Question 1
Caledonia should focus on cash flows and not accounting profits when analyzing the new project because of several reasons. First, in capital budgeting decisions, investments are usually in the form of cash outflows. Therefore, only costs that result in actual outflow of cash are relevant n such decisions. However, accounting profits includes sunk costs and non-cash expenses such as depreciation that are not relevant in capital budgeting.
Secondly, in capital budgeting decisions, the timing of cash flows is very important. This is because of time value of money. In using free cash flows, only actual cash out flows and in flows are recorded in their respective years. However, in accounting profits expenses are matched with the revenues. For example, the cost of an asset is spread over the entire life of the asset not just in the year it was purchased. Lastly, free cash flows are easier to calculate and there is only one method of calculating free cash flows. Free cash flows are obtained by cash inflows less cash outflows. On the other hand, accounting profits is more complex and there many methods of arriving at it which may result in different figures. For example, inventory maybe valued using LIFO, average cost method or FIFO.
Question 2
Incremental cash flows are obtained by adding net operating cash flows to cash flows from investments.Net operating cash flows refers to cash generated from sales revenue less any expenses incurred. It is given by profit after tax plus depreciation. Cash flows from investments normally comprise of initial investment and net working capital changes. On the other hand, accounting profit is the net profit after tax.
The computation of the accounting profit and the incremental cash flows for the new project for the 5 years is in the excel sheet.
