Team_D_Caledonia_Products

Caledonia Products Integrative Problem Michelle M. Rayford, Peter Pontone, and Sibylle Letzelter FIN/370 June 18, 2012 Laura Haase Caledonia Products Integrative Problem Question 1 Caledonia should focus on project free cash flows as opposed to accounting profits earned because free cash lows show the value of the projects. Caledonia needs to isolate the project independent from regular company financials to understand how the project will contribute value to the business. Accounting profits earned will take into account the entire business and it will not isolate the project. A good example is dry cleaners that decide to open up a second location. The owner needs to look at the cash flow from the second store on its own to see if it will add enough value on its own. If you look at just the accounting profits, it might indicate that the company will be “more” profitable. However, that does not show how much the new project contributes on its own. Question 2 Incremental Cash Flows Years 1-5 | YEAR 1 | YEAR 2 | YEAR 3 | YEAR 4 | YEAR 5 | Project Revenues (sales price/unit * # units) | 21,000,000 | 36,000,000 | 42,000,000 | 24,000,000 | 15,600,000 | Cost of Goods Sold ($180/unit) | 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 | Cash operating expenses | 200,000 | 200,000 | 200,000 | 200,000 | 200,000 | Depreciation ($7.9M/5) | 1,580,000 | 1,580,000 | 1,580,000 | 1,580,000 | 1,580,000 | Net Operating Income | 6,620,000 | 12,620,000 | 15,020,000 | 7,820,000 | 3,020,000 | Taxes (34%) | 2250800 | 4290800 | 5106800 | 2658800 | 1026800 | NOPAT | 4,369,200 | 8,329,200 | 9,913,200 | 5,161,200 | 1,993,200 | Add Depreciation | 1,580,000 | 1,580,000 | 1,580,000 | 1,580,000 | 1,580,000 | Operating Cash Flow | $5,949,200 | $9,909,200 | $11,493,200 | $6,741,200 | $3,573,200 | These cash flows differ from accounting profits or earnings because they identify how much cash is available to the business. Profits indicate how much money is left after the company has sold its good and service from a performance standpoint. A company needs to be profitable, but it also needs to ensure there is cash available when needed. The cash flow statement allows the company to plan for purchasing raw materials and paying off taxes, debt and any other expenses. A company can be profitable, but can still go bankrupt because it does not have money to pay the bills or purchase raw materials. Question 3 The initial outlay of the project is calculated as follows. CAPEX + NOWC = ($7,900,000 +$100,000) = ($100,000) = $8,100,000 The initial outlay for the project is $8,100,000. Question 4 For cash flow diagram, you need to consider your Operating cash flow plus or minus your change in working capital. For this project Initial cash outlay: $8,100,000 Year 1 = $3,956,000 Year 2= $8,416,000 Year 3=$10,900,000 Year 4=$8,548,000 Year5=$5,980,400 Question 5 . The formula for Net Present Value (NPV) is as follows NPV= (-8,100,000)+3,956,000/1.15+8,416,000/1.15²+10,900,000/1.15³+8,548,000/1.154+5,980,000/1.155=$16,731,096 The NPV for this project is: $16,731,096 6. The project’s Internal Rate of Return is as follows 6. At IRR, NPV = 0 0 = -8,100,000 + 3,956,000/ (1 + IRR) + 8,416,000/ (1 + IRR) 2 + 10,900,000/ (1 + IRR) 3 + 8,548,000/ (1 + IRR) 4 + 5,980,000/ (1 + IRR) 5 Solving for IRR, IRR = 77% The IRR for this project is 77%. Question 7 Should the project be accepted' Why or why not' The project should be accepted because of a strong Net Present Value as well as a High Internal Rate of Return. Using NPV and IRR as your benchmarks to evaluate your projects are the two most common used measures. A higher NPV and IRR will show a stronger investment opportunity. Question 8 Describe the factors Caledonia must consider if it were to lease versus buying. There are many important factors that Caledonia must consider when attempting to determine if they should lease or buy. One essential factor is the time frame of the said project. Being that the said project is a short term project, expected to last just 5 years, it may be more beneficial to lease rather than buying. If the company decides to lease and there are significant unexpected changes such as a substantial increase in the term of the program, the company can always explore the option of buying the property. Another factor that must be considered when determining whether to lease or to purchase would be the financial strain that purchasing would put on the company. In order to purchase, a substantial amount of finances would be secured for the down payment of the property. If the company decided to lease then there would be no need for such a large initial down payment. Maintenance of the property would also be a factor. If the property was purchased, all maintenance and upkeep would be the financial responsibility of the company rather than the owners. After weighing all factors, the property should be leased! References Titman, S., Keown, A. J., & Martin, J. D. (2011). Financial management: Principles and http://hspm.sph.sc.edu/Courses/Econ/Invest/invest.html sam.baker@sc.edu Lorie JH, Savage LJ, "Three Problems in Capital Rationing," Journal of Business, Vol. 28, October 1955.