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To: The Assistant 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 5 years and then, because this is somewhat of a fad product, be
terminated. The following information describes the new project:
a. Should Caledonia focus on cash flows or accounting profits in making its capitalbudgeting decisions? Should the company be interested in incremental cash flows,
incremental profits, total free cash flows, or total profits?
How does depreciation affect free cash flows?
c. How do sunk costs affect the determination of cash flows?
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?
Draw a cash flow diagram for this project.
What is its net present value?
i. What is its internal rate of return?
j. Should the project be accepted? Why or why not?
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?
Explain how simulation works. What is the value in using a simulation
What is sensitivity analysis and what is its purpose?