Question

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:

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

b. Perform a sensitivity analysis on NPV of the project on the following scenarios :

(i) Sales increases/decreases by 10%.

(ii) Cost of capital increases/decreases by 10% . Comment on the feasibility of the project under each scenario. c. The global paper and pulp industry, one of the world largest industries, has been grow ing slowly, at a rate much less than expected over the last 20 years. The price chart below show s that the Products Industry Index on average grew at around 2.5% per year over the last 20 years , while lumber futures contract prices have negative growth. Some analysts believe that the industry needs more structural change to counter disruption of technology and tackle social impacts due to climate change. Identify and analyze three qualitative risk factors (ie . factors which are unquantifiable at present) faced by the industry. How would Bob Prescott consider these factors in evaluating the feasibility of the new on - site long - wood woodyard ?

Answer 1

a.Reasons why Prescott may be uneasy using the 15% hurdle rate for a discount rate:

This 15% hurdle rate is based on the study about costs of its borrowed funds ,carried out by the company,5 years ago.

Currently, both the funding patterns & the respective costs are more likely to be different .

NPV Analysis(Fig. in mlns)
Base case
Year	0	1	2	3	4	5	6
	2020	2021	2022	2023	2024	2025	2026
1.Initial investment	-16	-2
2.NWC (reqd.)/Recovered	-2.1	-0.9	0	0	0	0	3
3. After-tax salvage of m/c (3*(1-30%))							2.1
Sale of short-wood		14	20	20	20	20	20
COGS(Sales*75%)		-10.5	-15	-15	-15	-15	-15
Savings in opg. Costs		2	3.5	3.5	3.5	3.5	3.5
Depreciation(18/6)		-3	-3	-3	-3	-3	-3
Incl. EBT		2.5	5.5	5.5	5.5	5.5	5.5
Tax at 30%		-0.75	-1.65	-1.65	-1.65	-1.65	-1.65
Incl. EAT		1.75	3.85	3.85	3.85	3.85	3.85
Add Back"Depn.		3	3	3	3	3	3
4.Incl.OCF		4.75	6.85	6.85	6.85	6.85	6.85
Incl.ATCFs(1+2+3+4)	-18.1	1.85	6.85	6.85	6.85	6.85	11.95
PV F at 15%(1/1.15^Yr.n)	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
PV at 15%	-18.1	1.6087	5.1796	4.50399	3.91651	3.40566	5.1663
NPV=	5.6808

Sales increases by 10%
Year	0	1	2	3	4	5	6
	2020	2021	2022	2023	2024	2025	2026
1.Initial investment	-16	-2
2.NWC reqd.&Recovered	-2.31	-0.99	0	0	0	0	3.3
3. After-tax salvage of m/c (3*(1-30%))							2.1
Sale of short-wood		15.4	22	22	22	22	22
COGS(Sales*75%)		-11.55	-16.5	-16.5	-16.5	-16.5	-16.5
Savings in opg. Costs		2	3.5	3.5	3.5	3.5	3.5
Depreciation(18/6)		-3	-3	-3	-3	-3	-3
Incl. EBT		2.85	6	6	6	6	6
Tax at 30%		-0.855	-1.8	-1.8	-1.8	-1.8	-1.8
Incl. EAT		1.995	4.2	4.2	4.2	4.2	4.2
Add Back"Depn.		3	3	3	3	3	3
4.Incl.OCF		4.995	7.2	7.2	7.2	7.2	7.2
Incl.ATCFs(1+2+3+4)	-18.31	2.005	7.2	7.2	7.2	7.2	12.6
PV F at 15%(1/1.15^Yr.n)	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
PV at 15%	-18.31	1.7435	5.4442	4.73412	4.11662	3.57967	5.4473
NPV=	6.7555

Sales decreases by 10%
Year	0	1	2	3	4	5	6
	2020	2021	2022	2023	2024	2025	2026
1.Initial investment	-16	-2
2.NWC reqd.&Recovered	-1.89	-0.81	0	0	0	0	2.7
3. After-tax salvage of m/c (3*(1-30%))							2.1
Sale of short-wood		12.6	18	18	18	18	18
COGS(Sales*75%)		-9.45	-13.5	-13.5	-13.5	-13.5	-13.5
Savings in opg. Costs		2	3.5	3.5	3.5	3.5	3.5
Depreciation(18/6)		-3	-3	-3	-3	-3	-3
Incl. EBT		2.15	5	5	5	5	5
Tax at 30%		-0.645	-1.5	-1.5	-1.5	-1.5	-1.5
Incl. EAT		1.505	3.5	3.5	3.5	3.5	3.5
Add Back"Depn.		3	3	3	3	3	3
4.Incl.OCF		4.505	6.5	6.5	6.5	6.5	6.5
Incl.ATCFs(1+2+3+4)	-17.89	1.695	6.5	6.5	6.5	6.5	11.3
PV F at 15%(1/1.15^Yr.n)	1	0.86957	0.75614	0.65752	0.57175	0.49718	0.43233
PV at 15%	-17.89	1.4739	4.9149	4.27386	3.7164	3.23165	4.8853
NPV=	4.606

COC increases by 10%,ie. 15%*(1.1)=16.5%
Year	0	1	2	3	4	5	6
	2020	2021	2022	2023	2024	2025	2026
1.Initial investment	-16	-2
2.NWC reqd.&Recovered	-2.1	-0.9	0	0	0	0	3
3. After-tax salvage of m/c (3*(1-30%))							2.1
Sale of short-wood		14	20	20	20	20	20
COGS(Sales*75%)		-10.5	-15	-15	-15	-15	-15
Savings in opg. Costs		2	3.5	3.5	3.5	3.5	3.5
Depreciation(18/6)		-3	-3	-3	-3	-3	-3
Incl. EBT		2.5	5.5	5.5	5.5	5.5	5.5
Tax at 30%		-0.75	-1.65	-1.65	-1.65	-1.65	-1.65
Incl. EAT		1.75	3.85	3.85	3.85	3.85	3.85
Add Back"Depn.		3	3	3	3	3	3
4.Incl.OCF		4.75	6.85	6.85	6.85	6.85	6.85
Incl.ATCFs(1+2+3+4)	-18.1	1.85	6.85	6.85	6.85	6.85	11.95
PV F at 16.5%(1/1.16.5^Yr.n)	1	0.85837	0.73680	0.63244	0.54287	0.46598	0.39999
PV at 16.5%	-18.1	1.588	5.0471	4.33224	3.71866	3.19199	4.7798
NPV=	4.5578

  

Fig. in mlns.	Change in sales		Change in COC
Sensitivity of NPV to change in sales/COC	NPV	Change from base case	NPV	Change from base case
Base case	5.6808		5.6808
0.1	6.7555	18.92%	4.5578	-19.77%
-0.1	4.606	-18.92%	6.8865	21.22%
Reduction in COC results in Maximum positive change in NPV than increase in sales price
whereas,
Increase in COC results in Maximum negative change in NPV than decrease in sales price