When companies are determining whether an investment must be undertaken, they decide if the investment will add to or detract from the value of the firm. There are several determining factors in evaluating an investment. These include project free cash flow versus accounting profits, incremental cash flows, net present value, and internal rate of return. Caledonia Products is deciding whether to undertake a new investment project. The firm must determine the cash flows for the life of the project, calculate the net present value and the internal rate of return, and decide whether the project is a sound investment.
Caledonia must focus on free cash flow somewhat than accounting earnings because the free cash flow profits the society obtains, which can invested. Through examining the free cash flow, Caledonia would be competent to decide the definite advantage or the cost complicated. The association mainly should focus on the incremental cash flow since the incremental cash flow grips a peripheral advantage from the development. Decrease is measured to be expenditure item that means that the superior the devaluation, the superior the expenditure motivation be to the association. Consequently, if Caledonia perceived at the development from an office profit view, the profit would be much slighter than that of the free cash flow.
The financial assistant received the important assignment by memorandum from the Chief Executive Officer. The memorandum stated that the company is considering the introduction of a new product (Titman, Keown, & Martin, 2011). Caledonia is currently at a 34% marginal tax bracket with a 15% required rate of return or cost of capital (Titman et al., 2011). The new project is estimated to last five years before termination because it is a fad project (Titman et al., 2011). The financial assistant must analyze two mutually exclusive projects. Each project has an 11% rate of return and a life span of five years (Titman et al., 2011). Consequently, profits are lowered and so are the taxes which are cash flow it.
Caledonia Products initial cash outlay equals the cost of new plant facilities and equipment plus shipping and installation costs plus the increase in working capital. This is the cost of entering into the project:
Cost of new plant and equipment: $ 7,900,000
Shipping and installation costs: $ 100,000
Working capital requirement of $ 100,000
Total $ 8,100,000
Table 1.1 Cash Flow Diagram
Year | 0 | 1 | 2 | 3 | 4 | 5 |
Unit Sales | | 70,000 | 120,000 | 140,000 | 80,000 | 60,000 |
Project Revenues | | 21,000,000 | 36,000,000 | 42,000,000 | 24,000,000 | 15,600,000 |
Variable Expense | | 12,600,000 | 21,600,000 | 25,200,000 | 14,400,000 | 10,800,000 |
Gross Profit | | 8,400,000 | 14,400,000 | 16,800,000 | 9,600,000 | 4,800,000 |
Fixed Expenses | | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 |
Depreciation | | 1,600,000 | 1,600,000 | 1,600,000 | 1,600,000 | 1,600,000 |
Net Operating Income | | 6,600,000 | 12,600,000 | 15,000,000 | 7,800,000 | 3,000,000 |
Taxes | | 2,244,000 | 4,284,000 | 5,100,000 | 2,652,000 | 1,020,000 |
Net operating profit after taxes | | 4,356,000 | 8,316,000 | 9,900,000 | 5,148,000 | 1,980,000 |
Depreciation | | 1,600,000 | 1,600,000 | 1,600,000 | 1,600,000 | 1,600,000 | less increase in CAPEX | -8000,000 | | | | | | less Increase in working capital | -100,000 | -2,000,000 | -1,500,000 | -600,000 | 1,800,000 | 2,200,000 |
Free Cash flow | -8100,000 | 3,956,000 | 8416000 | 10,900,000 | 8,548,000 | 5,780,000 |
Net Present Value
The goal of every corporation is to increase the return on the shareholder’s investment thereby generating increased wealth. The amount of wealth generated by an investment is measured using the net present value formula (NPV). The net present value of an investment represents the present value of future cash flows minus the initial cash outlay. “NPV is the gold standard of criteria for evaluating