Solutions Guide: Please reword the answers to essay type parts so as to guarantee that your answer is an original.

Do not
submit as your own.
It has been 2 months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been
pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your net assignment involves both the
calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually eclusive
pro!ects. "iven your lack of tenure and Caledonia, you have been asked not only to provide a recommendation but also to respond to a
number of #uestions aimed at !udging your understanding of the capital$budgeting process. %he memorandum you received outlining
your assignment follows& %o& %he Assistant 'inancial Analyst 'rom& (r. ). (orrison, C*+, Caledonia Products ,e& Cash 'low Analysis
and Capital ,ationing -e are considering the introduction of a new product. Currently we are in the ./ percent marginal ta bracket with
a 01 percent re#uired rate of return or cost of capital. %his pro!ect is epected to last 1 years and then, because this is somewhat of a fad
product, be terminated. %he following information describes the new pro!ect& Cost of new plant and e#uipment& 23,455,555 6hipping and
installation costs& 2055,555 7nit 6ales& Year 0& 7nits sold& 35,555 Year 2& 7nits sold& 025,555 Year .& 7nits sold& 0/5,555 Year /& 7nits
sold 85,555 Year 1& 7nits sold 95,555 6ales price per unit& 2.55:unit in years 0 through /, 2295:unit in year 1 )ariable Cost per unit&
2085:unit Annual 'ied Costs& 2255,555 -orking capital re#uirements& %here will be an initial working$capital re#uirement of 2055,555
!ust to get production started. 'or each year, the total investment in new working capital will be e#ual to 05 percent of the dollar value of
sales for that year. %hus, the investment in working capital will increase during years 0 through ., then decrease in year /. 'inally, all
working capital is li#uidated at the termination of the pro!ect at the end of year 1. %he depreciation method& 7se the simplified straight$
line method over 1 years. Assume that the plant and e#uipment will have no salvage value after 1 years. A.; 6hould Caledonia focus on
cash flows or accounting profits in making its capital$budgeting decisions< 6hould the company be interested in incremental cash flows,
incremental profits, total free cash flows, or total profits< =.; >ow does depreciation affect free cash flows or total profits< C.; >ow do
sunk costs affect the determination of cash flows< ?.; -hat is the pro!ect@s initial outlay< *.; -hat are the differential cash flows over
the pro!ect@s life< '.; -hat is the terminal cash flow< ".; ?raw a cash flow diagram for this pro!ect >.; -hat is its net present value< I.;
-hat is its internal rate of return< A.; 6hould the pro!ect be accepted< -hy or why not< B.; In capital budgeting, risk can be measured
from three perspectives. -hat are those three measures of a pro!ects risk< C.; According to CAP(, which measurement of a pro!ect@s risk
is relevant< -hat complications does reality introduce into the CAP( view of risk, and what does that mean for our view of the relevant
measure of a pro!ect@s risk< (.; *plain how simulation works. -hat is the value in using a simulation approach< D.; -hat is sensitivity
analysis and what is its purpose< Please provide answers in ecel showing the work for each answer.
a. -e focus on free cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest.
+nly by eamining cash flows are we able to correctly analyEe the timing of the benefit or cost. Also, we are only interested in
these cash flows on an after$ta 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 pro!ect from the point of the company as a whole, the incremental cash flows
are the marginal benefits from the pro!ect and, as such, are the increased value to the firm from accepting the pro!ect.
b. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the pro!ectFs life because
of its effect on taes. ?epreciation is an epense item and, the more depreciation incurred, the larger are epenses. %hus,
accounting profits become lower and in turn, so do taes which are a cash flow item.
c. -hen evaluating a capital budgeting proposal, sunk costs are ignored. -e are interested in only the incremental after$ta cash
flows, or free cash flows, to the company as a whole. ,egardless of the decision made on the investment at hand, the sunk costs
will have already occurred, which means these are not incremental cash flows. >ence, they are irrelevant.
Parts d, e, & f.
Section I. Calculate the change in !I", "a#es, and Depreciation $this become an input in the calculation of %perating Cash &low in Section II'.
(ear ) * + , - .
7nits 6old 35,555 025,555 0/5,555 85,555 95,555
6ale Price 2.55 2.55 2.55 2.55 2295
6ales ,evenue 220,555,555 2.9,555,555 2/2,555,555 22/,555,555 201,955,555
Cess& )ariable Costs 02,955,555 20,955,555 21,255,555 0/,/55,555 05,855,555
Cess& 'ied Costs 2255,555 2255,555 2255,555 2255,555 2255,555
*#uals& *=?I% 28,255,555 20/,255,555 209,955,555 24,/55,555 2/,955,555
Cess& ?epreciation 20,955,555 20,955,5555 20,955,5555 20,955,5555 20,955,5555
*#uals& *=I% 29,955,555 202,955,555 201,555,555 23,855,555 2.,555,555
%aes GH./I; 22,2//,555 2/,28/,555 21,055,555 22,912,555 20,525,555
Section II. Calculate %perating Cash &low $this becomes an input in the calculation of &ree Cash &low in Section I/'.
%perating Cash &low:
*=I% 29,955,555 202,955,555 201,555,555 23,855,555 2.,555,555
(inus& %aes 22,2//,555 2/,28/,555 21,055,555 22,912,555 20,525,555
Plus& ?epreciation 20,955,555 20,955,555 20,955,555 20,955,555 20,955,555
*#uals& +perating Cash 'low 21,419,555 24,409,555 200,155,555 29,3/8,555 2.,185,555
Section III. Calculate the 0et 1or2ing Capital $"his becomes an input in the calculation of &ree Cash &lows in Section I/'.
Change In 0et 1or2ing Capital:
,evenue& 220,555,555 2.9,555,555 2/2,555,555 22/,555,555 201,955,555
Initial -orking Capital ,e#uirement 2055,555
Det -orking Capital Deeds& 22,055,555 2.,955,555 2/,255,555 22,/55,555 20,195,555
Ci#uidation of -orking Capital 20,195,555
Change in -orking Capital& 2055,555 22,555,555 20,155,555 2955,555 G20,855,555; G22,/55,555;
Section I/. Calculate &ree Cash &low $using information calculated in Sections II and III, in addition to the Change in Capital Spending'.
&ree Cash &low:
+perating Cash 'low 21,419,555 24,409,555 200,155,555 29,3/8,555 2.,185,555
(inus& Change in Det -orking
Capital
2055,555 22,555,555 20,155,555 2955,555 G20,855,555; G22,/55,555;
(inus& Change in Capital 6pending 28,555,555 5 25 5 5 5
&ree Cash &low: $34,*)),)))' 3,,5.6,))) 34,-*6,))) 3*),5)),))) 34,.-4,))) 3.,54),)))

0P/ 7 3*6,8,*,)56
I99 7 33I
g. Cash flow diagram
2.,419,555 28,/09,555 205,455,555 28,1/8,555 21,485,/55
G28,055,555;
h. DP) J 209,3.0,549
i. I,, J 33I
!. Yes. %his pro!ect should be accepted because the DP) K 5. and the I,, K re#uired rate of
return.
k. 'irst, there is the total project risk also called project standing alone risk, which is a
pro!ect@s risk ignoring the fact that much of this risk will be diversified away as the
pro!ect is combined with the firm@s other pro!ects and assets. 6econd, we have the
pro!ect@s contribution to firm risk, which is the amount of risk that the pro!ect
contributes to the firm as a wholeL this measure considers the fact that some of the
pro!ect@s risk will be diversified away as the pro!ect is combined with the firm@s other
pro!ects and assets, but ignores the effects of diversification of the firm@s shareholders.
'inally, there is systematic risk, which is the risk of the pro!ect from the viewpoint of a
well$diversified shareholderL this measure considers the fact that some of a pro!ect@s
risk will be diversified away as the pro!ect is combined with the firm@s other pro!ects,
and, in addition, some of the remaining risk will be diversified away by the
shareholders as they combine this stock with other stocks in their portfolio.
l. According to the CAP(, systematic risk is the only relevant risk for capital$budgeting
purposesL however, reality complicates this somewhat. In many instances, a firm will
have undiversified shareholdersL for them, the relevant measure of risk is the pro!ect@s
contribution to firm risk. %he possibility of bankruptcy also affects our view of what
measure of risk is relevant. =ecause the pro!ect@s contribution to firm risk can affect
the possibility of bankruptcy, this may be an appropriate measure of risk since there are
costs associated with bankruptcy.
m. %he idea behind simulation is to imitate the performance of the pro!ect being evaluated.
%his is done by randomly selecting observations from each of the distributions that
affect the outcome of the pro!ect, combining each of those observations and
determining the final outcome of the pro!ect, continuing with this process until a
representative record of the pro!ect@s probable outcome is assembled. In effect, the
output from a simulation is a probability distribution of net present values or internal
rates of return for the pro!ect. %he decision maker then bases his decision on the full
range of possible outcomes.
n. 6ensitivity analysis involves determining how the distribution of possible net present
values or internal rates of return for a particular pro!ect is affected by a change in one
particular input variable. %his is done by changing the value of one input variable
while holding all other input variables constant.
/
1
9