a. 1. What is the nature of the investment that is under consideration, and what are the sources of value (cost savings and revenue increases)? 2. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount. Complete the table below using the detail summarized below: Investment: i. Initial Investment - $16M 2016, $2M 2017 ii. Working Capital - 10% of Incremental Sales b. Operating Savings - $2M 2017, $3.5M 2018-2022 Sales Revenue - $4M 20017, $10M 2018-2022 d. Expenses - CGS - 75% of Revenue, SG&A - 5% of Revenue Salvage: i. Working Capital - recoverable at cost ii. Initial Investment - 10% or $1.8M before tax, $1.08M after taxes f. Depreciation - Straight Line over 6 years, no salvage, start in 2017 c. e. 2016 2017 2018 2019 2020 2021 2022 ent: (16,000,000) (2,000,000) Capital Outlay Net Working Capital (10% Sales) (400,000) (600,000) (16,000,000) (2,400,000) 600,000) Total Investment Investment Recovery: 1,080,000 1,000,000 Equipment Salvage Net Working Capital (full recovery) Net Investment (16,000,000) (2,400,000) 600,000) 2,080,000 Earnings before Interest and Taxes (EBIT): Sales Revenue 4,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 (3,000,000) (7,500,000) (7,500,000) (7,500,000) (7,500,000) 7,500,000) Cost of Goods Sold (75% Sales) SG&A (5% Sales) (200,000) (500,000) (500,000) (500,000) (500,000) (500,000) 2,000,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 (3,000,000) (3,000,000) (3,000,000) (3,000,000) (3,000,000) (3,000,000) Operating Savings Depreciation ($18,000/6) Total Costs & Expenses (200,000) 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 EBIT (200,000) 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 Taxes (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000) (40%) NOPAT (200,000) 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Depreciation - Investment (16,000,000) (2,400,000) (600,000) 2,080,000 Free (16,000,000) 400,000 3,900,000 4,500,000 4,500,000 4,500,000 6,580,000 Cash Flow + 3. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Explain your recommended rate and the assumptions that you used to estimate it. 4. What is the net present value (NPV) and internal rate of return (IRR) for the investment? How do you interpret these numbers? 5. Propose two changes to the base case numbers presented in question 3 & 4. Explain the reasons for your changes and discuss the effect of those changes on the NPV and IRR. CASE 19 Worldwide Paper Company In December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was consid- ering the addition of a new on-site longwood woodyard. The addition would have two primary benefits: to eliminate the need to purchase shortwood from an outside sup- plier and create the opportunity to sell shortwood on the open market as a new mar- ket for Worldwide Paper Company (WPC). The new woodyard would allow the Blue Ridge Mill not only to reduce its operating costs but also to increase its revenues. The proposed woodyard utilized new technology that allowed tree-length logs, called long- wood, to be processed directly, whereas the current process required shortwood, which had to be purchased from the Shenandoah Mill. This nearby mill, owned by a com- petitor, had excess capacity that allowed it to produce more shortwood than it needed for its own pulp production. The excess was sold to several different mills, including the Blue Ridge Mill. Thus adding the new longwood equipment would mean that Prescott would no longer need to use the Shenandoah Mill as a shortwood supplier and that the Blue Ridge Mill would instead compete with the Shenandoah Mill by selling on the shortwood market. The question for Prescott was whether these expected benefits were enough to justify the $18 million capital outlay plus the incremental investment in working capital over the six-year life of the investment. Construction would start within a few months, and the investment outlay would be spent over two calendar years: $16 million in 2007 and the remaining $2 million in 2008. When the new woodyard began operating in 2008, it would significantly reduce the operating costs of the mill. These operating savings would come mostly from the difference in the cost of producing shortwood on-site versus buying it on the open mar- ket and were estimated to be $2.0 million for 2008 and $3.5 million per year thereafter. Prescott also planned on taking advantage of the excess production capacity afforded by the new facility by selling shortwood on the open market as soon as pos- sible. For 2008, he expected to show revenues of approximately $4 million, as the facility came on-line and began to break into the new market. He expected shortwood sales to reach $10 million in 2009 and continue at the $10 million level through 2013. This cas prepared by Professor Kenneth M. Eades and is intended for illustrative purposes only. Copyright 2002 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publica- tion may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. Rev. 9/10. 285 286 Part Four Capital Budgeting and Resource Allocation Prescott estimated that the cost of goods sold (before including depreciation expenses) would be 75% of revenues, and SG&A would be 5% of revenues. In addition to the capital outlay of $18 million, the increased revenues would necessitate higher levels of inventories and accounts receivable. The total working cap- ital would average 10% of annual revenues. Therefore the amount of working capital investment each year would equal 10% of incremental sales for the year. At the end of the life of the equipment, in 2013, all the net working capital on the books would be recoverable at cost, whereas only 10% or $1.8 million (before taxes) of the capi- tal investment would be recoverable. Taxes would be paid at a 40% rate, and depreciation was calculated on a straight- line basis over the six-year life, with zero salvage. WPC accountants had told Prescott that depreciation charges could not begin until 2008, when all the $18 million had been spent, and the machinery was in service. Prescott was conflicted about how to treat inflation in his analysis. He was rea- sonably confident that his estimates of revenues and costs for 2008 and 2009 reflected the dollar amounts that WPC would most likely experience during those years. The capital outlays were mostly contracted costs and therefore were highly reliable esti- mates. The expected shortwood revenue figure of $4.0 million had been based on a careful analysis of the shortwood market that included a conservative estimate of the Blue Ridge Mill's share of the market plus the expected market price of shortwood, taking into account the impact of Blue Ridge Mill as a new competitor in the market. Because he was unsure of how the operating costs and the price of shortwood would be impacted by inflation after 2009, Prescott decided not to include it in his analysis. Therefore the dollar estimates for 2010 and beyond were based on the same costs and prices per ton used in 2009. Prescott did not consider the omission critical to the final decision because he expected the increase in operating costs caused by inflation would be mostly offset by the increase in revenues associated with the rise in the price of shortwood. WPC had a company policy to use 15% as the hurdle rate for such investment opportunities. The hurdle rate was based on a study of the company's cost of capital conducted 10 years ago. Prescott was uneasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yield- ing 10%, whereas currently they were yielding less than 5% (Exhibit 1). a. 1. What is the nature of the investment that is under consideration, and what are the sources of value (cost savings and revenue increases)? 2. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount. Complete the table below using the detail summarized below: Investment: i. Initial Investment - $16M 2016, $2M 2017 ii. Working Capital - 10% of Incremental Sales b. Operating Savings - $2M 2017, $3.5M 2018-2022 Sales Revenue - $4M 20017, $10M 2018-2022 d. Expenses - CGS - 75% of Revenue, SG&A - 5% of Revenue Salvage: i. Working Capital - recoverable at cost ii. Initial Investment - 10% or $1.8M before tax, $1.08M after taxes f. Depreciation - Straight Line over 6 years, no salvage, start in 2017 c. e. 2016 2017 2018 2019 2020 2021 2022 ent: (16,000,000) (2,000,000) Capital Outlay Net Working Capital (10% Sales) (400,000) (600,000) (16,000,000) (2,400,000) 600,000) Total Investment Investment Recovery: 1,080,000 1,000,000 Equipment Salvage Net Working Capital (full recovery) Net Investment (16,000,000) (2,400,000) 600,000) 2,080,000 Earnings before Interest and Taxes (EBIT): Sales Revenue 4,000,000 10,000,000 10,000,000 10,000,000 10,000,000 10,000,000 (3,000,000) (7,500,000) (7,500,000) (7,500,000) (7,500,000) 7,500,000) Cost of Goods Sold (75% Sales) SG&A (5% Sales) (200,000) (500,000) (500,000) (500,000) (500,000) (500,000) 2,000,000 3,500,000 3,500,000 3,500,000 3,500,000 3,500,000 (3,000,000) (3,000,000) (3,000,000) (3,000,000) (3,000,000) (3,000,000) Operating Savings Depreciation ($18,000/6) Total Costs & Expenses (200,000) 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 EBIT (200,000) 2,500,000 2,500,000 2,500,000 2,500,000 2,500,000 Taxes (1,000,000) (1,000,000) (1,000,000) (1,000,000) (1,000,000) (40%) NOPAT (200,000) 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Depreciation - Investment (16,000,000) (2,400,000) (600,000) 2,080,000 Free (16,000,000) 400,000 3,900,000 4,500,000 4,500,000 4,500,000 6,580,000 Cash Flow + 3. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Explain your recommended rate and the assumptions that you used to estimate it. 4. What is the net present value (NPV) and internal rate of return (IRR) for the investment? How do you interpret these numbers? 5. Propose two changes to the base case numbers presented in question 3 & 4. Explain the reasons for your changes and discuss the effect of those changes on the NPV and IRR. CASE 19 Worldwide Paper Company In December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was consid- ering the addition of a new on-site longwood woodyard. The addition would have two primary benefits: to eliminate the need to purchase shortwood from an outside sup- plier and create the opportunity to sell shortwood on the open market as a new mar- ket for Worldwide Paper Company (WPC). The new woodyard would allow the Blue Ridge Mill not only to reduce its operating costs but also to increase its revenues. The proposed woodyard utilized new technology that allowed tree-length logs, called long- wood, to be processed directly, whereas the current process required shortwood, which had to be purchased from the Shenandoah Mill. This nearby mill, owned by a com- petitor, had excess capacity that allowed it to produce more shortwood than it needed for its own pulp production. The excess was sold to several different mills, including the Blue Ridge Mill. Thus adding the new longwood equipment would mean that Prescott would no longer need to use the Shenandoah Mill as a shortwood supplier and that the Blue Ridge Mill would instead compete with the Shenandoah Mill by selling on the shortwood market. The question for Prescott was whether these expected benefits were enough to justify the $18 million capital outlay plus the incremental investment in working capital over the six-year life of the investment. Construction would start within a few months, and the investment outlay would be spent over two calendar years: $16 million in 2007 and the remaining $2 million in 2008. When the new woodyard began operating in 2008, it would significantly reduce the operating costs of the mill. These operating savings would come mostly from the difference in the cost of producing shortwood on-site versus buying it on the open mar- ket and were estimated to be $2.0 million for 2008 and $3.5 million per year thereafter. Prescott also planned on taking advantage of the excess production capacity afforded by the new facility by selling shortwood on the open market as soon as pos- sible. For 2008, he expected to show revenues of approximately $4 million, as the facility came on-line and began to break into the new market. He expected shortwood sales to reach $10 million in 2009 and continue at the $10 million level through 2013. This cas prepared by Professor Kenneth M. Eades and is intended for illustrative purposes only. Copyright 2002 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publica- tion may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School Foundation. Rev. 9/10. 285 286 Part Four Capital Budgeting and Resource Allocation Prescott estimated that the cost of goods sold (before including depreciation expenses) would be 75% of revenues, and SG&A would be 5% of revenues. In addition to the capital outlay of $18 million, the increased revenues would necessitate higher levels of inventories and accounts receivable. The total working cap- ital would average 10% of annual revenues. Therefore the amount of working capital investment each year would equal 10% of incremental sales for the year. At the end of the life of the equipment, in 2013, all the net working capital on the books would be recoverable at cost, whereas only 10% or $1.8 million (before taxes) of the capi- tal investment would be recoverable. Taxes would be paid at a 40% rate, and depreciation was calculated on a straight- line basis over the six-year life, with zero salvage. WPC accountants had told Prescott that depreciation charges could not begin until 2008, when all the $18 million had been spent, and the machinery was in service. Prescott was conflicted about how to treat inflation in his analysis. He was rea- sonably confident that his estimates of revenues and costs for 2008 and 2009 reflected the dollar amounts that WPC would most likely experience during those years. The capital outlays were mostly contracted costs and therefore were highly reliable esti- mates. The expected shortwood revenue figure of $4.0 million had been based on a careful analysis of the shortwood market that included a conservative estimate of the Blue Ridge Mill's share of the market plus the expected market price of shortwood, taking into account the impact of Blue Ridge Mill as a new competitor in the market. Because he was unsure of how the operating costs and the price of shortwood would be impacted by inflation after 2009, Prescott decided not to include it in his analysis. Therefore the dollar estimates for 2010 and beyond were based on the same costs and prices per ton used in 2009. Prescott did not consider the omission critical to the final decision because he expected the increase in operating costs caused by inflation would be mostly offset by the increase in revenues associated with the rise in the price of shortwood. WPC had a company policy to use 15% as the hurdle rate for such investment opportunities. The hurdle rate was based on a study of the company's cost of capital conducted 10 years ago. Prescott was uneasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yield- ing 10%, whereas currently they were yielding less than 5% (Exhibit 1)