CASE 18 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: (1) eliminate the need to purchase shortwood from an outside sup- plier and (2) create the opportunity to sell shortwood on the open market as a new market for Worldwide Paper Company (WPC). Thus, the new woodyard would allow the Blue Ridge Mill not only to reduce its operating costs, but also to increase its rev- enues. 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 a nearby mill. The Shenandoah Mill, which was owned by a competitor, had excess capacity that allowed it to produce more shortwood than needed for its own pulp production and to sell the excess pro- duction 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 6 years 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 market, 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 by selling shortwood on the open market as soon as possible. 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. Prescott estimated This case was 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 publication 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 otherwise-without the permission of the Darden School Foundation. Rev. 12/06. 259260 Part Four Capital Budgeting and Resource Allocation 8 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 net work- ing capital (NWC) would average 10% of annual revenues. Therefore, the amount of NWC 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 would be recov- erable, whereas only 10%, or $1.8 million (before taxes), of the capital 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 $18 million had been spent and the machinery was in service. Because he did not have a good feel for how inflation would affect his analysis, Prescott had decided not to include it. WPC had a company policy to use its corporate cost of capital (15%) to analyze such investment opportunities. Unfortunately, the company had not changed its cost of capital for 10 years, and Prescott felt uneasy using an outdated figure. He was par- ticularly uncomfortable with the 15% figure because it was computed when 30-year Treasury bonds were yielding 10%, whereas they were currently yielding less than 5%. To estimate Worldwide's current weighted average cost of capital, Prescott had gathered the information presented in Exhibit 1. WWP Re= 4. 6 + 1. 1 x 6/0 Case 18 Worldwide Paper Company 261 Rf = 4. 60% EXHIBIT 1 2% Cost-of-Capital Information B = 1-10 Interest Rates: December 2006 Risk premium 6.0% Bank loan rates (LIBOR) Market risk premium Rd = 5. 7801 = Arating" year 5.38% Historical average 6.0% bord Government bonds Corporate bonds (10-year maturities): D = 2500 + 500 30001 -year 4.96% X Aaa 5.37% E = 500*24 Rf 5-year 4.57% 10-year Rf because Aa 4.60% optis A Rd 5.53% 5.78% = 12000 / Period of 30-year 4.73% 7 years Baa 6.25% Valuation Worldwide Paper Financial Data mil 7 choose Balance-sheet accounts ($ millions) the Bank loan payable (LIBOR + 1%) 500 task maturity ofhong-term debt 2,500 Common equity 500 (ACC = 5, 78x 3000 RT Retained earnings 2,000 3000+12000 Per-share data X ( 1 - 0. 4) + Shares outstanding (millions) 500 Book value per share $ 5.00 11. 2%x / 2000 Recent market value per share $24.00 Other 3000f /200 Bond rating Beta 1.10 9.65% Tax rate 40%