Question

Wansley Lumber is considering the purchase of a paper company. Purchasing the company would require an initial investment of $300 million. Wansley estimates that the paper company would provide net cash flows of $40 million at the end of each year for the next 20 years. The cost of capital for the paper company is 13%.

a. Should Wansley purchase the paper company?

b. Wansley realizes that the cash flows in Years 1 to 20 might be $30 million per year or $50 million per year, with a 50% probability of each outcome. Wansley can sell the company 2 years after purchase (at Year 2) for $280 million if it no longer wants to own it. Given this information, does decision-tree analysis indicate that it makes sense to purchase the paper company? Again, assume all cash flow are discounted at 13%

c. Wansley can wait for 1 year and find out whether the cash flows will be $30 million per year of $50 million per year before deciding to purchase. Wansley can no longer sell the company 2 years after purchase. Does decision-tree analysis indicate that it makes sense to purchase the paper company? If so, when?

Please show Excel functions and work!

Answer 1

A. To decide whether to purchase the said company or not we need to calculate Net Present Value of investment in paper company.

Given details for this are hereunder:

Initial Investment (I)= $300 Million

Net Annual Cash Flow (A)= $ 40 Million for 20 Years

Cost of Capital (K_c)= 13%

Therefore, Present Value of Future Cash Flows= Present Value Interest Factor of Annuity (PVIFA)

= PVIFA A(I, K_c)

_{= PVIFA 40 (13%, 20)}

=40 *7.0248 (This 7.0248 is Interest Factor of Annuity. It can be said that sum of Present Value of 13% i.e. 1.13 for 20 Years).

=$ 280.99 Mllion

Initial Investment= $ 300 Million

Therefore, Net Present Value= -$19.01 Million.

Therefore the purchase of paper company is not advisable.

B. If the annual cash flow is $50 million then the present values will be as follows:

Present Value of Future Cash Flows= Present Value Interest Factor of Annuity (PVIFA)

= PVIFA A(I, K_c)

_{= PVIFA 50 (13%, 20)}

=50 *7.0248 (This 7.0248 is Interest Factor of Annuity. It can be said that sum of Present Value of 13% i.e. 1.13 for 20 Years).

=$ 351.24 Mllion

Initial Investment= $ 300 Million

Therefore, Net Present Value= $51.24 Million.

Therefore the purchase of paper company is advisable.

If cash flow will be $ 30 million then purchase will not be advisable as NPV is already negative at Cash Flow $ 40 million.

However, if investor has option to sell at the end of Year 2 then NPV will be as follows:

NPV= PVIFA 30(13%, 2) + PVIF 280 (13%, 2) - 300

= 30 * 1.6681 + 280* 0.7831 - 300

= 50.043+219.268- 300

= - $ 30.69 Million

Still the purchase of paper company is not viable.

Further, lets calculate NPV if Cash Flow is $ 50 Million and we sell at the end of Year 2

NPV= PVIFA 50(13%, 2) + PVIF 280 (13%, 2) - 300

= 50 * 1.6681 + 280* 0.7831 - 300

= 83.405+219.268- 300

= - $ 2.67 Million

If cash flow is $ 50 million and we sell at the year 2 then also it is a viable investment. But since we are earning more by carrying paper company for 20 years with yearly Cash Flow of $ 50 million therefore there is no need to sale. Therefore option for sale is irrelevant.

C. We should purchase business after one year only if cash flow of $ 50 million will be certain.