It has 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 and 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 Unit Sales: Year 1: Units sold: 70,000 Year 2: Units sold: 120,000 Year 3: Units sold: 140,000 Year 4: Units
sold 80,000 Year 5: Units sold 60,000 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 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 new 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. The depreciation method: Use the simplified straight-line method over 5 years. Assume that the plant and
equipment will have no salvage value after 5 years. A.) Should Caledonia focus on cash flows or accounting profits in
making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits,
total free cash flows, or total profits? B.) How does depreciation affect free cash flows or total profits? C.) How do sunk costs