For this week’s assignment the learning team will represent an assistant manager at Caledonia Products. Acting as an assistant manager, the team has been given the task with the responsibility of recommending and responding to questions related to the capital budgeting process. The project has a planned budget that will last for about five years after which time it will be terminated. The following information represents the findings that were found.
Caledonia should focus on the project free cash flow because the free cash flow measures the financial performance as operating cash flow minus capital expenditure. The accounting profits tend to be higher than economic profits as they omit certain implicit costs such as opportunity costs. In this case focusing on the project free cash flow will give the company a better overall picture of the financial health during this project.
Cash flows differ from accounting profits due to depreciation expense which is non cash item. Ito earnings after tax while in calculating accounting profit depreciation is deducted, this will reduce the profits.
The equation is:
The NPV means Caledonia requires initial investment of $100,000 and provides future cash flows that have a present value of $319,230. Consequently, the project cash flows are $219,230 more than the required investment. Given that the project’s future cash flows are more than the initial cash outlay required to make the investment, the project is an acceptable project.
Caledonia’s Internal Rate of Return (IRR)
Using a financial calculator…
Caledonia’s requires an initial investment of $100,000 and provides future cash flows that after a return on the current investment of 89.12%. Since the minimum rate needed to earn on the investment is 15%, the new project is an adequate investment opportunity....