Question;Blue Ridge MillIn December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was consideringthe addition of a new on-site Longwood wood yard. The addition would have two primarybenefits: to eliminate the need to purchase short wood from an outside supplier and create theopportunity to sell short wood on the open market as a new market for Worldwide PaperCompany (WPC). Now the new wood yard would allow the Blue Ridge Mill not only to reduceits operating costs but also to increase its revenue. The proposed wood yard utilized newtechnology that allowed tree length logs, called long wood, to be processed directly, whereas thecurrent process required short wood, which had to be purchased from the Shenandoah Mill. Thisnearby 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 long wood equipment would mean thatPrescott would no longer need to use the Shenandoah Mill as a short wood supplier and that theBlue Ridge Mill would instead compete with the Shenandoah Mill by selling on the short woodmarket. The question for Prescott was whether these expected benefits were enough to justifythe $18 million capital outlay plus the incremental investments in working capital over the sixyear life of the investment.Construction would start within a few months, and the investment outlay would be spentover two calendar years: $16 million in 2007 and the remaining $2 million in 2008. When thenew wood yard began operating in 2008, it would significantly reduce the operating costs of themill. These operating saving would come mostly from the difference I the cost of producingshort wood on-site versus buying it on the open market and were estimated to be $2.0 million for2008 and $3.5 million per year thereafter.Prescott also planned on taking advantage of the excess production capacity afforded bythe new facility by selling short wood on the open market as soon as possible. For 2008, heexpected to show revenues of approximately $4 million, as the facility came on line and began tobread into the new market. He expected short wood sales to reach $10 million in 2009 andcontinue as 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% ofrevenues.In addition to the capital outlay of $18 million, the increased revenue would necessitatehigher levels of inventories and accounts receivable. The total working capital would average10% of annual revenues. Therefore the amount of working capital investment each year wouldequal 10% of incremental sales of the year. At the end of the life of the equipment, in 2013, allthe net working capital on the books would be recoverable at cost, whereas only 10% or $1.8million (before taxes) of the capital investment would be recoverable.Taxes would be paid at 40% rate, and depreciation was calculated on a straight-line basisover the six-year life, with zero salvage. WPC accountants had told Prescott that depreciationcharges could not begin until 2008, when all the $1.8 million had been spent, and the machinerywas in service.Prescott was conflicted about how to treat inflation in his analysis. He was reasonablyconfident that his estimate of revenue and costs for 2008 and 2009 reflected the dollar amountsthat WPC would most likely experience during those years. The capital outlays were mostlycontracted costs and therefore were highly reliable estimates. The expected short wood revenuefigure of $4.0 million had been based on a careful analysis of the short wood market thatincluded a conservative estimate of the Blue Ridge Mill?s share of the market plus the expectedmarket price of short wood, taking into account the impact of Blue Ridge Mill as a newcompetitor in the market. Because he was unsure of how the operating costs and the price ofshort wood would be impacted by inflation after 2009, Prescott decided not to include it in hisanalysis, Therefore the dollar estimates for 2010 and beyond were based on the same cost andprices per ton used in 2009. Prescott did not consider the omission critical to the final decisionbecause he expected the increase in operating costs caused by inflation would be m mostly offsetby the increase in revenues associated with the rise in the price of short wood.WPC had a company policy to use 15% as the hurdle is for such investmentopportunities. the hurdle rate was based on a study of the company?s cost of capital conducted10 years ago, Prescott was uneasy using as outdated figure for a discount rate, particularlybecause it was computed when30-year Treasury bonds were yielding 10%, whereas currentlythey were yielding less than 5% (Exhibit 1).Exhibit 1Blue Ridge MillCost-of-Capital InformationInterest Rates: December 2006Bank loan rates (LIBOR)Market risk premium1-yearHistorical average5.38%6%Government bondscorporate bonds (10-year maturities)1-year5-year10-year30-yearAaaAaABaa4.96%4.57%4.60%4.73%5.37%5.53%5.78%6.35%Worldwide Paper Financial DataBalance-sheet accounts ($ millions)Bank loan payable (LIBOR +1%)500Long-term debt2,500Common equity500Retained earnings2,000Per-share dataShares outstanding (millions)Book value per shareRecent market value per shareOtherBond ratingBeta500$ 5.00$ 24.00A1.10Questions1. Please identify the relevant cash flow for the firm (WPC) to be able to make the investmentdecision. Please also include the initial outlay (investment) (for 2007). Itemize the cash flowsfor each of the six years (2008 through 2013) of the investment in detail.2. Calculate WPC?s WACC to be used to analyze the cash flows and make clear all of yourassumptions and reasons to choose the number that you did in calculating WACC.3. Calculate the NPV, IRR and MIRR for the investment. What decision would you makebased on this?
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