- Cash flow
Caledonia should be focusing on free cash flow instead of accounting profit. This is due to reason that free cash flow may be used by companies to reinvest once again. Cash flow once examined can assist the company to analyse the benefit by timing it. Also, cash flow is the only available to the shareholders after taxation. To add to that, incremental cash flow are the increased values to the company from accommodating the project becoming the marginal benefits.
- Depreciation
Depreciation is the decrease in value of an asset, but not a cash flow item. Depreciation has an indirect effect to free cash flow through the effect of taxes which also affects cash flow. Thus, the greater rate of depreciation incurred, the more are expenses which in result lowers the accounting profit.
- Sunk cost
Sunk costs are the already past cost that have been incurred and cannot be gotten back. These costs are ignored when justifying the budget proposal. It shows that when looking at the company as a whole, only the incremental after-tax cash is to be analysed. This indicates that if there is any decision made concerning the investment, the sunk cost has no any effect. The sunk cost has no incremental cash flow as it has already occurred hence irrelevant to the determination of cash flows.
Calculations for questions d), e) and f) are done using the formulae given below. The values= obtained are tabulated as shown below:
Sales revenue= units sold * sale price ($300)
Variable cost= variable cost (180)* units sold
EBDIT=sales revenue-variable cost-fixed cost
Taxes =34% of EBIT
Depreciation (straight method) = (cost of plant & equip)1/5
Project’s free cash flows = ∆TI - ∆T + ∆D - ∆WC - ∆CS
∆TI =change in earnings before taxes and interest
∆T= changes in taxes
∆D= change in depreciation
∆WC=change in net working capital
∆CS= change in capital spending
Operating Cash Flows = ∆TI- ∆T + ∆D
NPV = R * 1- (1+i)-ni– Initial investment where: R=net cash inflow expected, i=rate of return, n=number of periods
IRR = 0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . +Pn/(1+IRR)n where P0, p1 ..pn is the cash flow in the period on 1, 2,n(Wallstreet Oasis, 2010)
j) The project should be accepted since its net present value is greater than zero and the internal rate of return is also greater than the rate of return.
k)According to (Simister, 1994), there are three measures that should be put in measure of the project’s risk. Namely:
- Total project risk which ignores the truth of the risk diversifying on the combination of the project and assets with a project of other firms.
- Contribution to firm risk. This is the amount of risk contributed by a project to the firm. It takes into consider the truth that the risks of the project will be spread all over whereby various projects are combined with other assets and projects without taking into consideration of the firm’s shareholders thus resulting to this firm risk.
- Systematic risk is the risk will generates from well-diversified shareholders. In this risk, diversification of some project while combining with the firm’s project whereby the remaining risks is diversified by the shareholders. These shareholders combine the stock at present with other stock in their collection.
l) According to CAPM, the only relevant risk for the capital-budgeting task is the systematic risk. Where there are undiversified shareholders, the type of risk likely to face is the project’s contribution to firm risk. Since the project’s contribution to firm risk may lead to bankruptcy, it can be used as a measuring tool of risk as there are costs related to bankruptcy.
m) Simulation work
Simulation work gives an estimate on how the evaluation performance of the project will be. To achieve this, random selection of observation from each distribution which is likely to affect the result of the project, combined and the result of the project is obtained. The whole process is repeated till the projects’ expected result is assembled. The simulation’s result represents the net present values where decision makers grounds their decisions as intensively as possible to yield good results
n)
n) Sensitivity analysis
Keown, Martin & Petty (2011) defined sensitivity analysis as “a method for dealing with risk where the change in the distribution of possible net present values or internal rates of return for a particular project resulting from a change in one particular input variable is calculated. This is done by changing the value of one input variable while holding all other input variables constant”.
They also stated that it is very essential to check the incremental cash flows during financial decision making processes. In this case, Keown, Martin & Petty (2011) defined incremental cash flow of a company as “the difference between the cash flows the company will produce both with and without the investment it’s thinking about making.”
Reference
Keown, A., Martin, J., & Petty, J. (2011).Foundations of finance (7th ed.). Boston, MA: Prentice Hall. ISBN: 9780136113652
Simister, S. J. (1994). International Journal of Project Management. Usage and benefits of project risk analysis and management, 12(1), 5-8.
Wallstreet Oasis. (2010, April 4). EBITDA Vs OPerating Cash flow Vs Cash Flow. Retrieved March 10, 2013, from Wall street Oasis: http://www.wallstreetoasis.com/forums/ebitda-vsoperating-cash-flow-vs-free-cash-flow
