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

Working Notes: Calculation Cash Flows from project

Calculation of Cash Inflow from Operations
	2007	2008	2009	2010	2011	2012	2013
Revenue		4000000	10000000	10000000	10000000	10000000	10000000
Less: COGS (75% of Revenue)		3000000	7500000	7500000	7500000	7500000	7500000
Less: SG&A (5% of Revenue)		200000	500000	500000	500000	500000	500000
Operating Income		800000	2000000	2000000	2000000	2000000	2000000
Operating Savings (reduction in operating cost)		2000000	3500000	3500000	3500000	3500000	3500000
Total Operating Income		2800000	5500000	5500000	5500000	5500000	5500000
Less: Depreciation (18 million /6)		-3000000	-3000000	-3000000	-3000000	-3000000	-3000000
EBIT		-200000	2500000	2500000	2500000	2500000	2500000
Less: Taxes (at 40%)		80000	1000000	1000000	1000000	1000000	1000000
Profit after tax		-120000	1500000	1500000	1500000	1500000	1500000
Add: Depreciation		3000000	3000000	3000000	3000000	3000000	3000000
Cash Inflow from Operations		2880000	4500000	4500000	4500000	4500000	4500000

Calculation of Cash Flow from Investment
	2007	2008	2009	2010	2011	2012	2013
Initial Investment	-16000000	-2000000
Working Capital (10% of Revenue)		-400000	-600000
Recovery of Working Capital							1000000
Recovery of Initial Investment (Net of Taxes)							1080000
Cash Flow of Investment	-16000000	-2400000	-600000				2080000

Now we can summrise the cash Flow as follow:

	Cash Outflows	Cash Inflows	Net Cash Flow
2007	-16000000		-16000000
2008	-2400000	2880000	480000
2009	-600000	4500000	3900000
2010		4500000	4500000
2011		4500000	4500000
2012		4500000	4500000
2013		6580000	6580000

Note: In 2013 cash inflow = Cash Flow from Operations + Recovery of Investment and W.C.

                                             = 4,500,000 + 2,080,000 = 6,580,000.

SOLUTION:

1. Payback Period:

From the table its out of total investment of $ 18,000,000, a sum of $ 16,380,00 will be recovered up to 2011 and the balance $ 1,620,000 in 2012. So payback period is

= 4 years (2008-2011) + (1,620,000/4,500,000) years

= 4 years + 0.36 years = 4.36 years

2. Net Present Value:

= Present Value of Cash Inflows – Present Value of Total Investment (Cash Outflows)

= 19,520,683.13 – 18,687,820.91

= 832,862.22

3. Profitability Index:

= Present Value of Cash Inflows / Present Value of Total Investment (Cash Outflow)

= 19,520,683.13 / 18,687,820.91

= 1.044

4. Internal Rate of Return = 11.07%

All calculation done using excel