Finance

a. The primary objective for the management of Caledonia is to focus on cash flows of the firm rather than on the accounting profits which the firm generates during the year because the cash flows debate over the receives and reinvestment of the firm. After the detailed examination and assessment of cash flows, financial managers are able to interpret the results related to the benefit and the cost. Moreover, in the assessment of cash flows, the timing is also an important factor. Incremental cash flows are also an essential aspect that every financial manager looks at because they provide an overall outlook of the project and also the perspective of the company. Moreover, incremental cash flow debates over the marginal revenues of the project. On the basis of marginal increment or decrement, the management of the firm decides whether to accept the project or not (Keown, Martin,  Petty, 2008).

b. Depreciation is not an item of cash flow, but it impacts the cash flows of the project due to tax benefit. One thing that should be kept in view is that depreciation is a part of expense and it is reported in the profits and losses of the company. More depreciation translates to a larger expense bracket, which means that lower tax percentage is imposed on the company s net income. Thus, the management of the company benefits from depreciation due to higher reported depreciation expense (Keown et al., 2008).

c. It is very important to ignore the factor of sunk costs whenever the financial manager analyzes the proposal of capital budgeting. Companies are often interested in the free cash flows. When deciding about investments, from the perspective of the financial manager, it is clearly noted that sunk costs have already been incurred due to that fact they are not a part of free cash flows. Therefore, sunk costs are irrelevant in decision making (Keown et al., 2008).    

The calculation related with the questions d, e and f are computed below
DATA
Cost of plant and equipment 7,900,000
Shipping and installation 100,000
Tax rate 34
Required rate of return 15
Sales Price per unit (yrs 1-4) 300
Sales Price per unit (yr 5) 260
Variable cost per unit 180
Annual fixed cost 200,000
Depreciation life 5

Section 1  Calculate EBIT
Year012345Units Sold70,000 120,000 140,000 80,000 60,000 Sales Revenue21,000,000 36,000,000 42,000,000 24,000,000 15,600,000 Less Variable Costs12,600,000 21,600,000 25,200,000 14,400,000 10,800,000 Less Fixed Costs200,000 200,000 200,000 200,000 200,000 Equals EBDIT8,200,000 14,200,000 16,600,000 9,400,000 4,600,000 Less Depreciation1,600,000 1,600,000 1,600,000 1,600,000 1,600,000 Equals EBIT6,600,000 12,600,000 15,000,000 7,800,000 3,000,000 Taxes (34)2,244,000 4,284,000 5,100,000 2,652,000 1,020,000

Section 2  Calculate Operating Cash Flow
Year012345EBIT6,600,000 12,600,000 15,000,000 7,800,000 3,000,000 Less  Taxes2,244,000 4,284,000 5,100,000 2,652,000 1,020,000 Plus  Depreciation1,600,000 1,600,000 1,600,000 1,600,000 1,600,000 Operating Cash Flow5,956,000 9,916,000 11,500,000 6,748,000 3,580,000

Section 3  Calculate Net Working Capital
Year012345Revenue21,000,00036,000,00042,000,00024,000,00015,600,000Initial Working Capital Requirement100,000Net Working Capital Needs2,100,0003,600,0004,200,0002,400,0001,560,000Liquidation of Working Capital1,560,000Change in Working Capital100,0002,000,0001,500,000600,000(1,800,000)(2,400,000)

Section 4  Calculate Free Cash Flow
Year012345Operating Cash Flow5,956,0009,916,00011,500,0006,748,0003,580,000Minus Change in Net Working Capital100,0002,000,0001,500,000600,000(1,800,000)(2,400,000)Minus Change in Capital Spending8,000,00000000Free Cash Flow(8,100,000)3,956,0008,416,00010,900,0008,548,0005,980,000

After the calculation above, it is concluded that
The project initial outlay is 8,100,000.
For the differential cash flows over the project s life, please see the calculation of section 2.
For terminal cash flow of the project, please see the calculation of section 3.

g. Cash flow diagram for the project is drawn below

3,956,000 8,416,000 10,900,000 8,548,000 5,980,000

         (8,100,000)
h. After the calculation of project s Net Present Value in Excel, it is concluded that project s NPV is 14,548,779.  

i. After the calculation of project s internal rate of return (IRR) in Excel, it is concluded that project s IRR is 77.  

j. Based on the calculation, it is recommended that the project should be accepted because it produces a strong rate of return on the investment and a positive NPV. Moreover, if the rate of return (77) is more than the cost of capital (15), then the firm should accept the project.

k. In capital budgeting, there are three general perspectives through which risk is assessed and measured. These risks are
A single project risk
A company risk
A shareholders risk

Single project risk evaluates the total risk of an investment on the basis of stand alone. In addition, single project risk is measured based on the variability in cash flows. This practice is also known as the coefficient of variation or the standard deviation (Keown et al., 2008).  
  
Company s project risk debates every single project in accordance with the contribution towards company s total risk. Moreover, this risk assesses the uncertainty of firm future projected cash flows (Keown et al., 2008).  

Shareholders risk considers every individual project according to the light of contribution towards the diversified portfolio of shareholders. This type of risk primarily focuses on and pays attention to market risk. Market risk is calculated on the basis of beta coefficient (Keown et al., 2008).
l. CAPM is based on the proposition that any stock s required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after the diversification, or it can be defined in the following manner the relevant riskiness of an individual stock is its contribution to the riskiness of a well diversified portfolio.
The formula of CAPM is


As we know that all investors are focusing on the risk of individual securities in order to maintain feasible portfolio of their investment. All investors working on the above quote high risk high return low risk low return. All things considered, different models and theories emerge as one in CAPM and in Modern Portfolio Theory. There is a relation between these two.

CAPM concludes that all investors should hold the market portfolio and the modern portfolio theory provides a broad context for understanding the interactions of systematic risk and reward (Graham  Harvey, 2001).

CAPM introduces the beta  and the theory holds on a broad context for understanding the interactions of systematic risk and reward.

There are no transaction costs in buying and selling securities both in CAPM and in modern portfolio theory.

CAPM and modern portfolio theory also both assume that investors do not consider taxes when making investment decisions, and they are rational and risk adverse.
Investors have the same or identical information regarding the market risk and how the market will
respond.

CAPM and in modern portfolio theory both work on risk. CAPM works on SML or BETA  and theory works on Efficient Frontier.

With respect to the application of CAPM, Fama and French (2004) conclude that there is no systematic link between the return and risk by calculating through Beta. It is the reality that the size of a company does matter in evaluating the appropriate result (French  Fama, 2004). All in all, CAPM plays a pivotal role in assessing the cost of capital of most companies and most firms prefers CAPM. Although CAPM has been challenged in academic literature, but in a practical sense, there is conflict over the market risk premium which is the main part of the CAPM.

m. Simulation examines the possible changes in more than one variable under consideration and its effect on the expected outcome. Simulation is basically a risk management technique which helps managers in the decision-making process under a highly uncertain environment (Keown et al., 2008). Simulation builds different models of possible outcomes. Simulation substitutes and considers different variables at a time. By using simulation, if any factor is uncertain, then the management recalculates the values over and over until the desired result (Keown et al., 2008). In addition, simulation generates distributions of expected possible outcome. Simulation defines the uncertainty or uncertain variables in the form of probability distribution by using different approaches such as triangular, uniform, normal, and distribution. All the distribution approaches depend on the behavior of variable.        

n. In capital budgeting decision, the role of sensitivity analysis is to consider uncertainty of not more than one variable at a time. Sensitivity analysis determines the sensitivity of a model or a project by changing the in the values of given parameters of the project or model. Sensitivity analysis enables the management to evaluate the level at which the model or project gives valid, appropriate, and sufficient results.

For Example
ABC Company interested to invest in a project which requires 50,000 investment in year 0 which will brings 30,000 annual contribution for 5 years and annual fixed cost of 15,000. Cost of capital rate is 8.
YEAR NARRATIVE CASH FLOWS DF  8   PV
0 Initial Investment       (50,000) 1.000 (50,000)
1-5 Contribution       30,000 4.623 138,690
1-5 Fixed Cost       15,000 4.623 (69,345)
NPV 19,345
Sensitivity to initial investment 19,34550,000 39
Means an increment of 39 in initial investment cost falls the NPV to zero.
Sensitivity to fixed cost 19,34569,345 28

The purpose of sensitivity analysis is stated below
This analysis provides viable results in crucial estimates.
With the help of sensitivity analysis, management can make subjective judgments.  
Sensitivity analysis indicates the level of uncertainty about the forecasts.
This analysis tool indicates and identifies the crucial areas of the project and helps the management to take right decision in order to increase shareholders wealth.