Chapter 11 Mini Case, Capital Budgeting, Capital Rationing, and Cash Flow

Its 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. 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:

Cost of new plant and equipment: $7,900,000

Shipping and installation costs: $100,000

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 15

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.

Use the simplified straight-line method over 5 years. Assume that the plant and equipment will have no salvage value after 5 years.

Year Units Sold

1 70,000

2 120,000

3 140,000

4 80,000

5 60,000

The purpose/risk classes and preassigned required rates of return are as follows:

• Replacement decision 12%
• Modification or expansion of existing product line 15%
• Project unrelated to current operations 18%
• Research and development operations 20%

1. What is its modified internal rate of return?