Case Study Wisconsin Paper Company (WPC) 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 Wisconsin 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 producemore shortwood than it needed forits own pulp production.The excesswassold 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 incrementalinvestmentinworking capital overthe six-yearlifeof the investment. Construction would start within a few months, and the investment outlay would be spent over two calendar years: $15 million in 2016 and the remaining $3 million in 2017. When the new woodyard began operating in 2017, it would significantly reduce the operating costs of the mill.These operating savingswould comemostly 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 $3.5 million per year thereafter. These cost savings were not reflected in estimates of Cost of Goods Sold (COGS) or other expenses. 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 $8 million, as the facility came on-line and began to break into the new market. He expected shortwood sales to reach $10 million in 2018 and continue at the $10 million level through 2022. Prescott estimated that the cost of goodssold (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 capital 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 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 through market sale. Taxes would be paid at a 30% rate, and depreciation was calculated on a straight-line basis over the six- yearlife, with zero estimated salvage value. WPCaccountants had told Prescott that depreciation charges could not begin until 2017, when all the $18 million had been spent, and the machinery was in service. The annual interest expense was estimated at $96 million per year. The accountant had proposed an overhead charge of 1% times the book value of the asset acquired for the project per year. Prescott had argued with the accountant on the rationale of the overhead charge. Prescott was conflicted about how to treat inflation in his analysis. He was reasonably confident that his estimates of revenues and costs for 2016 and 2017 reflected the dollar amounts that WPC would most likely experience during those years. However, the dollar estimates for 2018 and beyond were based on the same costs, expenses, and prices used in 2017 without adjusting for inflation. The capital outlays were mostly contracted costs and therefore were highly reliable estimates of actual costs.The expected shortwood revenue figure of $8.0million had been based on a careful analysis ofthe shortwoodmarket that included a conservative estimate oftheBlueRidgeMillsshareofthemarket plus the expected market price ofshortwood, taking into account the impact ofBlueRidgeMill as a new competitor in themarket.Because he was unsure of howthe operating costs and the price of shortwoodwould be impacted by inflation after 2017, Prescott asked Tom the company Treasurer to provide expected inflation estimates. Tom used the 10-year Treasury Inflation Protected Securities (TIPS) issued on January 15, 2016 to arrive at the implied expected inflation rate of 2% for years 2018 through 2022. WPC had historically used 13.5% as the cost of capital to evaluate such investment opportunities. This hurdle rate was based on a study of the companys cost of capital conducted 10 years ago. Prescott was uneasy using an outdated figure for a discount rate, particularly because it was computed when 10-year Treasury bonds were yielding 4.7%, whereas currently they were yielding around 2%. Prescott asked Tom to collect current data on WPCs debt and equity in order to revise or validate the cost of capital figure. WPC shares were listed on the Midwest Stock Exchange in 2010 and were actively traded. A total of 500 million shares were outstanding with a recent closing price of $24.00. WPC had a long-term bond issue that paid 8.75% coupon semi-annually (par value of $1,000) and had 10 years remaining to maturity. The most recent bond price was $970. The bonds were rated as A by both Moodys and S&P. A total of 2.5 million bonds were outstanding. Tom also collected stock returns and other relevant data summarized in Exhibit 1.

What discount rate should WPC use to evaluate the project cash flows? Answer the following questions as part of estimating the projects hurdle rate.

1. What is your estimate of the after-tax cost of debt component of capital __________? 2. What is your estimate of stocks beta based on more recent data _________ and the regression R-Square ___________?

3. Based on the market data and your beta estimate, what is the firms cost of equity capital _____________?

4. What are the appropriate weights of debt ______and equity capital __________?

5. What is your estimate of the firms WACC __________?

(b) Estimate the relevant cash flows (2016-2022) of the project and determine its NPV and IRR. Answer the following questions.

6. What is the projects net operating profit after-tax (NOPAT) in 2017 _________ and 2020_______________?

7. What amount of additional investment in net working capital will be required in 2017 _______________ and 2020 _________________?

8. What is your estimate of the after-tax salvage value of the capital investment at the end of projects life __________?

9. What is the total amount of free cash flow (FCFF) available to the firm in year 2017 __________ and 2020 ____________?

10. Based on your estimate of cash flows and the discount rate, what is the projects NPV ____________ and IRR __________?

(c) Clearly state whether the statement below is true or false and briefly explain your reasoning.

11. Your firm has an opportunity to invest $10 million in a new project. The interest rate on the firms new debt is 8% before tax and the cost of new equity is 15%. Corporate tax rate is 40%. The cost of capital to evaluate the project depends on whether the firm finances the project with new debt or new equity. True or false? Briefly explain.

12. The analyst at your firm has discounted real cash flows at a nominal discount rate. This is likely to overestimate the net present value of the project. True or false? Briefly explain.

Please Upload the working

Exhibit 1 Wisconsin Paper Company Cost-of-Capital Information as of January 15, 2016 LIBOR 1-year 7.0% Market risk premium 1.15% Historical average Treasury Securities 1-year 0.49% 5-year 1.46% 10-year 2.04% Wisconsin Paper Financial Data Balance-sheet accounts (in millions) Long-term debt @ 1,000 par value 2,500 Common equity 500 Retained earnings 2,000 Per-share data Shares outstanding (millions) 500 Book value per share $5.00 Recent market value per share $24.00 Other Data WPC Bond rating (Current) A Stock Beta 1.50 (Last estimated in 2010) Tax rate = 30% Stock and Market Return Data WPC Russell Year Return 1000 % Return% 2011 17 13 2012 -3 - 1 2013 14 12 2014 14 10 2015 13 11 Exhibit 1 Wisconsin Paper Company Cost-of-Capital Information as of January 15, 2016 LIBOR 1-year 7.0% Market risk premium 1.15% Historical average Treasury Securities 1-year 0.49% 5-year 1.46% 10-year 2.04% Wisconsin Paper Financial Data Balance-sheet accounts (in millions) Long-term debt @ 1,000 par value 2,500 Common equity 500 Retained earnings 2,000 Per-share data Shares outstanding (millions) 500 Book value per share $5.00 Recent market value per share $24.00 Other Data WPC Bond rating (Current) A Stock Beta 1.50 (Last estimated in 2010) Tax rate = 30% Stock and Market Return Data WPC Russell Year Return 1000 % Return% 2011 17 13 2012 -3 - 1 2013 14 12 2014 14 10 2015 13 11