Caladonia Products Integrative Problem

“Caladonia Products” Integrative Problem

Based on your Week readings, prepare a response to the Caladonia Products Integrative Problem located in Chapter 10 of the Financial Management: Principles and Applications text by Keown. In your response, be sure to address the following:

A.   Formulate answers to questions 12a-12e and be sure to explain what the answer is telling you, please don’t just provide me with a number.

B.   Describe the factors that Caladonia would have to consider if they were doing a lease versus buy for the two projects.

Edit, review, putting paper together with word or excel.

a. What is each project’s payback period?

b. What is each project’s net present value?

c. What is each project’s internal rate of return?

d. What has caused the ranking conflict?

e. Which project should be accepted? Why?

Solutions Guide:

1.            We focus on free cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest.  Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost.  Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder.  In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project.

2.            Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project’s life because of its effect on taxes.  Depreciation is an expense item and, the more depreciation incurred, the larger are expenses.  Thus, accounting profits become lower and in turn, so do taxes which are a cash flow item.

3.            When evaluating a capital budgeting proposal, sunk costs are ignored.  We are interested in only the incremental after-tax cash flows, or free cash flows, to the company as a whole.  Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows.  Hence, they are irrelevant.