Question: We are considering the introduction of a new product. Currently we are in the 34% marginal tax bracket with a 15% required rate of return or cost of capital. This project is expected to last five years and them, because this is somewhat of a fad product, be terminated. The following data describes the new project:
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Cost of new plant and equipment
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$7,900,000
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Shipping and installation costs
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$100,000
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Unit sales
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YEAR
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UNITS SOLD
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1
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70,000
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2
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120,000
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3
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140,000
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4
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80,000
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5
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60,000
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Sales price per unit
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$300/unit in years 1 through 4, $260/unit in year 5
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Variable cost per unit
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$480/unit
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Annual fixed costs
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$200,000
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Working-capital requirements
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There' will be an initial working-capital requirement of $1000, 000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during year 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
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The depreciation method
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Use the simplified straight-line method over 5 years. Suppose that the plant and equipment will have no salvage value after 5 years.
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[A] Should Caledonia focus on cash flow or accounting profits in making its capital budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profiles?
[B] Compute the differential cash flows over the project's life?
[C] Compute the terminal cash flow?
[D] Make a cash flow diagram for this project.
[E] Compute its net present value?
[F] Compute its internal rate of return?
[G] Should the project be accepted? Why or why not?
[H] In capital budgeting, risk can be measured from three perspectives. What are those three?
[I] How does depreciation affect free cash flows?
[J] How do sunk costs affect the determination of cash flows?
[K] Compute the project's initial outlay?