Question

The case is based on an actual investment decision made by a major paper-products company in the 1990s. The numbers and the company name have been disguised at the request of the company. The dates have been revised for pedagogical reasons. The case provides a glimpse into the paper business but is primarily designed to present a straightforward problem in assessing cash flows, cost of capital, and net present value of a capital-investment decision. The case works well for all audiences who are learning the basics of discounted cash flow and investment analysis. I have used it successfully with executives as an in-class exercise following introductory classes on cash flows, discounted cash flow, and cost of capital. I encourage participants to work in groups of two or three to bring together the concepts of the earlier classes in this simple but comprehensive, capital-investment example. The case touches on the following capital-investment topics:  Estimation of relevant cash flows (both cost savings and increased revenues)  Influence of taxes vis-à-vis cost savings and revenues  Change in net working capital as a cash flow  Component costs of capital as determined by current market conditions  Weighted average cost of capital (WACC) as the discount rate for the average investment Questions for Advance Assignment to Students 1. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount. 2. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Be prepared to justify your recommended rate and the assumptions that you used to estimate it. 3. What is the net present value (NPV) and internal rate of return (IRR) for the investment?

Answer 1

1.Yearly Cash flows means cash inflows and cash outflows.Cash inflows includes Cash receipts of sale of products , cash receipt of sale capital assets and cash receipt on sale of scrap at the end of project ,Cash outflows includes Cash payment for various business expenditure like payment to creditors,rent payment etc.But cash outflow does not include Non cash expenditure like depreciation etc.

2.Weighted average cost of capital (WACC)should be used as discount rate .It is the rate that a company is expected to pay on an average to all its security holders to finance its assets.

WACC = Cost of equity * weight of equity +Cost of Debt * weight of debt + Cost of Preference Shares * Weight of preference shares

3.NPV = NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.It is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

IRR =  The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.It is a metric used in capital budgeting to estimate the profitability of potential investments.