Caoleia Products Case Study

Caledonia Products Cash Flow Analysis and Project Risk
Caledonia Products must be aware of their cash flows and the affects of various outside influences over the life of their projects. Knowing where and how the cash is flowing is key to successful capital budgeting. Many risks are involved with funding investments; it just depends on the perspective in which they are being observed to determine if they are worth the cash flow. Capital-budgeting decisions, affects on cash flows, and project risk will be discussed in this paper.
Caledonia Products should focus on cash flows instead of accounting profits in making its capital-budgeting decisions because the firm the funds are received and can be reinvested. According to Keown & Martin, (2010)
As depreciation expenses increase, more up-front costs are incurred by the firm. Depreciation is a tax-deductible expense that is directly responsible for decreased taxes (cash flow item) although profits are lessened as well.
When considering sunk costs affect on the determination of cash flows, they are irrelevant. Decision making in capital budget proposal negates sunk costs because they have already taken place and cannot be undone. They have no consequence on any cash flows and should not be used as criterion for acceptance or rejection of a project in capital-budgeting analysis.
The project’s initial outlay cost equals $8,100,000. The net present value is $15,955,500. The internal rate of return is 76.16%. After careful consideration of these values, it is in the best interest of the firm to accept this project. The net present value is positive or greater than zero and the internal rate of return is greater than the required rate of return 15%. This is to be considered a “good”
Firstly, project standing alone risk also known as total project risk because of the fact that much of the risk will be diversified into other assets and projects is ignored. This risk causes the least amount of concern and requires the least amount of attention. “In short, because much of a project’s risk is diversified away within the firm, the project standing alone risk is an inappropriate measure of the meaningful level of risk of a capital-budgeting project.” (Keown, Martin, & Petty, 2011. Pg. 319) Secondly, the contribution-to-form risk is the amount of risk contributed to the firm as a whole. The fact that some of this project’s risk will be diversified away as the project is merged with the firms other projects is taken into consideration. This measure does not consider diversification effects of the firm’s shareholders. Lastly, systematic risk is the most important risk from the perspective of a well-diversified shareholder. This measure considers that some risks will be diversified away while some risk will remain as stocks are combined and added to the shareholder’s existing portfolios. “If inflation has been running about 3 percent, some managers add 3 percent for all resources used in the project. This lump-sum approach does not address exactly where price protection is needed and fails to provide for tracking and control. On cost sensitive