The Worldwide Paper Company Case Study
Case 19:
Worldwide Paper Company
Recommendation
The company should adapt the hurdle rate at 9.76% rather than 15%. Because the 15% hurdle rate was based on the data that from 10 years ago, and it is not accurate to use to calculate the NPV and the IRR for investing in Longwood Woodyard.
The Blue Ridge Mill should accept the idea of the addition of a new on-site longwood woodyard. The reason for that is because the NPV is positive when discount the cash flow by 9.76% hurdle rate, which means that doing so will add value to the company. Also, the IRR is 11.7% which is higher than the minimum required rate of return (which is considered as WACC in this case) at 9.76%. That is to say, the expected return will justify the $18 million capital outlay plus the investment in working capital over the 6-year life.
The Statement of Problem
Bob Prescott was considering the addition of a new on-site longwood woodyard, because the new on-site longwood woodyard will bring benefits for company, and will reduce the operating expense for company. However, it is needed to know if the benefits that longwood woodyard brings are enough to the company to justify the $18 million capital outlay plus the incremental investment in working capital over the six year life of the investment. In addition, the company is using the WACC at 15% , which was based on the information 10 years ago. Last but not least, is it true that the increase in operating costs caused by inflation would be mostly offset by the increase in revenues associated with the rise in the price of shortwood.
Analysis
As far as concerned, the investment of the new longwood woodyard has two major advantages to the company: decrease the operating cost and increase the shortwood sales. Based on the book information, the operating cost is estimated to reduce $2,000,000 in the first year and $3,500,000 in the following five years. Second, as mentioned in the text, the addition would create the opportunity to sell shortwood on the open market. The estimate sales for year 2008 is $4 million, and $10 million per year after. Before making the decision, there are calculations needed, such as WACC, NPV, and IRR.
The company currently using the hurdle rate at 15%, which based on a study of the company’s cost of capital conducted 10 years ago. Apparently, this number cannot be used because of the inaccuracy. According to the newest information provided in the text, we can find the cost of debt for company is 5.78% based on the corporate bond rating A, and use the 30-year government bond yield as the risk free rate, which is 4.73%. The debt of company including long-term debt and bank loan payable, the total amount is $3,000,000. The equity of company equal to the number of shares outstanding times the market price per share, which is $12,000 million. According to these data, the weight of debt is 20%,