It’s been two 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 next assignment involves both the calculation of the cash flows associated
with a new investment under consideration and the evaluation of several mutually exclusive projects.
Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation,
but also to respond to a number of questions aimed at judging your understanding of the capitalbudgeting
process. The memorandum you received outlining your assignment follows:
TO: XXXXX XXXXX Financial Analyst
FROM: Mr. V. Morrison, CEO, Caledonia Products
RE: Cash Flow Analysis and Capital Rationing
We are considering the introduction of a new product. Currently we are in the 34 percent marginal
tax bracket with a 15 percent required rate of return or cost of capital. This project is
expected to last five years and then, because this is somewhat of a fad project, to be terminated.
The following information describes the new project:
Cost of new plant and equipment: $7,900,000
Shipping and installation costs: $ 100,000
Unit sales: Year Units Sold
Sales price per unit: $300/unit in years 1–4, $260/unit in year 5
Variable cost per unit: $180/unit
Annual fixed costs: $200,000
Working-capital requirements: There will be an initial working-capital requirement of $100,000 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 years 1 through 3,
then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of
The depreciation method: Use the simplified straight-line method over five years. It is assumed that the plant and
equipment will have no salvage value after five years.
1. Should Caledonia focus on cash flows or accounting profits in making our capital-budgeting
decisions? Should we be interested in incremental cash flows, incremental profits, total free
cash flows, or total profits?
2. How does depreciation affect free cash flows?
3. How do sunk costs affect the determination of cash flows?
4. What is the project’s initial outlay?
5. What are the differential cash flows over the project’s life?
6. What is the terminal cash flow?
7. Draw a cash flow diagram for this project.
8. What is its net present value?
9. What is its internal rate of return?
10. Should the project be accepted? Why or why not?
You have also been asked for your views on three unrelated sets of projects. Each set of projects
involves two mutually exclusive projects. These projects follow:
11. Caledonia is considering two investments with one-year lives. The more expensive of the two
is the better and will produce more savings. Assume these projects are mutually exclusive and
that the required rate of return is 10 percent. Given the following after-tax net cash flows:
YEAR PROJECT A PROJECT B
0 -$195,000 -$1,200,000
1 240,000 1,650,000
a. Calculate the net present value.
b. Calculate the profitability index.
c. Calculate the internal rate of return.
d. If there is no capital-rationing constraint, which project should be selected? If there is a
capital-rationing constraint, how should the decision be made?
12. Caledonia is considering two additional mutually exclusive projects. The cash flows associated
with these projects are as follows:
YEAR PROJECT A PROJECT B
0 -$100,000 -$100,000
1 32,000 0
2 32,000 0
3 32,000 0
4 32,000 0
5 32,000 $200,000
The required rate of return on these projects is 11 percent.
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?
13. The final two mutually exclusive projects that Caledonia is considering involve mutually
exclusive pieces of machinery that perform the same task. The two alternatives available provide
the following set of after-tax net cash flows:
YEAR EQUIPMENT A EQUIPMENT B
0 -$100,000 -$100,000
1 65,000 32,500
2 65,000 32,500
3 65,000 32,500
Equipment A has an expected life of three years, whereas equipment B has an expected life of
nine years. Assume a required rate of return of 14 percent.
a. Calculate each project’s payback period.
b. Calculate each project’s net present value.
c. Calculate each project’s internal rate of return.
d. Are these projects comparable?
e. Compare these projects using replacement chains and EAAs. Which project should be
selected? Support your recommendation.