Question

What yearly cash flows are relevant for this investment decision? Do no forget the effect of taxes and the initial investment amount.

19 CASE Worldwide Paper Company In December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was consid- ering the addition of a new 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 ne 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 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 on-site longwood woodyard. The addition would have two C a com- 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. C This case was prepared by Professor Kenneth M. Eades and is intended for illustrative purposes only. Copyright O 2002 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publica- tion may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means-electronic, mechanical, photocopying, recording, or otherwise-without the permission of the Darden School Foundation. Rev. 9/10. 285 Part Four Capital Budgeting and Resource Allocation 286 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 at cost, whereas only 10% or $1.8 million (before taxes) of the capi- be recoverable tal investment would be recoverable. Taxes would be paid at a 40 % rate , and depreciation was calculated on 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. a straight- 286 Part Four Capital Budgeting and Resource Allocation 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 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 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. Prescott was uneasy using an outdated figure for a discount rate, particularly because it was ing 10%, whereas currently they were yielding less than 5% (Exhibit 1). begin until 2008, when all the $18 million had not likely experience during those years. The C computed when 30-year Treasury bonds were yield- Case 19 Worldwide Paper Company 287 EXHIBIT 1 Cost-of-Capital Information Interest Rates: December 2006 Market risk premium Historical average Bank loan rates (LIBOR) 1-year 5.38% 6.0% Corporate bonds (10-year maturities): 5.37% 5.53% 5.78% 6.25% Government bonds 4.96% 1-year 5-year 10-year 30-year Aaa 4.57% Aa A 4.60% 4.73% Baa Worldwide Paper Financial Data Balance-sheet accounts (S millions) Bank loan payable (LIBOR Long-term debt Common equity Retained earnings 1%) 500 2,500 500 2,000 Per-share data Shares outstanding (millions) Book value per share Recent market value per share $ 5.00 $24.00 Other Bond rating Beta A 1.10

Answer 1

Working Calcla tion of cash inflow {rom ope ialions dol3 Rolo aco lo000000 o000000 loooocco looo0000 l00000 00 4000000 Le:Co 300000 O 35000001500000 1500000 15000OD 500000 Reveoue) 500o0o 500000 5 00000 5000 00 aooo0o 500000 uhs:i1 (51.of 1evenue) oрстоling o0000 Д000000 200ор0о д000ро0 2000000 2000000 in(ome оp-тоtimg Savings (reduction 3500000 3500000 3500 000 3500o00 ao00000 3500000 in ope1oling cost) Tolal opeTating aBoooo0 5500000 550000055b0000 5500000550000 income less Depieciation - 3000000-3000000 3000000 3000000-3000000- 30000C (14 millioo6) E BIT -200000 35 00 00 2500000a500000 2500000 250000 Less:Tayes B0000 oooo00 loророо Посоо00 | lo000 Cat o')

7500000 500000 1500000 1500000 15000 00 Profit aflei 120000 3000000 3000000 Add: repiecia- 3000000 3000000 3000000 3000000 lion Cash in flou a6%o000 45 00000 4500o 0045000Oo 450000o45 00000 {rom opeTali -o0s Calculation of Cash inflow -from inVvestment ao13 2ola aoll 201o 3009 д00% ini-tial iovest--16000000-acovooo - Ment woTking capital Clo. of Revenu |-чо0000 600000 Recoueny dorking Capta of 0o0000 Recovery of 08000D intlial inVest- Taxcs Cash floco ot-16000000|-3yoodoo-Goo000 2080000 Iovestment

Nou cue can summaise lhe cash -flou as -follow Nlet_casb flow Cash oulflocos Cash inflocos 16000o00 1G000000 200g - 2400000 0D00 Q9a088e aoo9 - 60000D 4500000 3900o00 aolo 450000D 4500000 aol) 4500000 500000 aol2 4500000 450000 D 2o13 65300oo 6530000 Note: in 3013 Cash infloo Cash Flow -from opeTalfonstRecovery of Inveslment and Wc 4,500 000 t a.090,000 = 6,530'000 . Solurtion payback period: FIom -the -lable its out of tolal inveslment of $181000 oco, a Sum G380/00 coi) be Tecovered up to aoll and the balance of s payback pertad -чуса15 (ао0$- 201) і (hsa0-00b/4. - ч:36 чеать- .000) чгaтs 500 ycaTst 036ca1s

2. Net pieseol value: Present value of cash inflows - present Volue of -total inveslment Ccash outflows) 19,5 a o68 3.13 - 16 687,830.91 3a86 22 3. profitobility inde PTtScot value of Cash infloos/piesent velue ol toial invesł ment (cash outflocos) 195a063313 1-O44 Intenal Rate of Retun = 107/.