Question

In December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was considering the addition of a new on-site longwood woodyard. The addition would have two primary benefits: to eliminate the need to purchase shortwood from an outside supplier and create the opportunity to sell shortwood 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 utilized new technology that allowed tree-length logs, called longwood, to be processed directly, whereas the current process required shortwood, which had to be purchased from the Shenandoah Mill. This nearby mill, owned by a competitor, 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 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 market 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 possible. 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. 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 capital 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 capital 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 not begin until 2008, when all the $18 million had been spent, and the machinery was in service. You have been approached by Prescott with a request to evaluate the project.

If the required rate of return is 9.65%, what are the payback period, profitability index, net present value, and internal rate of return for the investment project? Should WPC implement the investment project?

Answer 1

Step1: Computation of the free cash flow after taxes for the project.We have,

($ in million)

Year	2008	2009	2010	2011	2012	2013
Sales	4.00	10.00	10.00	10.00	10.00	10.00
Less: Cost of Good Sold (75% of Revenue)	3.00	7.50	7.50	7.50	7.50	7.50
Gross Profit	1.00	2.50	2.50	2.50	2.50	2.50
Less: SG&A (5% of revenue)	0.20	0.50	0.50	0.50	0.50	0.50
Less: Depreciation expenses	3.00	3.00	3.00	3.00	3.00	3.00
Less: Investment in WC	0.40	1.00	1.00	1.00	1.00	1.00
Operating profit	- 2.60	- 2.00	- 2.00	- 2.00	- 2.00	- 2.00
Add: Working capital recovery	0	0	0	0	0	1.80
Add: Saving in operating cost	2.00	3.50	3.50	3.50	3.50	3.50
Total profit before taxes	- 0.60	1.50	1.50	1.50	1.50	3.30
Less: taxes @ 40%	0.00	0.60	0.60	0.60	0.60	1.32
Profit after taxes	- 0.60	0.90	0.90	0.90	0.90	1.98
Add: Depreciation expenses	3.00	3.00	3.00	3.00	3.00	3.00
Free cash flow after taxes	2.40	3.90	3.90	3.90	3.90	4.98

Step2: Computation of present value of free cash flow after taxes.We have,

Free cash flow after taxes	2.40	3.90	3.90	3.90	3.90	4.98	Total
PVF at 9.65 %	0.912	0.831	0.758	0.692	0.631	0.575
Present Value	2.19	3.24	2.96	2.70	2.46	2.86	16.41

Step3: Computation of the payback period of the project.We have,

Year	Cash flow	Cumulative Cash flow
2008	2.40	2.40
2009	3.90	6.30
2010	3.90	12.60
2011	3.90	16.50
2012	3.90	20.40
2013	4.98	25.38

Payback period = 4 + (18.00 - 16.50) / 3.90

Payback period = 4 + 0.38 = 4.38 years

Hence,the payback period for the project is 4.38 years.

Step-4: Computation of the profitability index for the project.We have,

Profitability index = Present value of cash inflows / Cash outflow

Profitability index = 16.41 / 18.00 = 0.91

Hence,the profitability index for the project is 0.91.

Step5: Computation of the net present value of the project.We have,

NPV = Present value of cash inflow - Cash outflow

NPV = 16.41 - 18.00 = - $ 1.59 Million

Hence,the net present value of the project shall be - $ 1.59 million.

Step6: Computation of the internal rate of return(IRR) of the project.We have,

Free cash flow after taxes	2.40	3.90	3.90	3.90	3.90	4.98	Total
PVF at 6.00 %	0.943	0.889	0.840	0.792	0.747	0.705
Present Value	2.26	3.47	3.28	3.09	2.91	3.51	18.52

IRR = r - [ ( Cash outflow - PV of CFAT(9.65%)) / ( PV of CFAT(6.00%) - PV of CFAT(9.65%) ] x difference in interest rate

IRR = 9.65 - [ ( 18.00 - 16.41) / (18.52 - 16.41) ] X (9.65 - 6.00)

IRR = 9.65 - 0.75 X 3.65 = 9.65 - 2.74 = 6.91%

Hence,the internal rate of return for the project is 6.91 %.

Conclusion:

From payback period:

The payback period for the project is 4.38 years. Therfore, project should be accpted from payback criteria.

From Profitability index:

For accepting the project, the profitablilty index must be 1.0 for the project. But, the profitability index of the project is 0.91. Therfore, project should not be accepted from the profitability index criteria.

From NPV:

For accepting the project, the net present value must have positve value.But the project NPV is - $ 1.59 million. Therefore, project should not be accepted from the NPV criteria.

From IRR:

For accepting the project, the IRR of the project must be greater than cost of capital of the project. But the project IRR is 6.91 % which is lower than cost of capital 9.65 %. Therefore, the project is not accepted from IRR Criteria.