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The following observation will describe the decisions made by a financial analyst who is working for the capital budget department at Caledonia Products. The organization has asked Team B to evaluate the potential risk involved in an upcoming transaction and identify several options in how to proceed. Because this is the team’s first assignments dealing with risk analyzes the team has been ask to further explain the details. The organization analysis will focus on free cash flows, projection of cash flows, projects initial outlay, cash flow diagram, net present value, internal rate of return, and if the project should be accepted.
Why focus on project free cash flows
Team B believes that Caledonia should focus on the project’s free cash flows and not the accounting profits. Evidence exists that the accounting profits will be earned by the project because there is a positive cash flow to the shareholders. With any investment there is the expectation that there will be an increase to the firm’s cash flow. Free cash flow is the total cash available to creditors who have invested their monies to finance the project. Accounting profits includes costs such as depreciation, interest, and taxes to run a business therefore it should not affect free cash flows. The project free cash flows range from year zero to year five and illustrate how much Caledonia Products will benefit if they choose to take on this project.
Projection of project in years one through five
There is annual working capital requirement of $100,000 to initiate the project. The incremental cash flows for the project in years one through five shows increase. For each year, the total investment in net working capital will be equal to 10% of the dollar value of sales for that year. In year one free cash flow is $2,100,000 in year two $3,600,000, which means fist year increase of $1,500,000, and it is about 53% increase. In year two 23% increase and year three to four decreases of 28%, and in year five free cash flow is $1,560,000, which means 43% decrease.
This project’s initial outlay includes the necessary capital needed to purchase fixed assets and ensure they are in operating order to start the project.
Cost of new plant and equipment: 7,900,000 Shipping and installation cost: 100,000 Initial working capital required to start the production: 100,000 8,100,000
The initial outlay for this project is $8,100,000
Cash flow diagram
Net Present Value and Internal Rate of Return
Unit Price x units sold
Therefore, NPV = $94,575.83
NPV Values for Years
The Internal Rate of Return (IRR) = 12.61%
Deciding on whether to follow through with a project is done by evaluating either the internal rate of return or net present value. According to Investopedia, “All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings” (Investopedia, 2013). If comparing one project to another, the one with the higher rate or return would be the more favorable one. In this instance several projects were not compared, and the IRR is below the current discount rate, which makes the project not feasible. The problem with IRR, however, is that it does not take into account changing discount rates.
As market conditions and other factors change, so does the IRR. Net Present Value (NPV) on the other hand, takes changing rates into account and is a calculated using very complex formula taking many factors into account for each stage of the project. If the Net Present Value is calculated to be above zero, or positive, it is considered to be feasible, and the project should be accepted. Our calculations show the NPV in each year to be positive and believe that the project in this case should indeed be accepted.
Investopedia US, A Division of ValueClick, Inc. . (2013). Internal Rate Of Return – IRR. Retrieved from http://www.investopedia.com/terms/i/irr.asp#axzz2HtkRBF6q