What is the nature of the investment that is under consideration and what are the sources of value (cost savings and revenue increases)? The investment proposed by Bob Prescott, an on-site longwood woodyard, would reduce operating costs by processing tree-length logs, as well as increase revenues by selling shortwood. Cost Savings: In 2006, Worldwide Paper’s Blue Ridge Mill had to purchase shortwood from competitor, Shenandoah Mill. The new woodyard would begin operations in 2008, thus saving Blue Ridge Mill $2mm in year one and $3. 5mm the years after.
The savings would come from the difference in the cost of producing shortwood on-site versus purchasing it on the open market. Revenues: Revenues would be generated by taking advantage of the excess production capacity by selling shortwood on the open market as soon as possible. Blue Ridge Mill would show expected revenues of $4mm in 2008 and $10mm from 2009 – 2013. On paper this project seemed like a can’t miss investment. What are the yearly cash flows that are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount.
Itemize the cash flows for each of the six years of the investment. There are several cash flows in this project that need to be included in the discounted cash flow analysis: Capital Spending – Though the capital spending for the project will be $18M, only $16M of it will be spent in 2007; the remainder will be spent in 2008. Thus, the initial cash flow for this project is $16M for Year 0, 2007 and $2M in 2008. Depreciation – the Longwood yard will not be operational until 2008; thus, depreciation will be begin in 2008 and continue for 6 years on a straight line basis of $3M per year. After Tax Salvage – 10%, or $1. M pre-tax, of the initial investment is expected to be recovered at the end of the project. Since the book value of the investment is 0, the after tax salvage value can be calculated as $1. 8M-$0. 72M = $1. 08M. This is recognized as a positive cash flow at the end of the project in 2013. Recovery of Net Working Capital – 100% of net working capital will be recovered at the end of the project. Net working capital is estimated to be 10% of annual revenues (10M). This requires the project to maintain a $1M NWC level from 2009-2012 ($400k in 2008) and a $0 NWC in 2013. This will result in a positive cash flow of $1M.
Revenue, COGS, SG&A – Revenues are estimated to be $4M in the first year of operation (2008), and then reach $10M for the remainder of the project. COGS will be calculated as 75% of annual revenues, and SG&A costs will be 5% of annual revenues. Operating Savings – these cash flows are captured in the cash flows resulting from operations. Savings were estimated to be $2M in the first operational year (2008), and $3. 5M thereafter. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Justify the recommended rate and identify the assumptions used to estimate it.
What are the components of the cost of capital and the weights used to get Worldwide’s WACC? Bob Prescott, Controller at the Blue Ridge Mill, has two options with respect to the discount rate; adhere to company policy and use the existing corporate cost of capital rate of 15%, or gather the necessary data inputs to calculate a new weighted average cost of capital (WACC). Our team of analysts is in firm agreement with Mr. Prescott’s apprehension as it relates to the validity of the existing corporate cost of capital and therefore supports his inclination to calculate a new cost of capital via WACC.
In support of this recommendation we offer several considerations. For starters, we cite the fact that the existing corporate rate of 15% is simply outdated (ten years old) and the market for the cost of capital has changed significantly in recent years (e. g. , 30-year treasury bonds currently yield 4. 73% vs. 10% when existing corporate rate was calculated). Additionally, by calculating WACC, Mr. Prescott will have clarity with respect to how the market views the risk associated with the company’s assets and it will also help with calculating the required return for this and future capital budgeting projects.
As for the latter, the required return is a critical data input and reference point that Mr. Prescott will need when calculating the net present value (NPV) of the project. Finally, when making capital budgeting decisions with NPV and internal rate of return (IRR) it is imperative that the business managers have knowledge with respect to the applicable discount rate and the data inputs/variables used to compute it. In this case, Mr. Prescott was lacking critical knowledge associated with the existing corporate cost of capital rate; therefore he lacked the confidence needed to apply it and in good conscious had to calculate a new WACC.
Calculating WWP’s WACC is a multi-step process that starts with calculating the enterprise value. There are two components of enterprise value, the first is debt and the second is equity; enterprise value equals the sum of these variables. Starting with debt, WPP has an outstanding bank loan of $500. 0m and long-term debt of $2,500. 0m totaling $3mm of total firm debt. On the equity side of the equation, WWP has current market capitalization of $12mm (500. 0m shares times current share price of $24. 00), common equity of $500. 0m and retained earnings of $2,000. m totaling $14,500. 0 total firm equity. Taken together debt and equity yield an enterprise value of $17,500. 0m. The next step in calculating WACC is to determine the cost of debt and equity. To calculate the cost of debt, we first found the ratio of short and long term debt (17% and 83% respectively), indentified the corresponding borrowing rates; short-term being the one-year rate of 5. 38% plus 1% for a total of 6. 38%; long-term rate being the ten-year A-rated corporate bond rate of 5. 78% (“A” being consistent with WWP’s bond rating).
Accounting for the tax rate of 40%, we calculated a total cost of debt of 3. 53%; (. 0638*(1-. 40)*. 17) + (. 0578*(1-. 4)*. 83) = 3. 53%. To calculate the cost of equity we are applying WWP’s beta of 1. 10, a risk premium of six 6% and a 5-year government bond rate of 4. 57%. While beta and risk premiums are given by Mr. Prescott, we chose to use a five-year government bond rate because the project term is six years and this is the closest applicable rate to project duration. With that being said, WPP’s cost of equity came out to 11. 17% (0. 0457+(1. 10*. 06)=11. 17%).
With enterprise value we calculated the ratio of debt to equity then applied our debt and equity costs to calculate WWP’s WACC – see table below for calculation and WACC yield. What is the net present value (NPV) and internal rate of return (IRR) for the investment? Having identified the cost savings, revenue increases, relevant cash flows and the WACC our team was now able to calculate the net present value (NPV) and internal rate of return (IRR) for this project – see table below. As a result, with a positive NPV and IRR that is greater than WACC our team recommends that WWP proceed with the investment.