Running head: I am prepared to do this by analyzing the financial statement analysis and funds flow.

Running head: CALEDONIA PRODUCTS

Caledonia Products

Lori Ann Ringold

BUS 401 Principles of Finance

Instructor Daniel Brogan

April 1, 2012

Caledonia Products

As the financial analyst, my job is to help Caledonia decide how best to invest its money and to use the information and financial data given to me to monitor and evaluate the firm’s financial position. I am prepared to do this by analyzing the financial statement analysis and funds flow.

The ultimate goal of any financial manager is to maximize shareholders’ wealth. I assume that this is also the goal of the firm. So, what I have in mind is to consider and weigh the risk of undertaking a certain project against the profits associated with undertaking such a project. Capital budgeting techniques will help me in my decisions.

As the financial analyst, should I focus on cash flows or profits? This is a risky project and according to our text, “if the project has more risk than a typical project, then a higher required rate of return should apply. Otherwise, marginal projects will lower the firm’s share price—that is, reduce shareholders’ wealth” (Keown, Martin, & Petty, ch. 11, pg. 321). My decision when measuring wealth or value, is to use cash flows, not accounting profits, as our measurement tool. This means we should be concerned with when the cash flow comes in and when we should invest it to start earning interest on it. We also have to be concerned with when we can give it back to the shareholders in the form of dividends. In other words, it is the cash flows, not profits that are actually received by the firm which can be reinvested.

Accounting profits appear when they are earned, not when the money is actually in hand.

So, considering that it is cash flow that buys new equipment used to pay our suppliers and employees, we also need to understand that the cash must be reinvested to increase shareholder’s wealth which will, in turn, allow us to become closer to our goal.

Another question I have about this project is should all cash flows associated with the project be considered? It is my understanding that when we measure cash flows, we need to think incrementally. Incremental or marginal is what I am trying to explain. Incremental cash flows would affect the capital budgeting decisions. But, understand that incremental cash flows must be considered on after-tax basis because what really increases the value of the firm is the net cash flow that would be available to the financial analyst when I consider future investments.

Also, when I analyze a project, I have to consider depreciation, and although depreciation in itself is a noncash expense, it still affects free cash flow because it has an effect on taxes. Depreciation reduces earnings before tax (EBT), and therefore reduces the tax expense.

Another important type of cost that needs to be discussed is sunk costs. As I stated earlier, incremental cash flows have to be considered when making a capital budgeting decision. For instance, if our firm had an empty building it had purchased could be used for the investment decision we are considering, should I consider the cost of the building when making my budgeting decision? I do not think that would be reasonable because if the investment is not accepted, the cost of the building would not be recovered, So, in other words whether or not the investment is undertaken; the cost of the building would be a sunk cost and it would be irrelevant to the decision.

When I make a capital budgeting decision, I need to consider only incremental cash flows. In order to consider an investment, I need to make sure we have the funds required to undertake the project we are considering. These funds include cost of equipment, installation costs, cost of training as well as any increase in working capital.

Based on my calculations (which I have attached in excel format), the initial costs for the new project is $8,100,000.

We also need to consider differential cash flows. Our text states that “To determine the differential annual free cash flows, we first need to determine the annual change in operating cash flow” (Keown, Martin, & Petty, ch. 11, pg. 312). In my opinion, these are cash flows that are relevant to the project we are considering. These differential cash flows include such things as added revenues less added selling expenses, labor, material used or saved, and any increase or decrease in overhead costs. So, we have to consider these cash flows and analyze them on an after-tax basis.

So, after deep consideration, I think that Caledonia’s differential cash flow will be:

______________________________________________________________________________

Year

1 2 3 4 5

$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000

______________________________________________________________________________

Finally, we should consider terminal cash flow. This includes all incremental cash flows realized at the termination of the project such as the salvage value of the equipment, whether positive or negative and any taxable gains or losses associated with selling the equipment. Terminal cash flows would include any nonexpenses related to the project. Caledonia’s terminal cash flow then is $5,980,000 as shown in the table above and my attached excel sheet.

I have included a cash flow diagram of the project to show you a complete image of the cash out flows and cash inflows associated with the project. I think this provides an excellent summary of those cash flows that are to be analyzed using the various capital budgeting techniques:

Year

0 1 2 3 4 5

($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000

In conclusion, my job is to maximize shareholder’s wealth. I think the project should be accepted because the NPV (net present value) is greater than 0 and the IRR (internal rate of return) is greater than the required rate of return.

Answers to A – N

A.) Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?

I think Caledonia should focus on free cash flows rather than accounting profits. These are the flows that the firm receives and can reinvest. If Caledonia would examine cash flows and were able to analyze the timing of the benefit or cost, that would help in the decision making.

Caledonia should only be interested in these cash flows on an after-tax basis because these flows are available to the shareholder. Only the incremental cash flows should interest Caledonia because looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and are the increased value to the firm from accepting the project.

B.) How does depreciation affect free cash flows or total profits?

Depreciation may not be a cash flow item, but it does affect the level of the differential cash flows over the project's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. So, profits become lower and so do taxes which are a cash flow item.

C.) How do sunk costs affect the determination of cash flows?

If we were to evaluate the capital budgeting proposal, sunk costs would be ignored. Caledonia should be interested in the free cash flows, to the company as a whole. It really does not matter because the sunk costs will have already occurred, which means these are not incremental cash flows. So sunk costs should be irrelevant.

D, E, & F

See spreadsheet

G.) Draw a cash flow diagram for this project

Year

0 1 2 3 4 5

($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000

H.) What is its net present value?

NPV= $16,731,096

I.) What is its internal rate of return?

IRR=77%

J.) Should the project be accepted? Why or why not?

Yes. I believe this project should be accepted because the NPV is > 0 and the IRR is > required rate of return

K.) In capital budgeting, risk can be measured from three perspectives. What are those three measures of a projects risk?

There is the total project risk also called project standing alone risk. This is the project’s risk ignoring the fact that much of this risk will be diversified away as the project is combined with the firm’s other projects and assets. We also have the project’s contribution to firm risk This is the amount of risk that the project contributes to the firm as a whole. Finally, there is systematic risk, which is the risk of the project from the view of a shareholder.

L.) According to CAPM, which measurement of a project’s risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that mean for our view of the relevant measure of a project’s risk?

According to the CAPM, systematic risk is the only relevant risk for capital-budgeting purposes; however, reality complicates this somewhat. Sometimes, a firm may have undiversified shareholders and for them, the relevant measure of risk is the project’s contribution to firm risk. The possibility of bankruptcy also affects our view of what measure of risk is relevant. Because the project’s contribution to firm risk can affect the possibility of bankruptcy, this may be an appropriate measure of risk since there are costs associated with bankruptcy

M.) Explain how simulation works. What is the value in using a simulation approach?

Simulation imitates the performance of the project being evaluated. This is done by randomly selecting observations from each of the distributions that affect the outcome of the project, combining each of those observations and determining the final outcome of the project, continuing with this process until a representative record of the project’s probable outcome is assembled. In effect, the output from a simulation is a probability distribution of net present values or internal rates of return for the project. The decision maker then bases his decision on the full range of possible outcomes.

N.) What is sensitivity analysis and what is its purpose? Please provide answers in excel showing the work for each answer.

Sensitivity analysis involves determining how the distribution of possible net present values or internal rates of return for a particular project is affected by a change in one particular input variable. This is done by changing the value of one input variable while holding all other input variables constant.

References

Reference: Keown, Martin, & Petty. Foundations of finance. (7th ed). 2011. Pearson. Boston, MA.