Question

CAPITAL BUDGETING

In December 2019, Bob Prescott, the controller for the Blue Ridge Mill, was considering the addition of new on-site long-wood woodyard. The addition would have two primary benefits: to eliminate the need to purchase short-wood from an outside supplier and create the opportunity to sell short-wood on the open market as a new market 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 will utilise new technology that allows tree-length logs, called long-wood, to be processed directly, whereas the current process required short-wood, which had to be purchased from the Shenandoah Mill.

This nearby mill, owned by a competitor, has excess capacity that allows it to produce more short-wood than it needs for its own pulp production. The excess is sold to several different mills, including the Blue Ridge Mill. Thus, adding the new long-wood equipment would mean that Prescott would no longer need to use the Shenandoah Mill as a short-wood supplier and that the Blue Ridge Mill would instead compete with the Shenandoah Mill by selling on the short-wood market. The question for Prescott was whether these expected benefits were enough to justify the $18m 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: $16m in 2020 and the remaining $2m in 2021. When the woodyard begins operating in 2021, it would significantly reduce the operating costs of the mill. These operating savings would come mostly from the difference in the cost of producing short-wood on-site versus buying it on the open market and were estimated to be $2m for 2021 and $3.5m per year thereafter.

Prescott also planned on taking advantage of the excess production capacity afforded by the new facility by selling short-wood on the open market as soon as possible. For 2021, he expected to show revenues of approximately $14m, as the facility came on-line and began to break into the new market. He expected shortwood sales to reach $20m in 2022 and continue at the $20m level through 2026. Prescott estimated that the cost of goods sold (before including depreciation expense) would be 75%.

In addition to the capital outlay of $18m, the increased revenues would necessitate higher levels of inventories and accounts receivable. Therefore the amount of working capital investment each year would equal 15% of incremental sales for the year. At the end of the life of the equipment, in 2026, all the networking capital on the books would be recoverable at cost fully.

Taxes would be paid at a 30% rate, and the equipment depreciation is to be calculated on a straight-line basis over the six-year life to zero balance. However, the new equipment is estimated to have a salvage value (scrap value) of $3m at the end of its life. WPC’s accountants have told Prescott that depreciation charges could not begin until 2021, when all the $18m had been spent and the equipment is in service.

WPC has a company policy to use 15% as the hurdle rate for such investment opportunities. The hurdle rate is based on the study of the company’s cost of capital conducted 5 years ago.

Required:

1. Prepare cash flow statement/s and compute the NPV and IRR of the proposed project. Comment on the feasibility of the project.

2. Outline reasons why Prescott may be uneasy using the 15% hurdle rate for a discount rate.

Answer 1

		Present value of Cash flow=(Cash flow)/((1+i)^N)
		i=discount rate=Hurdle Ratel=15%=0.15
		N=year of Cash Flow
		ANALYSIS OF CASH FLOW
	2	Prescott may be uneasy to use the discount rate because,it was calculated 5 years ago
		Costs and weightage of debt in total capital might have changed
		A new calculation of WACC should be carried out and cost of capitalmay be estimated
		Initial Cash Flow:
			Year0	year1	Year6
		Investment Outlay	$16,000,000	$2,000,000
		Terminal Cash Flow(Salvage Value)			$3,000,000
		After tax Salvage Value			$2,100,000	$3million*(1-0.3)
		Annual Cash Flow:	2020	2021	2022	2023	2024	2025	2026
	N	Year	0	1	2	3	4	5	6
	I	Investment Outlay	($16,000,000)	($2,000,000)
	a	Sales Revenue		$14,000,000	$20,000,000	$20,000,000	$20,000,000	$20,000,000	$20,000,000
	b=a*75%	Cost of goods sold(75%)		-$10,500,000	-$15,000,000	-$15,000,000	-$15,000,000	-$15,000,000	-$15,000,000
	c=a+b	Contribution from additionalsales		$3,500,000	$5,000,000	$5,000,000	$5,000,000	$5,000,000	$5,000,000
	d	Savings in Operating Costs		$2,000,000	$3,500,000	$3,500,000	$3,500,000	$3,500,000	$3,500,000
	e=$18million/6	Depreciation expenses		-$3,000,000	-$3,000,000	-$3,000,000	-$3,000,000	-$3,000,000	-$3,000,000
	f=c+d+e	Profit before tax		$2,500,000	$5,500,000	$5,500,000	$5,500,000	$5,500,000	$5,500,000
	g=f*30%	Tax expense		($750,000)	($1,650,000)	($1,650,000)	($1,650,000)	($1,650,000)	($1,650,000)
	h=f+g	After tax profit		$1,750,000	$3,850,000	$3,850,000	$3,850,000	$3,850,000	$3,850,000
	i	Add: Depreciation (non cash expense)		$3,000,000	$3,000,000	$3,000,000	$3,000,000	$3,000,000	$3,000,000
	j=h+i	Operating Cash Flow		$4,750,000	$6,850,000	$6,850,000	$6,850,000	$6,850,000	$6,850,000
	k	Working Capital Cash flow(15% )		-$2,100,000	-$900,000	$0	$0	$0	$3,000,000
	l	Terminal Cash Flow(Salvage Value)							$2,100,000
	m=I+j+k+l	Net Cash Flow	($16,000,000)	$650,000	$5,950,000	$6,850,000	$6,850,000	$6,850,000	$11,950,000	SUM
	PV=m/(1.15^N)	Present Value ofNet Cash Flow	-$16,000,000	$565,217	$4,499,055	$4,503,986	$3,916,510	$3,405,661	$5,166,315	$6,056,744
	NPV=Sum of PV	Net Present Value(NPV)=Sumof PVs	$6,056,744
		Internal Rate of Return (IRR)for ABC	25.04%	(using IRR Function of excel over the Net Cash Flow)