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Submitted to:

Dr. Nawazish Mirza

Submitted by:

Ali Nawaz

M. Amir Wazir

Shahzeb Ahmed

Huma Ijaz

Sidra Arshad

Zahra Ali

Introduction

Knight International, a century old company that believes in community work and corporate social

responsibility, is one of the largest producers of paper and pulp with 3.5 billion sales in recent year. The

company flourished in its initial years but reluctance of companys top management to decentralize led to

hiring of Andy Kurzer as a chairman who changed the budgeting procedures of the company and made a

6-person Expenditure Committee who would decide on projects costing more than 2 million. The main

issue that been discussed here is weather to renovate the old production facility or to build a new one as

the exiting production facility will reduce its capacity significantly in the coming years.

The initial controversy arose as the management of the old facility, who had doubts about the new facility,

estimated the production tonnage per day more than facility could produce, lower variable cost thus

higher after-tax cash flows but then after discussion it was unanimously tonnage per day was decreased,

variable cost was increased thus the after-tax cash flows were decreased. Another controversy pointed out

by a member of EC was that 20 years was a relatively longer time for a modernized old facility;

considering 15 years was more realistic option. But in the end they decided to go with 20 years.

Moreover, some EC members considered that relocating the facility would make employees lose their

jobs although it would be creating more managerial positions but the change in the location would not be

feasible for all employees some who were with the company for more than a decade thus some allowance

is necessary.

Question No. 1

a. Calculate the NPV of modernizing the existing paper mill.

Initial investment

Operating Cash Flow (each year)

Total Cash Inflow

PVCF at 12%

NPV (PVCF-initial investment)

-170,000,000

44,653,600

$893,072,000.00

$333,537,548

$163,537,548

Initial investment

Operating Cash Flow (each year)

Total Cash Inflow

PVCF at 12%

NPV (PVCF-initial investment)

680,000,000

118,384,000

$2,367,680,000

$884,262,614

$204,262,614

Question No. 2

a. Calculate the IRR of each investment.

Existing paper mill 26.009%

New paper mill 16.603%

b. Calculate the payback of each.

Existing paper mill 3.81

New paper mill 5.74

Question No. 3

a. Do the NPV and IRR methods give the same accept/ reject signals?

They are mutually co related because

i. NPV is Positive

ii. IRR is greater than 12%

b. Explain why the NPV and IRR methods can give divergent signals when evaluating mutually

exclusive alternatives.

As NPV is the difference between the market value of a project and its cost and it is worked out as

positive for both New facility and Revised-Old facility projects i.e. 204,262,614.02 &

163,537,547.82, it is therefore expected to add value to the facility and will therefore increase the

wealth of the owners and since our goal is to evaluate so to increase owner wealth, NPV is a direct

measure of how well New facility project will meet our goal.

For IRR, the numbers are worked out as 16.603% for new facility and 26.009% for Revised Old

facility. It provides us information to go for Revised-Old facility but its NPV numbers are lesser than

new facility.

Question No. 4

Suppose that the appropriate life of a modernized factory is 15 instead of 20 years. Evaluate the argument

that assuming a 20-year horizon for this project adds $44,653,600 times 5 or $223,268,000 to the yearly

cash flows.

Cash flow for 20 Years

Cash flow for 15 Years

Difference

$893,072,000

$669,804,000

$223,268,000

Questions No. 5

Based on your calculations in the previous questions and information in the case, what decision do you

recommend? Justify your answer.

Project A

Question No. 6

a. Building a new mill requires $510 million more than modernizing the old mill but will generate

an extra $73,730,400 in yearly cash flow. Calculate the IRR on this incremental expenditure.

Compare your answer to the 12 percent required return.

Incremental IRR

13.26%

b. Based on your answer in part (a), suggest a decision rule for the IRR in evaluating mutually

exclusive alternatives with different initial costs.

Question No.7

Use the information in Exhibit 2 to explain how the yearly cash flow estimate was obtained for:

(a) Modernizing the old mill.

Operating Cash Flow= NI + Depreciation

NI

36,153,600

Depreciation

8,500,000

1-20 years

44,653,600

Operating Cash Flow= NI + Depreciation

NI

84,384,000

Depreciation

34,000,000

1-20 years

118,384,000

Question No. 8.

(a) How would the NPV and IRR of each project be affected? Explain briefly.

Existing Paper Mill

Initial investment

Operating Cash Flow (each year)

Total Cash Inflow (for 5 years)

Scrap Value

PVCF at 12%

NPV (PVCF-initial investment)

IRR

New Paper Mill

Initial investment

Operating Cash Flow (each year)

Total Cash Inflow (for 5 years)

Scrap Value

PVCF at 12%

NPV (PVCF-initial investment)

IRR

170,000,000

44,653,600

$350,768,000

127,500,000

$225,561,703

$55,561,703

21.266%

680,000,000

118,384,000

$591,920,000

510,000,000

$685,129,698

$5,129,698

12.211%

(b) Which of these two projects will have the larger NPV change? Why?

Existing paper mill

NPV (20 years)=163,537,548

NPV (5 years) = 55,561,703

Difference=107,975,845

NPV (20 years)=204,262,614

NPV (5 years)=5,129,698

Difference=199,132,916

New paper mill project is showing larger NPV difference because of these two reasons:

1. Cash flow return of new paper mill is higher

2. As NPV of 5 years is low so the difference is greater

Question No. 9

How low can average annual production go before each proposal is unexpected?

New Facility

1,694

667

Question No. 10

(a) Is it appropriate to use the same discount rate to evaluate both proposals? Explain your position.

For like comparison we have to use the same discount rate. The starting period for both the

projects is same

(b) How, if at all, does your answer to 10 (a) affect your choice in question 5?

No, we would not change our decision

Annexure

Given information

EXHIBIT 2

Information on Renovation and New Facility

Project 1

Project 2

New Facility

(Original)

Old

Facility

A

After-tax cost ($)

680,000,000

170,000,000

Project 3

(Revised)

Old Facility

Project Length (Years)

Price per ton ($)

Tonnage per day B

40

20

500

1,200

40

20

500

2,200

40

20

500

1,600

170,000,000

Fixed operating cost per

year ($)C

Fixed operating cost per

ton ($)C

Depreciation Method

Depreciation life (years)

Depreciation per year ($)

Depreciation per ton ($)

After-tax cash flow ($)

Required Return

Days

250

57,360,000

290

21,824,000

310

21,824,000

72.42

37.89

50.52

SL

20

34,000,000

42.93

118,384,000

12%

360

SL

20

8,500,000

14.76

67,981,600

12%

360

SL

20

8,500,000

19.68

44,653,600

12%

360

Income Statement

Sales

396000000

Cost Of Production

Variable Cost

198000000

Gross Profit

198000000

Expenses

Fixed Expenses

Operational Cost without Depreciation

23,360,000

Formula

=Price per ton *Tonnage per

day*days

ton*days

=Sales-VC

-Depreciation

Other Expenses

Depreciation

34,000,000

given

Total Expenses

57,360,000

EBIT

Tax

140,640,000

56256000

EBIT*40%

Net Income

84,384,000

EBIT-Tax

Year

Operating Cash Flow

Total Cash Inflow

0

-680000000

1

118,384,000

$2,367,680,000

118,384,000

Initial Investment

NI+Dep

680,000,000

given

PVCF

$884,262,614

NPV

$204,262,614

PVCF-initial investment

IRR

16.603%

Payback

5.74

formula

INITIAL INVESTMENT/OPERATING

CASH FLOW

Incremental Cost

Incremental Cash flow

510,000,000

73,730,400

Incremental IRR

13.26%

Note: Operating cash flow is same for 20 years growth rate and/or inflation rate is not given in data

set.

Income Statement

Sales

216000000

Cost Of Production

Variable Cost

133920000

Gross Profit

82080000

ton*days

=Sales-VC

Expenses

Fixed Expenses

Operational Cost without Dep

13,324,000

Other Expenses

-Depreciation

Depreciation

8,500,000

given

Total Expenses

21,824,000

EBIT

Tax

60,256,000

24102400

EBIT*40%

Net Income

36,153,600

EBIT-Tax

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