n January 2018, Jimmy McGill, the Manager for the Longwood Yard (A lumber 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 Yellow Wood Paper Company (YWPC). The new woodyard would allow the Longwood Yard 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 Wabash 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 Longwood Yard. Thus adding the new longwood equipment would mean that McGill would no longer need to use the Wabash Mill as a shortwood supplier and that the Longwood Yard would instead compete with the Wabash Mill by selling on the shortwood market. The question for McGill 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 2018 and the remaining $2 million in 2019. When the new woodyard began operating in 2020, 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 2020 and $3.5 million per year thereafter. McGill 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 2020, 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 2021 and continue at the $10 million level through the end of the project. Jimmy is very concerned about the required EPA audit before starting the project that will cost $1 million. He wants to include this cost in the analysis.

McGill 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 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, all the net working capital on the books would be recoverable at cost (Meaning the company recovers all paid net working capital at time zero), whereas only $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 straightline basis over the six-year life, with zero salvage (straightline means each year the company depreciates 1/6 of the total value). 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 Longwood Yards share of the market plus the expected market price of shortwood, taking into account the impact of Longwood Yard as a new competitor in the market. YWPC had a company policy to use 15% as the hurdle rate for such investment opportunities. The hurdle rate was based on a study of the

companys cost of capital conducted 10 years ago. McGill 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 A).

Exhibit A: Cost of capital information

INTEREST RATES: JANUARY 2018

GOVERNMENT BONDS Market Risk Premium

1-YEAR 3.5% Historical Average 6.0%

CORPORATE BOND

INFORMATION

PAR VALUE $1,000

MARKET VALUE $986

COUPON RATE 5.0%

AVERAGE LIFE 12 years

LONGWOOD FINANCIAL DATA

BALANCE SHEET (IN

MILLIONS) Other Information

LONG-TERM DEBT 2,500 Beta 1.10

COMMON EQUITY 500

RETAINED EARNINGS 2,000

PER-SHARE DATA

SHARES OUTSTANDING 500 million

BOOK VALUE PER SHARE $5.00

RECENT SHARE PRICE $24

Answer the following questions. Only responses that show complete work will be given credit.

1. List the income/costs associated with this project. Categorize each cost/benefit into what component of FCF it belongs to. Is the cost/benefit short or long-term?

Example:

EBIT (Earnings before interest and tax) $2.0 million for 2020 and $3.5 million per year thereafter 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 2021 SG&A would be 5% of revenues

Depreciation

CAPEX (Capital Expenditure) $18 million for the project (one time/short-term)

NOWC (Net Operating Working Capital) SG&A would be 5% of revenues

2. Identify any costs/benefits mentioned in the case that should not be include in the analysis.

3. Using the information provided in Exhibit A, compute the cost of common equity, and debt. Assume Longwood has no preferred stock. Should the company continue to use its historic hurdle rate, yes or no? Support your answer.

COMMON EQUITY COST DEBT COST

4. Using the information from part 3, compute the WACC. Assume Longwood has no preferred stock. Should the company continue to use its historic hurdle rate, yes or no? Support your answer.