c 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. 1. Investment i Initial Investment - $16M 2016, $2M 2017 i 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 c. Salvage i Working Capital -recoverable at cont Initial Investment - 10% of $1.8M before tax, $1.08M after taxes Depreciation - Straight Line over 6 years, no talvage, start in 2017 2016 2017 2018 2019 2020 2021 2022 Investment Capital Outlay Net Working Capital (10% Sales) Total Investment Investment Recovery Equipment Salvage Net Working Capital (full recovery) Earnings before Interest and Taxes EBIT Sales Revenge Cost of Goods Sold 75% Sales) SG&A 5% Sales Protected View. Enable Editing Operating Savings Depreciation ($18,000/6) Total Costs & Expenses EBIT Taxes (40%) NOPAT + Depreciation - Investment = Free Cash Flow 3. What discount rate should Worldwide Paper Company (WPC) woe to analyze those cash flow? Explain your recommended tate and the assumptions that you used to estimate it 4. What is the net present value NPV) and internal rate of totum (IRR) for the investments How do you interpret these numbers 5. Propone two changes to the base case numbers presented question 3 & 4. Explain the reason for your changes and discuss the effect of those changes on the NPV and IRR In January 2016, Bob Prescott, the controller for the Blue Ridge Mill, was considering 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 supplier and create the opportunity to sell shortwood on the open market as a new market for Worldwide Paper Company (WPC). Now 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 longwood, 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 competitor, 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 S18 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: S16 million in 2016 and the remaining $2 million in 2017. When the new woodyard began operating in 2017, 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 market and were estimated to be $2.0 million for 2017 and 53.5 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 possible. For 2017, 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 STO million in 2018 and continue at the S10 million level through 2022. Prescott Estimated that the cost of goods sold before including depreciation expenses) would be 75% of Page 250 estimated that the cost of goods sold (before including depreciation expenses) would be 75% of Page 250 revenues, and SG&A would be 5% of revenues. In addition to the capital outlay of S18 million, the increased revenues would necessitate higher levels of inventories and accounts receivable. The total working capital would average 10% of annual revenues. Therefore the amount of working capital investment cach year would equal 10% of incremental sales for the year. At the end of the life of the equipment, in 2022, all the net working capital on the books would be recoverable at cost, whereas only 10% or $1.8 million before taxes) of the capital investment would be recoverable Taxes would be paid at a 40% rates 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 2017, when all the S18 million had been spent, and the machinery was in service. Prescott was conflicted about how to treat inflation in his analysis. He was reasonably conlident that is estimates of revenues and costs for 2016 and 2017 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 estimates. The expected shortwood revenue figure of S4.0 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 2017, Prescott decided not to include it in his analysis. Therefore the dollar estimates for 2018 and beyond were based on the same costs and prices per ton used in 2017. 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 10% 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 uncasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yielding 47%, whereas currently they were yielding less than 3% Exhibit 18.1). EXHIBIT 18.1 Cost-of-Capital Information Interest Rates: January 15, 2016 Bank loan rates (LIDOR) Market risk premium 1-year 1.15% Historical average 6.0% Government bonds 1-year 5-year 10 year 30 year 0.49% 1.46% 2.04% 2.82% Corporate bonds (10-year maturities) Aaa 2.45% Aa 3.38% A 3.85% Bas 15.05% Workdwide Paper Financial Data Balanco-shoot accounts (in millions of dollars) Bank icon payable (LIBOR + 1) 500 Long term dost 2.500 Common equity 500 pelanned earning 2.000 Pershare data Shares outstanding millions Look value per share Recent market was por sha 500 $ 0.00 $24.00 Other fondato c 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. 1. Investment i Initial Investment - $16M 2016, $2M 2017 i 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 c. Salvage i Working Capital -recoverable at cont Initial Investment - 10% of $1.8M before tax, $1.08M after taxes Depreciation - Straight Line over 6 years, no talvage, start in 2017 2016 2017 2018 2019 2020 2021 2022 Investment Capital Outlay Net Working Capital (10% Sales) Total Investment Investment Recovery Equipment Salvage Net Working Capital (full recovery) Earnings before Interest and Taxes EBIT Sales Revenge Cost of Goods Sold 75% Sales) SG&A 5% Sales Protected View. Enable Editing Operating Savings Depreciation ($18,000/6) Total Costs & Expenses EBIT Taxes (40%) NOPAT + Depreciation - Investment = Free Cash Flow 3. What discount rate should Worldwide Paper Company (WPC) woe to analyze those cash flow? Explain your recommended tate and the assumptions that you used to estimate it 4. What is the net present value NPV) and internal rate of totum (IRR) for the investments How do you interpret these numbers 5. Propone two changes to the base case numbers presented question 3 & 4. Explain the reason for your changes and discuss the effect of those changes on the NPV and IRR In January 2016, Bob Prescott, the controller for the Blue Ridge Mill, was considering 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 supplier and create the opportunity to sell shortwood on the open market as a new market for Worldwide Paper Company (WPC). Now 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 longwood, 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 competitor, 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 S18 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: S16 million in 2016 and the remaining $2 million in 2017. When the new woodyard began operating in 2017, 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 market and were estimated to be $2.0 million for 2017 and 53.5 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 possible. For 2017, 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 STO million in 2018 and continue at the S10 million level through 2022. Prescott Estimated that the cost of goods sold before including depreciation expenses) would be 75% of Page 250 estimated that the cost of goods sold (before including depreciation expenses) would be 75% of Page 250 revenues, and SG&A would be 5% of revenues. In addition to the capital outlay of S18 million, the increased revenues would necessitate higher levels of inventories and accounts receivable. The total working capital would average 10% of annual revenues. Therefore the amount of working capital investment cach year would equal 10% of incremental sales for the year. At the end of the life of the equipment, in 2022, all the net working capital on the books would be recoverable at cost, whereas only 10% or $1.8 million before taxes) of the capital investment would be recoverable Taxes would be paid at a 40% rates 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 2017, when all the S18 million had been spent, and the machinery was in service. Prescott was conflicted about how to treat inflation in his analysis. He was reasonably conlident that is estimates of revenues and costs for 2016 and 2017 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 estimates. The expected shortwood revenue figure of S4.0 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 2017, Prescott decided not to include it in his analysis. Therefore the dollar estimates for 2018 and beyond were based on the same costs and prices per ton used in 2017. 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 10% 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 uncasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yielding 47%, whereas currently they were yielding less than 3% Exhibit 18.1). EXHIBIT 18.1 Cost-of-Capital Information Interest Rates: January 15, 2016 Bank loan rates (LIDOR) Market risk premium 1-year 1.15% Historical average 6.0% Government bonds 1-year 5-year 10 year 30 year 0.49% 1.46% 2.04% 2.82% Corporate bonds (10-year maturities) Aaa 2.45% Aa 3.38% A 3.85% Bas 15.05% Workdwide Paper Financial Data Balanco-shoot accounts (in millions of dollars) Bank icon payable (LIBOR + 1) 500 Long term dost 2.500 Common equity 500 pelanned earning 2.000 Pershare data Shares outstanding millions Look value per share Recent market was por sha 500 $ 0.00 $24.00 Other fondato