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Case 3
Case 3
QUESTION 1
(A) Calculation of NPV of modernizing the existing paper mill:
If actual cash flows are used
Investment required for the modernization = $154,700,000
Required rate of return = 12%
Yearly cash flow after tax deduction = $40,634,680 (for 20 years)
Net present value = C0 + present value of all future cash flows of 20 years
NPV = 303,518,451.5 - 154,700,000
NPV = $148,818,451.5
a) Cash button
b) I% = 12%
c) Cash= D.editor x
X
1 -154700000
2 29,212,360
3 29,212,360
4 29,212,360
5 29,212,360
6 29,212,360
7 29,212,360
8 29,212,360
9 29,212,360
10 29,212,360
11 29,212,360
12 29,212,360
13 29,212,360
14 29,212,360
15 29,212,360
16 29,212,360
17 29,212,360
18 29,212,360
19 29,212,360
20 29,212,360
21 29,212,360
d) NPV = solve
e) NPV = $ 63,500,076.15
(B) Calculation of NPV for building a new paper mill
Investment required for the modernization = $618,800,000
Required rate of return = 12%
Yearly cash flow after tax deduction = $107,728,000 ( for 20 years)
Incremental cash flow =$107,728,000 - $ 11,422,320 = $ 96,305,680
Net present value = C0 + present value of all future cashflows of 20 years
Casio calculator
a) Cash button
b) I% = 12%
c) Cash= D.editor x
X
1 -618,800,000
2 96,305,680
3 96,305,680
4 96,305,680
5 96,305,680
6 96,305,680
7 96,305,680
8 96,305,680
9 96,305,680
10 96,305,680
11 96,305,680
12 96,305,680
13 96,305,680
14 96,305,680
15 96,305,680
16 96,305,680
17 96,305,680
18 96,305,680
19 96,305,680
20 96,305,680
21 96,305,680
d) NPV = solve
e) NPV = $ 100,549,850
This shows that NPV of new paper mill is higher than that of modernization of the existing facility.
Thus, using NPV rule demonstrates that new facility is better for the firm.
QUESTION 2:
With Incremental Cash flows
(A) Calculation of IRR of each investment
IRR of Modernization of existing mill :
Using the Casio calculator where the cash flows and the initial investment was entered we move on
to the
IRR = solve
IRR = 18.219%
IRR of new paper mill:
Using the Casio calculator where the cash flows and the initial investment was entered we move on
to the
IRR = solve
IRR = 14.531%
According to IRR rule the firm should invest in the modernization of the existing paper mill as it has
a higher IRR .
QUESTION 3:
(A) NPV and IRR methods give the same accept / reject signals:
No, NPV and IRR methods do not give the same accept/ reject signals. NPV accepts the
investment in building a new paper mill while IRR method accepts the investment in the
modernization of the existing paper mill.
(B) NPV and IRR methods can give divergent signals when evaluating mutually exclusive
alternatives:
In mutually exclusive projects, all projects serve the same purpose and therefore such projects
cannot be undertaken simultaneously. In case of mutually exclusive projects only one project
can be accepted and the others are to be rejected. In case of such projects the cash flows of
one project can actually be adversely affected by the acceptance of the other project.
The reason that NPV and IRR methods are giving different decisions for the projects, building of
new paper mill and modernization of existing paper mill are:
The investment scale is different for both the projects. Building a new paper mill requires higher
investment as compared to the other project.
The cash flows are also different of both the projects. The cash flow of building a new paper mill
is $67,093,320 more than the cash flow of the modernization of existing paper mill. Thus, the
magnitude of cash flows is also the reason of divergent signals.
QUESTION 4:
If the life of modernized paper mill becomes 15 years the payback period as calculated in Question 2
part b would not change and would remain 3.807 years but the NPV if calculated would change.
a) Cash button
b) I% = 12%
c) Cash= D.editor x
x
1 -154700000
2 29,212,360
3 29,212,360
4 29,212,360
5 29,212,360
6 29,212,360
7 29,212,360
8 29,212,360
9 29,212,360
10 29,212,360
11 29,212,360
12 29,212,360
13 29,212,360
14 29,212,360
15 29,212,360
16 29,212,360
d) NPV= solve
e) NPV=$ 44,261,425.38
f) IRR= solve
g) IRR = 17.118%
The NPV decreases with the decrease in number of years but still remain positive. Similarly there is a
decrease in IRR with the change in number of years. The IRR has decreased round about 1.1% as
compared to previous IRR calculation with 20 years cash flows.
Thus, it shows the effect of latter cash flows on IRR and NPV is less and early cash flows have
greater effect on IRR and NPV. Therefore it’s a better option to choose modernization of existing
paper mill as it has a lower payback, positive NPV and higher IRR and the employees only have to
cover 15 miles to reach it.
According to the statement the yearly cash flows if multiplied by 5 give a large cash flow that is
actually affecting the NPV but in reality the effect is very little and 5 years can also be omitted.
QUESTION 5:
Based on the calculations, modernization the existing facility would be better option because of its
early payback, higher IRR and positive NPV (although less than that of new facility). Based on the
information in the case, modernization the existing facility would be again better because new
facility location is 15 miles away from the existing facility which would increase the employees'
expense and this would be unfair with employees and it may decrease their loyalty for company. So,
we recommend to modernize the existing facility.
QUESTION 6:
(A)
Casio calculator
a) Cash button
b) I% = 12%
c) Cash= D.editor x
X
1 -464,100,000
2 67093320
3 67093320
4 67093320
5 67093320
6 67093320
7 67093320
8 67093320
9 67093320
10 67093320
11 67093320
12 67093320
13 67093320
14 67093320
15 67093320
16 67093320
17 67093320
18 67093320
19 67093320
20 67093320
21 67093320
d) IRR = solve
e) IRR = 13.258%
13.258% is the crossover rate of both the projects where there NPV = $126,379,470. If we compare
this rate to the required return 12% we will accept the project because the rate at which the NPV of
both the projects becomes equal is more than the required return.
Further if the cash flows have been overestimated this may be causing the result of IRR to be
13.248% that is only 1.25% more than required return may be the actual cash flows are lower which
may lower the IRR to 12% or even lower than that that can actually make the project unacceptable.
(B)
If we explain the decision rule for IRR in case of mutually exclusive alternatives, we accept a project
which has IRR greater than its cost of capital, and If both the projects have IRR greater than their
cost of capital than we select the project having the highest IRR.
In mutually exclusive alternatives normally IRR and NPV give divergent signals which means if IRR
accepts a project, NPV rejects that project. Thus in this case NPV should be used as a primary rule.
On the other hand if these projects would have been independent projects, IRR and NPV would have
given same answers. Normally in case of independent projects if NPV accepts the project than IRR
also gives the same decision. And In such projects we can accept all the projects if there are no
constraints.
QUESTION 7:
Data required for calculating the yearly cash flow
Modernization of existing paper mill ($) Building new paper mill ($)
Initial Cost 154,700,000 618,800,000
Price per ton 455 455
Working days in a year 360 days 360 days
Tonnage per day 1200 2200
Variable cost per ton 282.1 227.50
Fixed operating cost per year 19,860,000 52,200,000
SL value 20 years 20 years
Depreciation per year 7,735,000 30,940,000
Tax rate 40% 40%
Income statement for calculation of the operating cash flow:
Sales (Price per ton x number 455 x1200 x360= 455 x2200 x360=
of tons x no. of days in a year) $196,560,000 $360,360,000
Less: Fixed cost per year ($19,860,000) ($52,200,000)
(includes depreciation)
Less: variable cost per year 282.1 x 1200 x 360= 227.5 x 2200 x 360=
($121,867,200) ($180,180,000)
EBT $54,832,800 $ 127,980,000
Less: 40% tax ($ 21,933,120) ($ 51,192,000)
Net income $ 32,899,680 $ 76,788,000
Add Depreciation $ 7,735,000 $ 30,940,000
Net operating cash flow $ 40,634,680 $ 107,728,000
QUESTION 8:
(A) Calculating operating cash flows
If Incremental Cash flows are used with Depreciation being Charged for First 5
Years for Modernized Mill
Incremental cash flow for first 5 years of modernized mill
= $ 49,916,680 - $11,422,320 = $38,494,360
Incremental cash flow for last 15 years of modernized mill
=$ 37,540,680 -$ 11,422,320 = $ 26,118,360
Casio calculator
a) Cash button
b) I% = 12%
c) Cash= D.editor x
X
1 -154700000
2 38,494,360
3 38,494,360
4 38,494,360
5 38,494,360
6 38,494,360
7 26,118,360
8 26,118,360
9 26,118,360
10 26,118,360
11 26,118,360
12 26,118,360
13 26,118,360
14 26,118,360
15 26,118,360
16 26,118,360
17 26,118,360
18 26,118,360
19 26,118,360
20 26,118,360
21 26,118,360
d) NPV = solve
e) NPV = $ 85,002,327.86
f) IRR= solve
g) IRR = 21.5224%
The NPV change would be higher in building a new mill, possible reasons would be the magnitude
of early and latter cash flows. Latter cash flows experience greater impact of discount rate rather
early cash flows. 5 year depreciation makes early cash flows higher.
QUESTION 9:
For calculating the cash flow where the annual production is minimum which makes the project
unacceptable we calculate the payment through annuity formula:
PV= C x ((1-(1+r)-n)/r)
R= 12%
n= 20
Calculation of Cash Flow Modernization of existing mill Building New Mill
Cash Flows 154,700,000/((1-(1+0.12)-20)/0.12) 618,800,000/((1-(1+0.12)-20)/0.12)
=$ 20711047.27 = $ 82844189.09
QUESTION 10:
(A)
No, it is not appropriate to judge different proposals on same discount rate because each proposal has
its own cost and cost of capital which is according to its risk. So, in order to evaluate the proposals,
we should compare proposal's own cost of capital with its IRR. If IRR is greater than that of its cost
of capital proposal should be accepted otherwise rejected.
(B)
Yes, it is possible that my decision would be change if both projects have different cost of capital.
Change in cost of capital can also change the decision we made on the basis of IRR in question 5 of
selecting the project of modernization of existing mill. If both projects would have higher IRR than
their discount rate than I would select project with higher NPV.