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INDEX

1. Case Background…………………………………………………………………….Page 3

2. Critical Financial Problems identified in the case………………………………Page 4

3. Analysis and Interpretations for solving the case……………………………….Page 6

4. Specific Recommendations and Implementation…………………………….Page 10

5. Conclusion……………………………………………………………………………..Page 10

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Case Background
The Blue Ridge Mill which had hitherto been purchasing short wood from Shenandoah Mill for
its operations. However, now in January 2016, its controller Bob Prescott is considering
purchasing a new on-site wood-yard. This new technology allowed tree length logs, called
longwood, to be processed directly. The process at the mill required shortwood which had to be
purchased from Shenandoah Mill.
Purchasing the new wood yard would not only mean reduced purchase (operating) cost on account
of elimination of need to buy shortwood from market, but it would also increase revenue by
opening up opportunity to sell shortwood in the market and compete with Shenandoah.
Some other estimates that are given for the investment –
 It requires $18 million outlay ($16 million in 2016 and $2 million in 2017).
 Life of the investment would be 6 years.
 Depreciation would be calculated on straight line basis with zero salvage value after 6
years, but would be calculated only from 2017 after the machinery has been put to service.
 After 6 years, in 2022, only 10% or $1.8 million of the capital investment would be
recoverable.
 Operating savings on account of difference in cost of producing shortwood versus buying
it - $2 million for 2017 and $ 3.5 million every year thereafter.
 Expected revenues from sale of shortwood is $4 million for 2017 and $10 million every
year from 2018 onwards.
 It is also estimated that the cost of goods sold (before including depreciation) would be
75% of the revenues and selling, general and admin expenses would be 5% of revenues.
 The total working capital would average 10% of annual revenues.

Prescott is confident about the above estimates, except that he is unsure of how the operating costs
and the revenues would be impacted by inflation in the future. Also, WPC is still using 10% hurdle
rate, which is as per the cost of capital calculated 10 years earlier, when the 30 year Treasury bonds
were yielding 4.7%, whereas now they are yielding 2.82%.
In the above, scenario, whether Prescott should go ahead with the capital investment or not?

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Critical Financial Problems Identified in the Case
5 critical problems identified in the case –
1) Whether the investment should be made towards purchase of new on-site
longwood woodyard or they should continue purchasing shortwood from
Shenandoah Mill?

The major problem or concern of the case if evaluation of the proposed investment towards
project of addition of the new on site longwood woodyard. Up till now the shortwood was
purchased as raw material from Shenandoah Mills, however, from now if Blue Ridge Mill
produces its own shortwood, then it stands to gain from reduced purchase costs. At the
same time it has to incur additional operating costs as well as shell out the investment
outlay of $18 million and additionally working capital towards operational requirements.

Further, it also stands to gain from sale of shortwood to other prospective buyers, in
competition with Shenandoah Mill, and earn additional revenues.

So, there is a tug between increased revenues & reduced operating costs, and investment
outlay and additional net working capital investment. The problem, basically, is making an
accurate investment decision.

2) Whether the estimated are accurate or not?

As given in the case background, the entire investment is based on a lot of estimates
pertaining to savings on account of in house production of shortwood, additional revenues
from sale of shortwood owing to excess capacity, additional net working capital required,
cost of goods sold and SG&A expenses, etc.

Some of these estimates, like the depreciation rate, tax rates, etc would easily be estimated.
However, the other estimates could be made on flimsy grounds. For example, he estimated
revenues of $4 million in 2017 and thereafter $10 million from 2018 onwards. Whereas he
should be prudent about his market share as a new competitor.

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3) Whether inflation is to be accounted for in estimates?

Prescott was unsure of how the operating costs and price of shortwood would be impacted
by inflation after 2017 and he decided not to include it in his analysis. In fact the dollar
estimates he used for 2018 and beyond were based on the same prices he used for 2017.
He thought that increase in operating costs caused by inflation would be mostly offset by
the increase in revenues associated with the rise in price of shortwood.
Whereas in reality it might not be so.

4) Whether the company policy to use 10% as hurdle rate was appropriate and
relevant after 10 years?

The hurdle rate used by Prescott was based on a study of the Company’s cost of capital
conducted 10 years earlier, at which point the 30 year Treasury bonds were yielding 4.7%,
whereas currently they were yielding 2.82%. Such an outdated discount rate would
anyways give them a skewed picture as to their capital investment decision.

The discount rate must be freshly calculated as per the company’s cost of capital based on
present bank loan rates, market risk premium, government bonds yield and corporate bonds
yield.

5) Whether the expected inflows are enough to justify a huge outlay to the tune
of $18 million?

After all, the capital investment decision is pertaining to an outlay amounting to $18 million
– not only for self-consumption as raw material for pulp but also for entering the market
for shortwood as a competitor.

This decision entails estimates for additional costs and returns and therefore, the Net
Present Value, the IRR must be thoroughly calculated for reaching a decision after taking
into account a freshly calculated discount rate based on WACC (Weighted Average Cost
of Capital).

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Analysis and Interpretations for Solving the Case

The expected revenues from the sale of shortwood are as follows –


Year 2016 2017 2018 2019 2020 2021 2022
Projected Revenue 0 4000000 10000000 10000000 10000000 10000000 10000000

Accordingly, the cost of goods sold estimated at 75% of the revenues and SG&A expenses
estimated at 5% of revenues works out as follows –
Year 2016 2017 2018 2019 2020 2021 2022
Actual Sales 0 4000000 10000000 10000000 10000000 10000000 10000000
Cost of Goods
Sold 0 3000000 7500000 7500000 7500000 7500000 7500000
SG&A Expenses 0 200000 500000 500000 500000 500000 500000

The machinery will be installed with a total outlay of $18 million - $ 16 million in 2016 and $ 2
million in 2017. Also, it is given that only 10% of capital investment, i.e., $1.8 million will be
recoverable, which comes out to be the following after 40% tax –
1800000 (1-0.40) = $1080000
The cash flow due to capital spending may be given as –
Year 2016 2017 2018 2019 2020 2021 2022
Capital Spending -16000000 -2000000 0 0 0 0 1080000

The machinery will be installed and ready for use only in 2017. After this only the depreciation
will be calculated on machinery. Depreciation was calculated on straight line basis over six year
life with zero salvage value. Thus each year the depreciation calculated on $18 million is –
18000000/6 = 3000000
The annual depreciation may be shown as –
Year Opening Book Value Depreciation Closing Book Value
2016 16000000 0 16000000

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2017 18000000 3000000 15000000
2018 15000000 3000000 12000000
2019 12000000 3000000 9000000
2020 9000000 3000000 6000000
2021 6000000 3000000 3000000
2022 3000000 3000000 0

Further, we the depreciation tax shield may be calculated as –


Year 2016 2017 2018 2019 2020 2021 2022
Depreciation every Year 0 3000000 3000000 3000000 3000000 3000000 3000000
Depreciation tax shield 0 1200000 1200000 1200000 1200000 1200000 1200000

It is estimated that the savings every year on account of difference in cost of producing shortwood
versus buying it will be $2.5 million in 2017 and $3.5 million thereafter. So, the net savings after
accounting for 40% taxes may be given as –
Year 2016 2017 2018 2019 2020 2021 2022
Savings every year 0 2000000 3500000 3500000 3500000 3500000 3500000
Net Savings after tax 0 1200000 2100000 2100000 2100000 2100000 2100000

It is also given that additional net working capital is given as 10% of annual revenues. We assume
that at the end of 6 year period the additional net working capital will be recovered. So, the NWC
and cash flow due to NWC may be shown as –
Year 2016 2017 2018 2019 2020 2021 2022
1000000 1000000 1000000 1000000
Actual Sales 0 4000000 10000000 0 0 0 0
NWC 0 400000 1000000 1000000 1000000 1000000 1000000
Cash Flow 0 -400000 -600000 0 0 0 0
NWC Recovery 0 0 0 0 0 0 1000000
Total Change in
NWC 0 -400000 -600000 0 0 0 1000000

We can further calculate the operating cash flows from installation of the woodyard as follows –
Year 2016 2017 2018 2019 2020 2021 2022
1000000 1000000 1000000 1000000 1000000
Revenue 0 4000000 0 0 0 0 0
Cost of Goods Sold 0 3000000 7500000 7500000 7500000 7500000 7500000
Gross Profit 0 1000000 2500000 2500000 2500000 2500000 2500000
SG&A expenses 0 200000 500000 500000 500000 500000 500000
Depreciation 0 3000000 3000000 3000000 3000000 3000000 3000000
EBIT 0 -2200000 -1000000 -1000000 -1000000 -1000000 -1000000

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Taxes 0 0 0 0 0 0 0
Net Income 0 -2200000 -1000000 -1000000 -1000000 -1000000 -1000000

When we consider the combined project cash flow, we find the following –
Year 2016 2017 2018 2019 2020 2021 2022
Operating Cash Flow
- - - -
Net Income 0 -2200000 -1000000 1000000 1000000 1000000 1000000
Depreciation 0 3000000 3000000 3000000 3000000 3000000 3000000
Taxes 0 0 0 0 0 0 0
Operating Cash Flow 0 800000 2000000 2000000 2000000 2000000 2000000
Net Working Capital
Total Change in NWC 0 -400000 -600000 0 0 0 1000000
Capital Spending
-
Capital Spending 16000000 -2000000 0 0 0 0 1080000
Savings on account of in house production
Actual savings 0 2000000 3500000 3500000 3500000 3500000 3500000
Savings net of tax 0 1200000 2100000 2100000 2100000 2100000 2100000

The discount rate has been calculated by WACC using the following –

Weighted Average Cost of Capital 5.48


Weighted Cost of
Equity 4.32 Weighted Cost of Debt 1.16
Cost of Capital 8.64 Cost of Debt 2.31
30-Govt. Bond 2.04 Corporate Bond (10-year) 'A' 3.85
Market Risk premium 6.00 Tax Rate 0.40
Beta 1.10

Total Value of Equity 2500.00 Total Value of debt 2500.00


Common Equity 500.00 Long Term Debt 2500.00
Retained Earning 2000.00

Due to the change in risk free rate i.e. 30-year government bond, the Hurdle Rate previously used
as per the company policy of WPC would give ambiguous result while determining the investment

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policy. Hence, it is imperative to calculated new discount rate for WPC investment plan. We have
determined discount rate through Weighted Average Cost of Capital, and using the data provided
in the exhibit of the case, we calculated WACC=5.48%.

The total projected cash flow of WPC on investing for shortwood wood yard will be as follows-

Operating Cash Flow 0 800000 2000000 2000000 2000000 2000000 2000000


Change in NWC 0 -400000 -600000 0 0 0 1000000
Capital investing -16000000 -2000000 0 0 0 0 1080000
Savings net of tax 0 1200000 2100000 2100000 2100000 2100000 2100000
Total Projected cash
flows -16000000 -400000 3500000 4100000 4100000 4100000 6180000
- - -
Cumulative cash flow -16000000 -16400000 12900000 8800000 4700000 -600000 5580000
Discounted cash flow
@ WACC(5.48%) -16000000 -379218.81 3145776.1 3493603 3312099 3140026 4487121

Net Present Value, Internal Rate of Interest, Payback period of the aforementioned investment will
following-
NPV Value @ WACC
(5.48%) 1137093.3
Internal Rate of Return 7%
Payback 5.09

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Specific Recommendations and Implementation
After, calculating total cash flows for different year, we discounted the cash flows of the respective
years at the rate of 5.48% and calculated the cumulative cash flow for the mentioned period of
time. Through these parameter we were able to calculate NPV for the project, which is positive -
$1137093 and the IRR comes to 7%.
 A Positive NPV of $1137093 suggests that investment for new on site woodyard would be
prudent decision. Mr. Prescott should therefore make new investment rather than only
continuing with the previous operation of Longwood yard.

 An IRR value of 7% is significantly more than the hurdle rate of 5.48% expected by the
WPC for the new investment. Thus, this parameter would also enact as positive catalyst for
Mr. Prescott to take the new investment plan.

 Payback period for the new investment has been derived to 5.08 years. It suggests
breakeven will happen before the mentioned period of 6 years for investment made on new
project. It would be a positive driver for Mr. Prescott to invest for new expansion plan at
WPC.

Conclusion:
We therefore recommend that Mr Prescott should decide to invest in the
woodyard.

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