Introduction
In December 2006, Bob Prescott, the controller for the Blue Ridge Mill, was considering the addition of a new on-site longwood woodyard. Two primary benefits for this new addition include eliminating the need to purchase shortwood from an outside supplier and creating an opportunity to sell shortwood on the open market. Also, the new woodward would reduce operating costs and increase revenues. Blue Ridge Mill currently purchased shortwood from the Shenandoah Mill, which is a direct competitor. Thus, adding the new longwood equipment would mean that the Prescott would no longer need to use the Shenandoah Mill as a shortwood supplier and that the Blue Ridge Mill would instead compete with the Shenandoah Mill by selling on the shortwood market. The question for Prescott was whether these expected benefits were enough to justify the $18 million capital outlay plus the incremental investment in working capital over the six-year life of the investment.
SYMPTOMS
The addition of a new on-site longwood woodyard would bring benefit to Blue
Ridge Mill in term of decreasing their operating cost and also increasing their revenue or sales. But the estimation of revenue and cost did by Prescott do not reflect the inflation rate. Thus, this project’s evaluation will be less accurate.
PROBLEMS
By adding the new on-site longwood woodyard, Prescott estimates that the revenue for their company would increase to $4 million in year 2008 and goes to $8 million every year until year 2013. And also the cost of goods sold would be 75% of revenue and SG&A would be 5% of revenue. But all of this estimation does not include the inflation. So, we are using the net present value (NPV) and internal rate of return (IRR) to evaluate this longwood woodyard project which these methods involve the discounted cash flow.
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PROBLEM SOLVINGS
First, we need to find the required rate of return (WACC) to calculate the discounted cash inflow so that we can evaluate the longwood woodyard project more accurately. Calculate KE : Cost of Equity (CAMP)
KE = KRF + (KM – KRF) Beta
Beta = 1.1
KRF= 4.60% : Government bonds 10-year,
Risk premium = 6.0%
KE = 4.6% + (6.0%) 1.1
= 11.2%
Calculate KD: Cost of Debt
KD = Bank Loan Payable + Long Term Debt
= $ 500 + $ 2500
= $ 3000
KD = (500/3000) * (5.38% + 1%) + (2500/3000) * (5.78%)
= 5.88%
KD (1-Tax)
=5.88% (1-40%)
= 3.528%
Calculate capital structure: WE and WD
Equity = Current Market Share Price x Shares Outstanding
= $24 x 500m
= $12000m
Debt = Bank Loan Payable + Long Term Debt
= RM 500 + RM 2500
= RM 3000
E+D = $ 12000 + $ 3000
= $ 15000
WE = 12000/15000
= 0.8/80%
WD = 3000/15000
= 0.2/20%
Calculate WACC
WACC = WE. KE + WD .KD (1-T)
= 0.8 (11.2%) + 0.2 (3.528%)
= 9.6656 @ 9.67%
So. The WACC (required rate of return) is 9.67%
Second, we need to find the cash inflow of this project.
2007
2008
2009
2010
2011
2012
2013
$’million
$’million
$’million
$’million
$’million
$’million
$’million
Revenue
4
10
10
10
10
10
(-) COGS (75% of reveue)
3
7.5
7.5
7.5
7.5
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7.5
(-) SG & A (5% of revenue)
0.2
0.5
0.5
0.5
0.5
0.5
Net Shortwood Income
0.8
2
2
2
2
2
Operating Saving
2
3.5
3.5
3.5
3.5
3.5
(-) Depreciation ($18million/6 years)
3
3
3
3
3
3
Earning Before Interest & Tax
-0.2
2.5
2.5
2.5
2.5
2.5
(-) Tax (40%)
-0.08
1
1
1
1
1
Earning After Tax
-0.12
1.5
1.5
1.5
1.5
1.5
Add Back Depreciation
3
3
3
3
3
3
Free Cash Flow
2.88
4.5
4.5
4.5
4.5
4.5
Third, we need to calculate the discounted cash inflow of this project.
Year
1
2
3
4
5
6
Cash inflow
($’million)
2.88
4.5
4.5
4.5
4.5
4.5
Total cash inflow=
$25.38million
Discounted cash inflow
($’million)
2.62606
3.7414
3.4115
3.1107
2.8364
2.5863
Total discounted cash inflow=
$18.31236million
Project Evaluation Methods
I. Net present value (NPV)
Discounted Cash Inflow – Cash Outflow
= $18.31236 million – $18 million
= $0.31236 million
The NPV is $0.31236 million which is positive.
This means that longwood woodyard project will bring positive return which is $0.31236 million.
II. IRR
Firstly, calculate the discounted cash flow by using required interest rateat 10%and 12% respectively.
10%
2.618208
3.7188
3.38085
3.0735
2.79405
2.54025
Total discounted cash inflow: $18.12566 million
*rate too low
12%
2.571552
3.5874
3.2031
2.85975
2.5533
2.2797
Total discounted cash inflow: $17.0548 million
*rate too high
X= 0.12566
0.02 1.07086
X =0.12566 (0.02)
1.07086
X=0.002346
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IRR=0.102346 @ 10.23%
So, the IRR is 10.23% which is higher than required rate of return (10.23% > 9.67%) This means that the company will receive 10.23% for each dollar that invested in this project at a cost of 9.67%.
RECOMMENDATION
The expected benefits are enough to justify $18 million capital outlay plus the incremental investment in working capital over the six-year life of the investment. The current WACC (9.67%); the NPV is positive ($0.31236); the IRR is greater than WACC (10.23% > 9.67%).
Therefore, Prescott should invest in the new longwood woodyard.
Conclusion
The investing in the new longwood woodyard gives benefits of eliminating the need to purchase shortwood from an outside supplier and creating an opportunity to sell shortwood on the open market. Besides, the new woodward will reduce operating costs and increase revenues. We use the current WACC, NPV and IRR method to decide whether Prescott should invest in the woodyard. The result shows that Prescott should invest in the new woodyard because the expected benefits are enough to justify $18 million capital outlay plus the incremental investment in working capital over the six-year life of the investment.
