Why or why not?



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