This instrument assesses the following Course Learning Outcomes (CLO):
Tick Course Learning Outcomes (CLO) Questions Marks
1 1. Calculate and interpret the results using different capital budgeting methods to evaluate and select projects in the UAE.
- Calculate and interpret the weighted average cost of capital (WACC) and its components for a UAE company. 5
5
Total /10
Your mark will be deducted if you do not show analysis on each part of the below questions.
It’s 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 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 capital-budgeting process. The memorandum you received outlining your assignment follows:
To: The Assistant Financial Analyst
From: Mr. V.Ahmed, CEO, Caledonia Products
Re: Cash Flow Analysis and Capital Rationing
We are considering the introduction of a new product. Currently we are in the 20 percent marginal tax bracket with a 14m,5percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project:
Cost of new production equipment $7,950,000
Shipping and installation costs $ 100,000
UNIT SALES YEAR UNITS SOLD
1 72,000
2 120,000
3 140,000
4 80,000
5 62,000
Sales price per unit $300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000 per year in years 1–5
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 year 5.
Depreciation method Bonus depreciation method, and as a result the bonus depreciation occurs in year 1, with no depreciation in any other years. If any losses occur, they would be offset by profits in other areas of the company. a. Should Caledonia focus on cash flows 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 profits?
b. How does depreciation affect free cash flows?
c. How do sunk costs affect the determination of cash flows?
d. What is the project’s initial outlay?
e. What are the differential cash flows over the project’s life?
f. What is the terminal cash flow?
g. Draw a cash flow diagram for this project.
h. What is its net present value?
i. What is its internal rate of return?
j. Should the project be accepted? Why or why not?
k. In capital budgeting, risk can be measured from three perspectives. What are
those three measures of a project’s risk?
l. According to the CAPM, which measurement of a project’s risk is relevant?
What complications does reality introduce into the CAPM view of risk, and
what does that mean for our view of the relevant measure of a project’s
risk?
m. Explain how simulation works. What is the value in using a simulation
approach?
n. What is sensitivity analysis, and what is its purpose?
Sample Solution
