Question

You have an opportunity to buy the Newton Falls Paper mill for $15 million. Currently the mill sells standard paper reams and revenues total $6 million per year with fixed costs of $2 million and variable costs of 40% of revenue. If you buy the facility your plan is to produce one or more specialty papers where you believe the margins are higher. You would also like to update and modernize the mill. To do this you will have to purchase two new paper machines for $1.5 million each and a new computer system for another $1 million.

You expect revenues to be:

$9 million year 1

$10 million year 2

$12 million year 3 and ongoing.

You expect your variable costs to equal 20% of revenues and your fixed costs to equal $4.5 million (depreciation expense is not included in this estimate of fixed costs). Assume depreciation on mill is $1 million per year and the machines and computer system is 3 year MACRS property.

1. If you paid the $15 million and operated the mill as it is now, meaning you earned the $6 million per year in revenues what would be your NPV? If negative what would you have to pay to get a 0 NPV?

2. Should you purchase the mill and implement your plan of producing different paper? What is the NPV?

3. Assume your sales projections are not what you thought and your sales are only $8 million each year going forward and variable costs jump to 25% of revenue while fixed costs remain $4.5 million what is your NPV? What is your breakeven revenue to have at least a 0 NPV? What does this mean?

4. If you take on this project how should you finance it? What are some of the advantages and disadvantages of the different financing methods?

5. Assume you go with a capital structure of 50% debt and 50% equity, what is your net income and your NPV? Now assume you choose 80% debt and 20% equity how does this change your net income and NPV?

Assume 100% equity financed so you will use the cost of equity to compute.  To get the cost of equity and cost of debt use International Paper as a proxy for this project (you can use its beta and cost of debt). Assume a risk free rate of 1%, the market rate of 8%, and a tax rate of 35%. (You can find International Paper’s cost of debt and Beta online).

Answer 1

The cost of equity is calculated to compute the discount rate for the above. Since, the assumption is that the project is 100% equity financed-

Using the CAPM formula, we get,

Ke= Rf + Beta (Rm- Rf) where Ke= cost of equity, Rf= Risk free rate, Beta= volatility or systematuc risk and Rm= Market Rate

Hence, putting the abive values and taking the Beta value online, we get

Ke= 1% + 1.16 (8%- 1%)

Ke= 9.12%

Therefore, the discount rate is 9.12%

Part 1

To calculate the NPV, we need the initial outlay and cashflow per year-

Initial outlay- 15m

Cashflow in year 1= Revenue- fixed cost - variable cost

= 6m- 2m- (6*0.4)

= 1.6m per year

Since, the depreciation is 1m per year, the Newton falls paper mill will operate for a period of 15 years as it would have a zero value at the end of 15 years.

Therefore, we can now calculate the PV of a constant annuity.

where, a= cashflow per year, r= discount rate and n= number of years

Putting the values in the above formula, we get

PV= 1.6/9.12%[1- 1/(1+0.0912)^15]

solving the above equation, we get PV as 12.8m

Hence the NPV is PV - initial outlay= 12.8m- 15m= (2.2m)

In order to get a 0 NPV, the initial outlay must be equal to the PV of the constant annuity which is 12.8m.

Part 2

The cash flows for part 2 are

Inital outlay- 15m + 1.5*2 + 1m= 19m

Year 1= 9m - 4.5m- (9m*0.2)= 4.7m

Year 2= 10m - 4.5m- (10m*0.2)= 3.5m

Year 3 and onwards= 12m- 4.5m- (12m*0.2)= 5.1m

The constant annuity begins from year 3 and ends at year 15, applying the above formula, we can calculate the PV at the end of year 2 as

PV= 5.1/9.12%[1- 1/(1+0.0912)^13]

PV at end of year 2= 37.94m

PV = 4.7/(1+0,0912) + (3.5+37.94)/(1+0.0912)^2

   = 4.3 + 34.8

= 39.1m

Hence, NPV= 39.1m- 19m= 20.1m

Since the NPV is positive, the plan of purchasing the mill should ideally be implemented.