FINA 1010 Individual Case Study

Global Paper Company

[1]In December 2019, Catherine Jones, the controller for the Green Ridge Mill, was considering the addition of the 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 Global Paper Company (GPC). The new woodyard would allow the Green Ridge Mill not only to reduce its operating cost 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 the 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 Green Ridge Mill. Thus, adding the new longwood equipment would mean that Jones would no longer need to use the Shenandoah Mill as a shortwood supplier and that the Green Ridge Mill would instead compete with the Shenandoah Mill by selling on the shortwood market. The question for Jones 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 the two calendar years: 16 million in 2020 and the remaining $2 million in 2021. When the new woodyard began operating in 2021, 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 2021 and $3.5 million per year thereafter.

Jones 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 2021, he expected to show revenues of approximately $4 million, as the facility came online and began to break into the new market. He expected shortwood sales to reach 10 million in 2022 and continue at the $10 million level through 2026. Jones estimated that the cost of goods sold (before including depreciation expenses) would be 75% of revenue, 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 incremental sales for the year. At the end of the life of the equipment, in 2026, 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% rate, and depreciation was calculated on a straight-line basis over the six-year life, with zero salvage, GPC accountants had total Jones that depreciation charges could not begin until 2021, when all of the $18 million had been spent, and the machinery was in service.

Jones was conflicted about how to treat inflation in his analysis. He was reasonably confident that his estimates of revenues and costs for 2021 and 2022 reflected the dollar amounts that GPC 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 $4.0 million had been based on a careful analysis of the shortwood market that included a conservative estimate of the Green Ridge Mills share of the market plus the expected market price of shortwood, taking into account the impact of Green 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 2022, Jones 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.

GPC had a company policy to use 15% as the hurdle rate for such investments opportunities. The hurdle rate was based on a study of the companys cost of capital conducted 10 years ago. Jones was uneasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yielding 10%, whereas currently they were yielding less than 5%.

Exhibit 1 Cost of Capital Information

Interest Rates and Market Data: December 2019

Bank Loan Rates Market risk permium

1 year 5.38% Historical average 6.0%

Government Bonds Corporate bonds (10 year maturities)

1 year 4.96% Aaa 5.37%

5 year 4.57% Aa 5.53%

10 year 4.60% A 5.78%

30 year 4.73% Baa 6.25%

Global Paper Company Financial Data

Balance Sheet accounts Other Information

Bank loan payable $500,000 Bond Rating A

Long-term debt (Bonds) $2,500,000 Beta 1.10

Common equity $500,000

Retained Earnings $2,000,000

Per-Share Data

Shares outstanding 500,000

Book Value per share $5.00 ( based on common equity and R/E account)

Recent Market Value per Share $24.00

1. Provide an overview of the case.
2. Identify any issues to be explored regarding evaluating the investment.
3. Calculate the WACC for Global Paper Company.
   1. Use the total of Bank Loan and Long-term debt to establish weighting
      1. Cost of LTD (Bonds) can be used for WACC. (ignore cost of bank loan but include bank loan for weighting in capital structure)
   2. Use CAPM model to calculate Cost of Equity.
4. In your opinion should the current WACC be used or the historical discount rate? Provide explanation for your opinion.
5. Identify the cash outflows and inflows (after tax were applicable). Must use Excel formulas to calculate NPV and IRR using the WACC calculated.
   1. Ignore tax shield calculations.
6. What is your recommendation?
7. Discuss further the issues regarding not adjusting the future cash flows (Revenue, COGS, SG&A, operating savings) for inflation.
8. Do a sensitivity analysis by providing revised cash flows, NPV and IRR calculations if revenue and expenses above were revised based on 2% inflation each year beginning in 2022.
9. Explain and analyze the results obtained based on the revised cash flows.
10. Choose another element in the cash flows and do a sensitivity analysis . Explain why you choose that element and what the results tell us. Would you change your decision?