a)Caledonia should focus on cash flows instead of accounting profits while making their capital-budgeting decisions because cash flows represents the actual cash that Caledonia receives from the project and can reinvest it in other viable ventures. The timing of the actual costs and benefits can only be analyzed using the cash flows and not the accounting profits. Accounting profit includes some non-cash expenses such as depreciation which do not represent actual cash outflows at that point in time.
In making capital budgeting decisions, it is only the incremental cash flows and not the accounting profit that are of interest to the management and the shareholder’s of Caledonia. This is because incremental cash flows represent the marginal benefits of the project that will subsequently increase the value of the company as a whole. The marginal benefits also reflect the increase in the shareholder’s wealth.
b)Normally depreciation expense is a non-cash item and is not included in the free cash flow statement of a project. Therefore, depreciation expense will not affect cash flows if it is not incorporated in the project’s free cash flow statement. However, if the income of a project is subject to income tax, depreciation expense will affect the cash flow’s expected from a project indirectly. Depreciation expense is an allowable expense for tax purposes. Including depreciation expense in the expenses increases the total expenses which in turn reduces the taxable income. Depreciation, therefore, reduces the total income that is exposed to tax. The tax saving that accrue from taxation is referred to as depreciation tax shield benefit. Therefore, depreciation expense only affects free cash flows in the presence of taxation.
c)Sunk costs refer to expenses already incurred when analyzing a project that the company intends to invest in. An example of a sunk cost is equipment that has already been purchased. In capital budgeting decisions, sunk costs are ignored. Management is only interested on incremental cash flows that accrue from the project. Sunk costs have already been incurred by the company irrespective of the decision the management take regarding the project. Therefore, sunk costs are irrelevant in capital budgeting decisions.
d)The initial outlay of the project is the sum of the cost of the new plant and equipment that was bought, the shipping and installation costs and the initial working capital requirement. This totaled to $8,100,000 as computed in the excel spreadsheet.
e)The differential cash flows are the five years are;$ 3,856,000 in year 1,$ 6,316,000 in the second year,$ 7,300,000 for the third year,$ 4,348,000 for the fourth year and $ 15,980,000 for the fifth year as computed in the excel spreadsheet.
f)The terminal cash flow of the project is the sum of cash flows expected in the final year of the project and the working capital released that was invested over the five years of the project. This totaled to $ 15,980,000 as computed in the excel spreadsheet.
g)The cash flow diagram has been drawn in the excel spreadsheet.
h)The net present value is $15,259,898 as calculated in the excel spreadsheet.
i)The internal rate of return is 16.76% as calculated in the excel spreadsheet.
j)The project should be accepted. Using net present value as the basis of evaluating the project; the project should be accepted because net present value of the project is positive.Net present value can be defined as the difference between the discounted cash flows and the initial outlay of the project. This is because incremental cash flows shown by a positive net present value represent the marginal benefits of the project and the increase in the overall value of the corporation. A positive net present value also reflects an increase in shareholder’s wealth at the given discounting rate.
Using the internal rate of return as the basis of evaluating the project as the basis of evaluating the project; the management should accept the project. The IRR of the project is higher than the cost of capital. The internal rate of return is the rate of return at which the net present value of the project is equal to zero.It is the rate of return that equates the present value of cash flows and the initial outlay. Internal rate of return determines the rate of return expected from the project. If it is higher than the cost of capital it implies that the company will be able to repay the providers of funds if they used external financing. If the company used funds from internal sources, it implies that the company will earn higher returns compared to alternative investments such as bonds.
Project risk refers to the likely variability of a project’s future returns. It the probability that the returns of a project’s future returns will deviate from the expected returns. There three main statistical devices that are used to measure the inherent risk of any project; standard deviation of the project’s cash flows, coefficient of variation and the beta coefficient.
Standard deviation is the square root of the summation of a project’s actual cash flows and the expected cash flows multiplied by the respective probabilities. Standard deviation of a project gives the management a rough estimate of how far each outcome falls away the expected value of the project’s cash flows. The greater the standard deviation of a project the higher the risk associated with the project. Management should, therefore, select projects with a lower coefficient of variation if the expected cash flows of the projects are the same. However, standard deviation makes it difficult to compare projects with different magnitudes of cash flows or cash flows denominated in different currencies.
Coefficient of variation is the second measure of risk inherent to a project. Coefficient of variation is given by dividing the standard deviation by the mean. Coefficient of variation overcomes the weakness of standard deviation as a measure of risk. Coefficient of variation is a relative measure and is therefore independent of units. It also makes it possible to compare projects of different magnitudes. The greater the coefficient of variation of a project the higher the risk associated with the project. Management should, therefore, select projects with a lower coefficient of variation if the expected cash flows of the projects are the same.
Another measure of risk is the beta coefficient which is represented by the symbol β. Beta coefficient is mostly used in evaluating risk associated with portfolio of equity stock. Beta normally measures return’s volatility of an individual stock relative to the stock market index of returns. Beta is widely used in capital asset pricing model to determine the rate of return expected by equity shareholders or the cost of capital of common stock and retained earnings. Beta coefficient is rarely used in measuring risk inherent to a particular project.
Shim, J. K., & Siegel, J. G. (2008). Financial Management (3, illustrated, revised ed.). New York: Barron's Educational Series.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (SAGE, 2007 ed.). New York: SAGE.