Case 18: Worldwide Paper
Worldwide Paper Company
In January 2016. Bob Prescott, the controller for the Blue Ridge Mill, was considering the addition of a new onsite longwood wood yard. Tlic addition would have two primary benefits: to eliminate tlie 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 (VVPC). Now tlx: new woodyard would allow tlx: 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 tlx: Blue Ridge Mill would instead compete with tlx: Shenandoah Mill by selling on the shortwood market. Tlx: 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 tlx: investment.
Construction would start within a few months, and the investment outlay would be spei« over two calendar years: S16 million in 2016 and the remaining S2 million in 2017. When tlx: new woodyard began operating in 2017. it would significantly reduce the operating costs of the null. 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 S2.0 million for 2017 and $3.5 million per year thereafter.
Prescott also planned on taking advantage of the excess production capacity afforded by tlx: new facility by selling shortwood on the open market as soon as possible. For 2017. he expected to show revenues of approximately S4 million, as the facility came on-line and began to break into tlx: new market. He expected shortwood sales to reach $10 million in 2018 and continue at the SI 0 million level tlirough 2022. Prescott estimated that tlx: cost of goods sold (before including depreciation expenses) would be 75% of pagç 250 revenues, aixl SG&A would be 5% of revenues.
1. What is the nature of the investment that is under consideration, and what are the sources of value (cost savings and revenue increases)?
2. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount. Complete the table below using the detail summarized below:
a. Investment:
i. Initial Investment – $16M 2016, $2M 2017
ii. Working Capital – 10% of Incremental Sales
b. Operating Savings – $2M 2017, $3.5M 2018-2022
c. Sales Revenue – $4M 20017, $10M 2018-2022
d. Expenses – CGS 75% of Revenue, SG&A – 5% of Revenue
e. Salvage:
i. Working Capital – recoverable at cost
ii. Initial Investment – 10% or $1.8M before tax, $1.08M after taxes
f. Depreciation Straight Line over 6 years, no salvage, start in 2017
2016
2017
2018
2019
2020
2021
2022
Investment:
Capital Outlay
Net Working Capital (10% Sales)
Total Investment
Investment Recovery:
Equipment Salvage
Net Working Capital (full recovery)
Earnings before Interest and Taxes (EBIT):
Sales Revenue
Cost of Goods Sold (75% Sales)
SG&A (5% Sales)
Operating Savings
Depreciation ($18,000/6)
Total Costs & Expenses
EBIT
– Taxes (40%)
NOPAT
+ Depreciation
– Investment
= Free Cash Flow
3. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Explain your recommended rate and the assumptions that you used to estimate it.
4. What is the net present value (NPV) and internal rate of return (IRR) for the investment? How do you interpret these numbers?
5. Propose two changes to the base case numbers presented in question 3 & 4. Explain the reasons for your changes and discuss the effect of those changes on the NPV and IRR.
