HW 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 Ey Draw 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 159 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. Prescou 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) TV Draw Case 19 Worldwide Paper Company 287 EXHIBIT 1 | Cost-of-Capital Information Interest Rates: December 2006 Market risk premium Historical average 6.0% Bank loan rates (LIBOR) 1-year 5.38% Government bonds 1-year 4.96% 5-year 4.57% 10-year 4.60% 30-year 4.73% Corporate bonds (10-year maturities): 5.37% 5.53% 5.78% Baa 6.25% Worldwide Paper Financial Data Balance-sheet accounts (5 millions) Bank loan payable (LIBOR + 1%) 500 Long-term debt 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 Bond rating Beta 1.10 gar/Desktop/WWP_Guideline.pdf + 2 WORLDWIDE PAPER COMPANY The case is based on an actual investment decision made by a major paper-products company in the 1990s. The numbers and the company name have been disguised at the request of the company. The dates have been revised for pedagogical reasons. The case provides a glimpse into the paper business but is primarily designed to present a straightforward problem in assessing cash flows, cost of capital, and net present value of a capital-investment decision. The case works well for all audiences who are learning the basics of discounted cash flow and investment analysis. I have used it successfully with executives as an in-class exercise following introductory classes on cash flows, discounted cash flow, and cost of capital. I encourage participants to work in groups of two or three to bring together the concepts of the earlier classes in this simple but comprehensive, capital-investment example. . The case touches on the following capital-investment topics: Estimation of relevant cash flows (both cost savings and increased revenues) Influence of taxes vis--vis cost savings and revenues Change in net working capital as a cash flow Component costs of capital as determined by current market conditions Weighted average cost of capital (WACC) as the discount rate for the average investment . Questions for Advance Assignment to Students 1. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount 2. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Be prepared to justify your recommended rate and the assumptions that you used to estimate it. 3. What is the net present value (NPV) and internal rate of return (IRR) for the investment? o i a HW 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 Ey Draw 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 159 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. Prescou 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) TV Draw Case 19 Worldwide Paper Company 287 EXHIBIT 1 | Cost-of-Capital Information Interest Rates: December 2006 Market risk premium Historical average 6.0% Bank loan rates (LIBOR) 1-year 5.38% Government bonds 1-year 4.96% 5-year 4.57% 10-year 4.60% 30-year 4.73% Corporate bonds (10-year maturities): 5.37% 5.53% 5.78% Baa 6.25% Worldwide Paper Financial Data Balance-sheet accounts (5 millions) Bank loan payable (LIBOR + 1%) 500 Long-term debt 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 Bond rating Beta 1.10 gar/Desktop/WWP_Guideline.pdf + 2 WORLDWIDE PAPER COMPANY The case is based on an actual investment decision made by a major paper-products company in the 1990s. The numbers and the company name have been disguised at the request of the company. The dates have been revised for pedagogical reasons. The case provides a glimpse into the paper business but is primarily designed to present a straightforward problem in assessing cash flows, cost of capital, and net present value of a capital-investment decision. The case works well for all audiences who are learning the basics of discounted cash flow and investment analysis. I have used it successfully with executives as an in-class exercise following introductory classes on cash flows, discounted cash flow, and cost of capital. I encourage participants to work in groups of two or three to bring together the concepts of the earlier classes in this simple but comprehensive, capital-investment example. . The case touches on the following capital-investment topics: Estimation of relevant cash flows (both cost savings and increased revenues) Influence of taxes vis--vis cost savings and revenues Change in net working capital as a cash flow Component costs of capital as determined by current market conditions Weighted average cost of capital (WACC) as the discount rate for the average investment . Questions for Advance Assignment to Students 1. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount 2. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Be prepared to justify your recommended rate and the assumptions that you used to estimate it. 3. What is the net present value (NPV) and internal rate of return (IRR) for the investment? o i a