In December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was considering
the addition of a new on-site Longwood wood yard. The addition would have two primary
benefits: to eliminate the need to purchase short wood from an outside supplier and create the
opportunity to sell short wood on the open market as a new market for Worldwide Paper
Company (WPC). Now the new wood yard would allow the Blue Ridge Mill not only to reduce
its operating costs but also to increase its revenue. The proposed wood yard utilized new
technology that allowed tree length logs, called long wood, to be processed directly, whereas the
current process required short wood, 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 short
wood 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 that
Prescott would no longer need to use the Shenandoah Mill as a short wood supplier and that the
Blue Ridge Mill would instead compete with the Shenandoah Mill by selling on the short wood
market. The question for Prescott was whether these expected benefits were enough to justify
the $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 spent
over two calendar years: $16 million in 2007 and the remaining $2 million in 2008. When the
new wood yard began operating in 2008, it would significantly reduce the operating costs of the
mill. These operating saving would come mostly from the difference I the cost of producing
short wood on-site versus buying it on the open market and were estimated to be $2.0 million for
2008 and $3.5 million per year thereafter.
Prescott also planned on taking advantage of the excess production capacity afforded by
the new facility by selling short wood on the open market as soon as possible. For 2008, he
expected to show revenues of approximately $4 million, as the facility came on line and began to
bread into the new market. He expected short wood sales to reach $10 million in 2009 and
continue 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% of
In addition to the capital outlay of $18 million, the increased revenue would necessitate
higher levels of inventories and accounts receivable. The total working capital would average
10% of annual revenues. Therefore the amount of working capital investment each year would
equal 10% of incremental sales of the year. At the end of the life of the equipment, in 2013, all
the net working capital on the books would be recoverable at cost, whereas only 10% or $1.8
million (before taxes) of the capital investment would be recoverable.
Taxes would be paid at 40% rate, and depreciation was calculated on a straight-line basis
over the six-year life, with zero salvage. WPC accountants had told Prescott that depreciation
charges could not begin until 2008, when all the $1.8 million had been spent, and the machinery
was in service.
Prescott was conflicted about how to treat inflation in his analysis. He was reasonably
confident that his estimate of revenue and costs for 2008 and 2009 reflected the dollar amounts
that WPC would most likely experience during those years. The capital outlays were mostly
contracted costs and therefore were highly reliable estimates. The expected short wood revenue
figure of $4.0 million had been based on a careful analysis of the short wood market that
included a conservative estimate of the Blue Ridge Millâ€™s share of the market plus the expected
market price of short wood, taking into account the impact of Blue Ridge Mill as a new
competitor in the market. Because he was unsure of how the operating costs and the price of
short wood would be impacted by inflation after 2009, Prescott decided not to include it in his
analysis, Therefore the dollar estimates for 2010 and beyond were based on the same cost and
prices per ton used in 2009. Prescott did not consider the omission critical to the final decision
because he expected the increase in operating costs caused by inflation would be m mostly offset
by the increase in revenues associated with the rise in the price of short wood.
WPC had a company policy to use 15% as the hurdle is for such investment
opportunities. the hurdle rate was based on a study of the companyâ€™s cost of capital conducted
10 years ago, Prescott was uneasy using as outdated figure for a discount rate, particularly
because it was computed when30-year Treasury bonds were yielding 10%, whereas currently
they were yielding less than 5% (Exhibit 1).
Blue Ridge Mill
Interest Rates: December 2006
Bank loan rates (LIBOR)
Market risk premium
corporate bonds (10-year maturities)
Worldwide Paper Financial Data
Balance-sheet accounts ($ millions)
Bank loan payable (LIBOR +1%)
Shares outstanding (millions)
Book value per share
Recent market value per share
1. Please identify the relevant cash flow for the firm (WPC) to be able to make the investment
decision. Please also include the initial outlay (investment) (for 2007). Itemize the cash flows
for each of the six years (2008 through 2013) of the investment in detail.
2. Calculate WPCâ€™s WACC to be used to analyze the cash flows and make clear all of your
assumptions 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 make
based on this?
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