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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% tax bracket with a 15% 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
Shipping and installation costs: $ 100,000
1 – 4 year Sales price per unit $300 - $180 Variable cost = $120
5 year sales price per unit $260 - $180 variable cost = $80
1. 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?
2. 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?
3. What is the project’s initial outlay?
4. Sketch out a cash flow diagram for this project.
1. 70,000 x $300 = $ 21,000,000
2. 120,000 x $300 = $ 36,000,000
3. 140,000 x $300 = $ 42,000,000
4. 80,000 x $300 = $ 24,000,000
5. 60,000 x $260 = $...
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