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 net working 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. Page 7 of 7

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

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

c. 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.

d. The global paper and pulp industry, one of the world largest industries, has been growing slowly, at a rate much less than expected over the last 20 years. The price chart below shows 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 analyse three qualitative risk factors (i.e. 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 longwood woodyard?

Answer 1

A. The table below shows the cash-flows which will be required for each item of the project. The only key things to keep in mind are the depreciation and working capital cash flow. Depreciation is a non-cash item and the only reason we calculated it is because it will reduce the taxable profit. So, depreciation will not be included in the cash flow statements. Also, additional working capital cash flow is a balance sheet item. So only the changes in the working capital requirement is a cash flow – hence the “Delta E” element is getting used in cash flow calculation. Moreover, the full working capital at the end of 2026 will be recovered and along with the salvage value, will be part of the cash flow statement.

NPV = $8.6Mn

IRR = 31%

Based on the above parameters, the project appears viable. The NPV is more than zero. The IRR is more than the hurdle rate of the company.

(calculations are shown below)

Line Item Number	(all figures in $ Mn)	2020	2021	2022	2023	2024	2025	2026
A	Capital outlay	-16.0	-2.0
	Additional Revenues
B	Additional revenues from shortwood sales		14.0	20.0	20.0	20.0	20.0	20.0
	Additional Expense
C	Improved operating cost		2.0	3.5	3.5	3.5	3.5	3.5
D = 0.75*A	Additional cost due to shortwood sales (75% of new sales)		-10.5	-15.0	-15.0	-15.0	-15.0	-15.0
E = 0.15*A	Additional working capital required (15% of new sales)		-2.1	-3.0	-3.0	-3.0	-3.0	-3.0
Delta E	Incremental working capital cash required		-2.1	-0.9	0.0	0.0	0.0	0.0
F = A/6	Depreciation - dividing total capital outlay over six years		-6.0	-6.0	-6.0	-6.0	-6.0	-6.0
G	Additional Taxable Profit		-0.5	2.5	2.5	2.5	2.5	2.5
H	Additional Tax (30% of additional profit)		0.15	-0.75	-0.75	-0.75	-0.75	-0.75
I = A+B+C+D+Delta E+H	Cash flows from new operations	-16.0	1.6	6.9	7.8	7.8	7.8	7.8
J	Salvage value of equipment							3
K = - E (for 2026)	Recovery of working capital in 2026							3.0
L = I + J + K	Total cash flows	-16.0	1.6	6.9	7.8	7.8	7.8	13.8
NPV	8.6
IRR	31%

B. The hurdle rate of 15% being used in the project has calculated 5 years ago. However, the circumstances of the company might have changed in the last few years. The company should use a more recent cost of capital. They could use comparable hurdle rates from similar projects.

C. i. Increasing the sales by 10%, the NPV of the project is $9.5Mn. Decreasing the sales by 10%, the NPV of the project is $7.6Mn. The project will be viable in both cases.

ii. Increasing the hurdle rate by 10%, to 25% (I am adding 10% to the original 15%) NPV is $2.3Mn. Decreasing the hurdle rate by 10%, to 5% (I am subtracting 10% from the original 15%), NPV is $20.1Mn.

The project is feasible in all the cases.

D. 1. Replacement risk = Usage of wood can be reduced because of replacement with other items such as plastics, steel or aluminium (e,g. wooden windows can become aluminium windows)

2. Obsolescence risk = One of the major end-uses of wood is in making paper. However, as more and more digital disruption takes place, the use of paper will be reduced. As a result, demand for wood might reduce.

3. Environmental risk = Cutting and felling of trees has an environmental impact. As a result, in the future, there could be risks to procuring the raw-material - wood. This might also reduce sales or cause the company to higher costs to operate.

All these risks can be quantified with more details by either reducing sales or increasing cost of operations. There could also be an increase in cost of capital / hurdle rate.