Question

​It's been 2 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 24 percent marginal tax bracket with a required rate of return or cost of capital of 17 percent. This project is expected to last 5 years and​ then, because this is somewhat of a fad​ product, be terminated. The new project information is here:

Cost of new plant and equipment: $7,900,000

Shipping and installation costs: $100,000

Unit Sales:  

YEAR	UNITS SOLD
1	55,000
2	120,000
3	140,000
4	65,000
5	45,000

Sales price per unit: $320/unit in years 1 through 4, $280/unit in year 5

Variable cost per unit: $200/unit

Annual fixed costs: $200,000 per year in years 1 - 5

Working-capital requirements: There will be an initial​ working-capital requirement of ​$90,000 just to get production started. For each​ year, the total investment in net working capital will be equal to 20 percent of the dollar value of sales for that year.​ Thus, the investment in working capital will increase during years 1 and​ 2, 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: Bonus depreciation​ method, and as a result the bonus depreciation occurs in year​ 1, with no depreciation in any other years. If any losses​ occur, they would be offset by profits in other areas of the company.

e. What is the annual free cash flow associated with this project in year​ 1?

    What is the annual free cash flow associated with this project in year​ 2?

    What is the annual free cash flow associated with this project in year​ 3?

    What is the annual free cash flow associated with this project in year​ 4?

f. What is the terminal cash flow in year 5 ​(that is, what is the free cash flow in year 5 plus any additional cash flows associated with the termination of the​ project)?

g. Enter the amount of cash flow into the following diagram for this project. Enter a negative number for a net cash outflow and a positive number for a net cash inflow.

h. What is its net present​ value?

i. What is its internal rate of​ return?

j. Should the project be​ accepted? 

    Since the​ project's NPV is ____(positive, negative), the project should be ___(accepted, rejected)

    Since the​ project's IRR is ___(greater, less) than the required rate of​ return, 17​%, the project should be ____(accepted, rejected).

Answer 1

Solution

Year	0	1	2	3	4	5
units Sold		55,000	120,000	140,000	65,000	45,000
Sales		$    17,600,000.00	$     38,400,000.00	$    44,800,000.00	$    20,800,000.00	$    12,600,000.00
Variable Cost		$ (11,000,000.00)	$   (24,000,000.00)	$ (28,000,000.00)	$ (13,000,000.00)	$    (9,000,000.00)
Fixed Cost		$        (200,000.00)	$         (200,000.00)	$        (200,000.00)	$        (200,000.00)	$        (200,000.00)
Depreciation		$    (8,000,000.00)	$                             -	$                            -	$                            -	$                            -
Profit Before tax		$    (1,600,000.00)	$     14,200,000.00	$    16,600,000.00	$       7,600,000.00	$       3,400,000.00
Carryforward of loss			$     (1,600,000.00)	$                            -	$                            -	$                            -
Profit Before tax		$    (1,600,000.00)	$     12,600,000.00	$    16,600,000.00	$       7,600,000.00	$       3,400,000.00
Less: Taxes		$                            -	$     (3,024,000.00)	$    (3,984,000.00)	$    (1,824,000.00)	$        (816,000.00)
Profit After Tax (PAT)		$    (1,600,000.00)	$        9,576,000.00	$    12,616,000.00	$       5,776,000.00	$       2,584,000.00
Add: Depreciation		$       8,000,000.00	$                             -	$                            -	$                            -	$                            -
NATCF		$       6,400,000.00	$        9,576,000.00	$    12,616,000.00	$       5,776,000.00	$       2,584,000.00
Equipment Cost	$ (7,900,000.00)
Shipping and installation cost	$     (100,000.00)
Total Equipment Cost	$ (8,000,000.00)
Working Capital	$       (90,000.00)	$    (3,430,000.00)	$     (4,160,000.00)	$    (1,280,000.00)	$       4,800,000.00	$       4,160,000.00
Total Cash Flows	(8,090,000.00)	$       2,970,000.00	$        5,416,000.00	$    11,336,000.00	$    10,576,000.00	$       6,744,000.00
Cost of Capital	17%
NPV`	=NPV(rate, value1,value2,value3..)
NPV	$12,139,046.22
IRR	=IRR(values,[guess])
IRR	67%

Note 1: Calculation of Bonus Depreciation

= Cost of Equipment * Current Bonus Depreciation rate

= ($ 7,900,000 + $ 100,000) *100%

= $ 8,000,000

Note 2: Calculation of Additional Working Capital requirement each year:

Year	0	1	2	3	4	5
Sales		$    17,600,000.00	$     38,400,000.00	$    44,800,000.00	$    20,800,000.00	$    12,600,000.00
Working Capital to be 20% of sales	$          90,000.00	$       3,520,000.00	$        7,680,000.00	$       8,960,000.00	$       4,160,000.00	$                            -
Additional Working Capital requirement	$          90,000.00	$       3,430,000.00	$        4,160,000.00	$       1,280,000.00	$    (4,800,000.00)	$    (4,160,000.00)

Hence,

Solution e)
the annual free cash flow associated with the project in year​ 1 is $ 6,400,000.00

the annual free cash flow associated with the project in year​ 2 is $ 9,576,000.00

the annual free cash flow associated with the project in year​ 3 is $ 12,616,000.00

the annual free cash flow associated with the project in year​ 4 is $ 5,776,000.00

Solution f)

the terminal cash flow in year 5 is $ 2,584,000 + $ 4,160,000.00 = $ 6,744,000.00

Solution g)

Year	0	1	2	3	4	5
Net Cash Flows	-8,090,000	2,970,000	5,416,000	11,336,000	10,576,000	6,744,000

Solution h)

the net present​ value of the project is $12,139,046.22

Solution i)

internal rate of​ return is 67%

Solution j)

Since the​ project's NPV is positive the project should be accepted

Since the​ project's IRR is greater than the required rate of​return, 17​%, the project should be accepted