Caledonia Products 1

Caledonia Project Cash Flow and Rationing Analysis

FIN/370












Caledonia Products Cash Flow and Rationing Analysis
Mr. Morrison, CEO of Caledonia has requested the assistant financial analyst (Team
C) to provide a recommendation of several exclusive projects and provide a report on the capital-
Caledonia Products 2

budgeting process. The assignments assessment include the incremental cash flows payback
period, the projects initial outlay, the projects cash flow diagram, the net present value, the
projects internal rate of return, the project with the best options, and the option to lease or buy.
After analyzing the Caledonia Project, Caledonia should focus on project free cash flow
as opposed to the accounting profits earned by the project when analyzing if the company should
undertake the project because of the cash free offers the company will receive. The company can
also evaluate the effectiveness of the benefits and reinvest the cash flow received from the
benefits. The only cash flows that Caledonia has interest in is the incremental cash flows;
therefore the incremental cash flows are the projects marginal benefits that increase the value
from the organization.
The incremental cash flows for the project in years one through five changes in net
working capital is:
The Net Operating Cash Flow - revenue net of expenses and liabilities for
the specific period
Net Initial Investment Outlay - investment cash credits and the sale of
existing or old and non-useful equipment cash expenditures and net cash
flows
Net Salvage Value - after tax net cash flow for liquidations, terminations,
and unmanageable projects businesses owners no longer need.
Incremental cash flows are different from earnings and accounting projects merely because of
the reasons the Caledonia Company uses the cash. However, because the cost spreads over a
period of five years through depreciation, the investments are a non-cash expense.

Caledonia Products 3

The projects initial outlay is $8,100,000. The answer to this question comes after certain
steps to find the initial outlay:
Step 1: Determine the Operating Cash Flow.
Year 0 1 2 3 4 5

Units Sold X

70,000 120,000 140,000 80,000 60,000
Sale Price =

$300 $300 $300 $300 $260

Revenue

$21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000
Less Variable
Costs

$12,600,000 $21,600,000 $25,200,000 $14,400,000 $10,800,000
Less Fixed
Costs=

$200,000 $200,000 $200,000 $200,000 $200,000



$8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,600,000
Less
Depreciation
Cost:
7,900,000 +
$100,000/5=
8,000,000

$1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Earnings
before Interest
and Taxes
(EBIT) -

$6,600,000 $12,600,000 $15,000,000 $7,800,000 $3,000,000
34% Tax Rate
Applied to
EBIT

$2,244,000 $4,284,000 $5,100,000 $2,652,000 $1,020,000
Plus
Depreciation

$1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
OPERATING
CASH
FLOW

$5,956,000 $9,916,000 $11,500,000 $6,748,000 $3,580,000


Step 2: Change in Net Working Capital.
Year 0 1 2 3 4 5

Revenue

$21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000
Caledonia Products 4


Initial
Working
Capital

$100,000

Yearly Net
Working
Capital

$2,100,000 $3,600,000 $4,200,000 $2,400,000 $1,560,000

End of
Project
Liquidation

$1,560,000

CHANGE
IN
WORKING
CAPITAL $100,000 $2,000,000 $1,500,000 $600,000 ($1,800,000) ($2,400,000)

Step 3: Free Cash Flow.
Year 0 1 2 3 4 5
OPERATING
CASH
FLOW

$5,956,000 $9,916,000 $11,500,000 $6,748,000 $3,580,000

Less change in
net working
capital $100,000 $2,000,000 $1,500,000 $600,000 -$1,800,000 -$2,400,000

Less Capital
Spending $8,000,000


FREE CASH
FLOW
-
($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000


The projects cash flow diagram is:
Year 0 1 2 3 4 5

-($8,100,000) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000

The projects net present value is:
Caledonia Products 5

The projects internal rate of return is:
Life of Asset 5 years
Cost of Asset $ (8,100,000.00)
Annual Cash Flow $ -
Internal Rate of Return 77.02%

Year Cash Flow
0 $ (8,100,000.00)
1 $ 3,956,000.00
2 $ 8,416,000.00
3 $ 10,900,000.00
4 $ 8,548,000.00
5 $ 5,980,000.00

This project should be accepted because it has a large NPV. Although the
NPV criterion is preferred because it makes the most acceptable assumption for the wealth
maximizing firm (Keown, T. Martin, J.D., 2011).
Caledonia must look at their tax rate versus that amount of debt they will absorb when
purchasing the equipment they need for their 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. But when deciding on a lease that number
could increase depending on 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.
Caledonia Products 6

The facts of the project could also help decide whether or not to lease or buy. The project
is considered a fad project and 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 of time and since
Caledonia plans not to carry the project after the fifth year 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.















Caledonia Products 7

References
Forbes. (2012). Retrieved from
http://www.forbes.com/08/04/2012/smallbusiness-equipmentlease-IRS-ent-fin-
cx_nl_0124nolo.html
Titman, S., Keown, A. J., & Martin, J. D. (2011). Financial Management: Principles and
Applications (11th ed,) Upper Saddle River, NJ: Pearson/Pre
: