Need help with 1 and 5 only. thank you

1. What is the nature of the investment that is under consideration, and what are the sources of value (cost savings and revenue increases)?
2. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount. Complete the table below using the detail summarized below:
   1. Investment:
      1. Initial Investment - $16M 2016, $2M 2017
      2. Working Capital - 10% of Incremental Sales
   2. Operating Savings - $2M 2017, $3.5M 2018-2022
   3. Sales Revenue - $4M 20017, $10M 2018-2022
   4. Expenses - CGS 75% of Revenue, SG&A - 5% of Revenue
   5. Salvage:
      1. Working Capital - recoverable at cost
      2. Initial Investment - 10% or $1.8M before tax, $1.08M after taxes
   6. Depreciation Straight Line over 6 years, no salvage, start in 2017
3. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Explain your recommended rate and the assumptions that you used to estimate it.
4. What is the net present value (NPV) and internal rate of return (IRR) for the investment? How do you interpret these numbers?
5. Propose two changes to the base case numbers presented in question 3 & 4. Explain the reasons for your changes and discuss the effect of those changes on the NPV and IRR.

CASE 18 Worldwide Paper Company 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 Worldwide Paper Company (WPC). Now the new woodyard would allow the Blue Ridge Mill not only to redwe 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 produce more shortwood than it needed for its own pulp production. The excess was sold to several different mills, including the Blue Ridge Mill. This adding the new longwood equipment would mean that Prescott would no longer need to use the Sherandoah Mill as a shortwood supplier and that the Blue Ridge Mill would instead compete with the Sherandoah 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 woud start within a few months, and the investment outlay would be spent over two calendar years: $16 million in 2016 and the remaining $2 million in 2017. When the new woodyard began operating in 2017, 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 2017 and $3.5 million per year thereafter. Prescott also plamed 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 $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 2018 and continue at the $10 million level through 2022. Prescott estimated that the cost of goods sold (before including depreciation expenses) would be 75% of Page 250 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 equl 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. 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 2017, 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 reasonably confident that his estimates of revenues and costs for 2016 and 2017 reflected the dollar amounts that WPC would most likely experienee 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 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 2017, Prescott decided not to include it in his analysis. Therefore the dollar estimates for 2018 and beyond were based on the same costs and prices per ton used in 2017. 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 10% as the hurdle rate for such investment opportunities. The hurdle rate was based on a study of the company's cost ofcapital conducted 10 years ago. Prescott was uneasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yielding 4.7%, whereas currently they were yielding less than 3% (Exhibit 18.1). Page 251 EXHIBIT 18.1 Cast-of-Capital Information Interest Rate January 15, 2016 Marlem Bank loan UBOR 1.15 60 Government bonds Corporate bonds (10-year mais Ae 2.45 10 385 505 204 A 2828 B Worldwide Paper Pinancial Date Balance sheet accounts millions of dollars) Bank loan payable LIBOR 500 Long term debe 2.500 Common 500 Retained 2.000 Pur-sharee Shares outstanding on Book value per share 500 $ 500 $2400 Other Bonding 110 State CASE 18 Worldwide Paper Company 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 Worldwide Paper Company (WPC). Now the new woodyard would allow the Blue Ridge Mill not only to redwe 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 produce more shortwood than it needed for its own pulp production. The excess was sold to several different mills, including the Blue Ridge Mill. This adding the new longwood equipment would mean that Prescott would no longer need to use the Sherandoah Mill as a shortwood supplier and that the Blue Ridge Mill would instead compete with the Sherandoah 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 woud start within a few months, and the investment outlay would be spent over two calendar years: $16 million in 2016 and the remaining $2 million in 2017. When the new woodyard began operating in 2017, 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 2017 and $3.5 million per year thereafter. Prescott also plamed 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 $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 2018 and continue at the $10 million level through 2022. Prescott estimated that the cost of goods sold (before including depreciation expenses) would be 75% of Page 250 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 equl 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. 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 2017, 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 reasonably confident that his estimates of revenues and costs for 2016 and 2017 reflected the dollar amounts that WPC would most likely experienee 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 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 2017, Prescott decided not to include it in his analysis. Therefore the dollar estimates for 2018 and beyond were based on the same costs and prices per ton used in 2017. 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 10% as the hurdle rate for such investment opportunities. The hurdle rate was based on a study of the company's cost ofcapital conducted 10 years ago. Prescott was uneasy using an outdated figure for a discount rate, particularly because it was computed when 30-year Treasury bonds were yielding 4.7%, whereas currently they were yielding less than 3% (Exhibit 18.1). Page 251 EXHIBIT 18.1 Cast-of-Capital Information Interest Rate January 15, 2016 Marlem Bank loan UBOR 1.15 60 Government bonds Corporate bonds (10-year mais Ae 2.45 10 385 505 204 A 2828 B Worldwide Paper Pinancial Date Balance sheet accounts millions of dollars) Bank loan payable LIBOR 500 Long term debe 2.500 Common 500 Retained 2.000 Pur-sharee Shares outstanding on Book value per share 500 $ 500 $2400 Other Bonding 110 State