The company’s cost of capital is 15%.
The cost of the new plant and equipment for the project is $7,900,000.
Shipping and Installation costs are $100,000.
Projected sales are:
Sales price per unit: $300 per unit in years 1-4, $260 per unit in year 5.
Variable cost per unit: $180 per unit.
Annual fixed costs: $200,000.
Initial Working Capital required is $100,000 to start the project.
Or each year, the total investment in net working capital will be equal to 10% of the dollar value
of sales for that year. Thus, the investment in working capital will increase in years 1-3, and
decrease in year 4. All working capital is liquidated at the termination of the project at the end of
Depreciation method: Use simplified straight-line depreciation over five years. It is assumed
the plant and equipment will have no salvage value at the end of the project.
Based on the above information, answer the following question:
Should ABC Corporation focus on cash flows or accounting profits in making our
capital-budgeting decisions? Should we be interested in incremental cash flows,
incremental profits, total free cash flows, or total profits?
In making capital budgeting decisions, it is best to focus on cash flows and not accounting profits
because cash flows provides a more accurate measure of a firm’s wealth or value.
Cash flow is
considered to be the actual money on hand that can be reinvested by the firm.
Cash flows reflect
the correct timing of the benefits and cost of an investment and the after-tax cash flow is of
particular interest because this is the cash that is actually available to the stockholders.
Accounting profits, on the other hand, is earned by the company and not the money actually on
hand (Principle 3 of Financial Management – Cash, not profit, is king).