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Making Capital Budgeting Decisions

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This report examines the firm's ability to interpret new project ideas based on the information extracted from various financial formulas and perspectives. Please do not use any portion of this paper …

This report examines the firm's ability to interpret new project ideas based on the information extracted from various financial formulas and perspectives. Please do not use any portion of this paper without properly referencing sources. Thank you

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  • 1. A Perspective on Making A Perspective on Making Capital Budgeting Decisions Alice Bell BUS401: Principles of Finance Instructor: P.Martin Fenlon May 29, 2010 1
  • 2. A Perspective on Making Cash Flows in Capital Budgeting Firms depend on fresh new ideas to increase shareholder value. These ideas are called projects or investments. There can be many new investment opportunities for Firms. Firms need to know which project or investment will produce the most benefits for the company. New ideas are plenty but many organizations have special circumstances that could limit the success of the new project or investment. Before choosing a new project or investment a firm must know if it will be profitable for the company. Capital budgeting is a process of finding projects or investments that are profitable for an organization by evaluating them in fixed assets (Keown, Martin, Petty & Scott, 2008). The process of capital budgeting uses free cash flows to reveal the benefits of a project or investment. Using capital budgeting to determine the profitability of a project or investment is necessary and feasible to create optimal shareholder value. In this report I will perform the duties of a financial analyst and use the capital budgeting process to determine the free cash flows for Caledonia Products. I will examine a new project proposal that is a fad project and is expected to last 5 years. I will use free cash flows and the results of the net present value and internal rate of return to determine the profitability of the project for Caledonia Products. I also will examine three different perspectives to measure project risks. Caledonia Products should focus on cash flows rather than accounting profits to make their capital budgeting decisions. To measure the profitability of a project free cash flows are used instead of accounting profits. Accounting profits are reported when they are earned, but free cash flows allow firms to determine when the money is received, when it can be invested and when it has to be paid out (Keown, Martin, Petty & Scott, 2008). 2
  • 3. A Perspective on Making Caledonia Products should be interested in incremental after- tax cash flows when determining the profitability of a project. “Depreciation is not a not a cash flow item, but it does affect cash flows by lowing the level of profits on which taxes are calculated (p302)”. Sunk costs are costs that have already occurred, and should not be included in the capital budgeting analysis because they are not affected by the decision to accept or reject the project. Alice Bell, BUS:401 May 29,2010 Chapter 10 Mini Case DATA Cost of plant and equipment 7,900, 000 Shipping and installation 100,000 Tax rate 34% Required rate of return 15% Sales Price per unit (yrs 1-4) 300 Sales Price per unit (yr 5) 260 Variable cost per unit 180 Annual fixed cost 200,000 Depreciation life 5 Section 1: Calculate EBIT Year 1 2 3 4 5 Units Sold 70,000 120,000 140,000 80,000 60,000 Sales Revenue 21,000,0 00 36,000, 000 42,000, 000 24,000,0 00 15,600,0 00 Less: Variable Costs 12,600,0 00 21,600, 000 25,200, 000 14,400,0 00 10,800,0 00 3
  • 4. A Perspective on Making Less: Fixed Costs 200,000 200,000 200,000 200,000 200,000 Equals: EBDIT 8,200,00 0 14,200, 000 16,600, 000 9,400,00 0 4,600,00 0 Less: Depreciation 1,600,00 0 1,600,0 00 1,600,0 00 1,600,00 0 1,600,00 0 Equals: EBIT 6,600,00 0 12,600, 000 15,000, 000 7,800,00 0 3,000,00 0 Taxes 2,244,00 0 4,284,0 00 5,100,0 00 2,652,00 0 1,020,00 0 Section 2: Calculate Operating Cash Flow EBIT 6,600,00 0 12,600, 000 15,000, 000 7,800,00 0 3,000,00 0 Less: Taxes 2,244,00 0 4,284,0 00 5,100,0 00 2,652,00 0 1,020,00 0 Plus: Depreciation 1,600,00 0 1,600,0 00 1,600,0 00 1,600,00 0 1,600,00 0 Operating Cash Flow 5,956,00 0 9,916,0 00 11,500, 000 6,748,00 0 3,580,00 0 Section 3: Calculate Net Working Capital Revenue: 21,000,0 00 36,000, 000 42,000, 000 24,000,0 00 15,600,0 00 Initial Working Capital Requirement 100,000 Net Working Capital Needs: 2,100,00 0 3,600,0 00 4,200,0 00 2,400,00 0 1,560,00 0 Liquidation of Working Capital 1,560,00 0 Change in Working Capital: 100,000 2,000,00 0 1,500,0 00 600,000 (1,800,0 00) (2,400,0 00) 4
  • 5. A Perspective on Making Section 4: Calculate Free Cash Flow Operating Cash Flow 5,956,00 0 9,916,0 00 11,500, 000 6,748,00 0 3,580,00 0 Minus: Change in Net Working Capital 100,000 2,000,00 0 1,500,0 00 600,000 (1,800,0 00) (2,400,0 00) Minus: Change in Capital Spending 8,000,000 0 0 0 0 0 Free Cash Flow: (8,100,000) 3,956,00 0 8,416,0 00 10,900, 000 8,548,00 0 5,980,00 0 PV = 3,440,00 0 6,363,7 05 7,166,9 27 4,887,34 7 2,973,11 7 NPV 16,731,096 IRR= 77.02% The initial outlay of Caledonia’s proposed project is $8,100,000. The differential cash flows over the products life are $3,956,000 on year 1, $8,416,000 on year 2 $10,900,000 on year 3 $8,548,000 on year 4, and $5,980,000 on year 5. The terminal cash flow of the fad project is $5,980,000 respectfully. 5
  • 6. A Perspective on Making Cash Flow Diagram for the Caledonia Products Project. The project’s net present value is 16,731,096, and the project has an internal rate of return of of 77.02%. In determining the profitability of a project, the net present value, and the internal rate of return of the project is considered. “The net present value of an investment proposal is equal to the present value of its annual free cash flows less the investment’s initial outlay (Inflows) (Outflows) 8,100,000 1 2 3 4 5 6 3,956,000 8,416,000 10,900,000 8,548,000 5,980,000
  • 7. A Perspective on Making (p262).” When the net present value of a project proposal is greater than or equal to zero, the project should be accepted. In this case the project proposal for Caledonia Products is greater than or equal to zero. “The internal rate of return is the discount rate that equates the present value of the project’s free cash flows with the projects initial cash outlay (p269).” A project is accepted if the internal rate of return is higher than the required rate of return. In this case the fad project proposal for Caledonia Products should be accepted because the net present value is greater than or equal to zero, and the internal rate of return is higher than the 15% required rate of return. In capital budgeting, risk can be measured from three perspectives. Those risk are project standing alone risk, contribution to firm risk, and systematic risk. “Project standing risk ignores the fact that most of the risk will be diversified away when the project is combined with other projects and assets (p314.)” Contribute to firm risk is the amount of risk that the project contributes as a whole, ignoring the effects of the diversification of the firm’s shareholders. Systematic risk is the risk of the project from the view point of a well diversified shareholder (Keown, Martin, Petty & Scott, 2008). Using capital budgeting to determine the profitability of a project or investment is necessary and feasible to create optimal shareholder value. To measure the profitability of the project proposed to Caledonia their free cash flows should be used instead of their accounting profits. When determining the profitability of a project using free cash flows the net present value and the internal rate of return can be calculated. These calculations measure the profitability of a project, and decide if the project should be accepted or rejected. In Caledonia case we see that the project should be accepted. The decision to accept Caledonia’s fad project proposal would create maximum wealth to its shareholders by creating more free cash flows for the organization. 7
  • 8. A Perspective on Making 8
  • 9. A Perspective on Making References Keown, A., Martin, J., & Petty, J. (2008). Foundations of finance (6th ed.). New York, New York : Prentice Hall. ISBN: 9780132339223. 9
  • 10. A Perspective on Making References Keown, A., Martin, J., & Petty, J. (2008). Foundations of finance (6th ed.). New York, New York : Prentice Hall. ISBN: 9780132339223. 9