Caledonia Products Integrative Problem

Caledonia Products Integrative Problem

Ruth Sears

FIN/370

March 25, 2013

Dr. Dana Williams

Caledonia Products Integrative Problem

Caledonia Products CEO V. Morrison assigned Team C to work together as a group of assistant financial analysts. Team C was asked to calculate the cash flows associated with a new investment under consideration as well as analyzing an evaluation of an exclusive project. The team has recommendations provided in regard to accepting or declining the new investment by responding to several questions based on the capital budget process of Caledonia.

Why should Caledonia focus on project free cash flows as opposed to the accounting

profits earned by the project when analyzing whether to undertake the project?

Caledonia organization needs to focus on cash flows instead of the accounting profits so the free cash flows the organization receives can reinvest when necessary. When analyzing the timing of the benefit or cost can examine the cash flows. The organizations should focus only on the cash flows on the after-tax basis for the shareholders interest. Caledonia interest is primarily on the incremental cash flow for it has a marginal benefit from the project would increase the value of the Caledonia organization.

What are the incremental cash flows for the project in years 1 through 5 and how do these cash differ from accounting projects or earnings?

Caledonia must look at their tax rate versus that amount of debt they will absorb when purchasing the equipment they need for the project. At the end of the five years if Caledonia decided to purchase the equipment, they will have an operating cash flow of $3,580,000. That is about five times what the cost of the equipment was. When deciding on a lease the number could increase depending on the terms of the lease. The financial statements of Caledonia can help decide if the organization can take the out-of- pocket expense of the purchase. If they cannot than leasing could be a better solution for the organization.

The facts of the project could also help decide whether or not to lease or buy. The project is considered a "fad" project which will be liquidated after the five years and if the terms of the lease can decrease that amount of debt collected in those five years than leasing would be a better solution. Leases are normally more expensive over a long period and because Caledonia plans not to carry the project after the fifth year of leasing seems to be the best solution. Leasing the equipment will also decrease the amount of taxes the organization will have to pay during this project. The organization can deduct the lease payments as a business expense creating more capital at the end of the year.

What is the project's initial outlay?

A project's initial layout is the cost of entering into a project. To calculate a project's initial outlay, costs must be calculated. This project's initial outlay begins with the capital expenditure of $7,900. Capital expenditure covers the cost of a new plant, property, and equipment. Next is the shipping and installation cost of $100,000. This covers the shipping and installation costs of all the equipment purchased. The final cost is the initial working capital requirement of $100.000 this is the required costs to get the project started. That calculates the project's initial outlay to a grand total of $8,100,000.

Year 1

Initial working capital (100,000)

New plant and equipment (7,900,000)

Shipping and installation cost (100,000)

Annual fixed costs (200,000)

Unit cost [70k@180] (12,600,000)

Sales [70@300] 21,000,000

Net 100,000

Year 2

Annual fixed costs (200,000)

Unit cost [120k@180] (21,600,000)

Sales [120k@300] 36,000,000

Net 14,100,000