1.

0 CASE SUMMARY
Before Bob Prescott, the controller for the Blue Ridge Mill, was considering the

addition of a new on-site longwood woodyard, the company is buying the shortwood

from its competitor which is Shenandoah Mill. In December 2006, Bob Prescott was

considering to produce the longwood woodyard. Worldwide paper company which

producing the longwood woodyard has two primaries benefit. First of all, the company

can eliminate the need to purchase shortwood from on outside supplier. Other than this,

the company can create the opportunity to sell shortwood on the open market as a new

market for the company. Thus, the new woodyard would allow the Blue Ridge Mill not

only to reduce its operating costs, but also increase its revenues. However, the proposed

woodyard utilized new technology that allowed tree-length logs called longwood. Thus,

adding the new longwood equipment would mean that 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.

We identify 3 main objective based on this case study. First of all, we need to

determine the importance to find the cost of capital. Secondly is to calculate the cost of

capital (WACC), operating cash flow of the company from year 2008 to 2013, net

present value (NPV) and internal rate of return (IRR). Finally is to make a decision

whether the Worldwide Paper Company should accept this project or not. However, we

also notice that there are two questions or problem in this case study. Firstly, 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.

Secondly, determine the current cost of capital, WACC of the project.

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2.0 INTRODUCTION

Based on our objective, there are four reasons why it is importance to find the

cost of capital since the management team always use cost of capital for the financial

decision purpose. The first reason is it can be used for making capital budgeting

decision. Cost of capital is used as a measuring tool for adopting an investment proposal

where they will choose a project that will give a maximum benefits to the firm. Second

reason is, for the purpose of designing the corporate financial structure. For example, a

capable financial executive always concern about the capital market fluctuations and try

various methods to minimize the cost of capital by increasing the market price and

earnings per share. Third, the cost of capital is important for deciding about method of

financing. A capable financial executive will use cost of capital as considerations of

relating control and of avoiding of risk. The fourth reason is to provide shareholder a

better view of top management’s performance. The cost of capital can be used to

evaluate the financial performance of a company.

In this case study, we calculate the current cost of capital, WACC by using 10-

year Treasury bonds was yielding 4.60% which is not same with the Worldwide Paper

Company. The Worldwide Paper using 30-year Treasury bond which was not match

with the yield period. Other than this, we also calculate operating cash flows for the

company in order to know whether the expected benefit enough to justify the capital

outlays. In addition, the purpose to calculate the net present value (NPV) and internal

rate of return (IRR) is to make a decision whether to accept the project or vice versa. For

the net present value (NPV), we will accept the project if the NPV is positive. Whereas

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if the internal rate of return (IRR) is greater than required rate of return, we will greatly

recommend the company to invest in the project.

3.0 ANALYSIS

3.1 SWOT ANALYSIS

Strengths Weaknesses

 Strong sale support  Applying outdated WACC

 Decreasing WACC  Wrong investment decision in the

pass due to incorrect WACC

Opportunity Threat

 Enjoy decreased operating cost  Competition from Shenandoah

due to having new machine mill

 Increased revenue from excess

capacity

 Independence from the current

supplier
Table 1

3.1.1 Strengths
With the addition of a new on-site longwood woodyard, Worldwide Paper

Company (WPC) will be able to growth vertically through backward integration by

taking over the function previously provided by supplier. This makes WPC able to take

advantage of the excess production capacity by selling shortwood on the open market as

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what Shenandoah Mill has doing. This is an entirely new market for Worldwide Paper

Company and also a strong sale support for the company too. Besides that, WPC has a

decreasing WACC in reality. This is due to the company had not changed its cost of

capital for 10 years, which is 15% as it was computed when 30-year Treasury bonds

were yielding 10%, while they were currently yielding less than 5%. As what we get

from our computation, the actual WACC is 9.67%.

3.1.2 Weakness
WPC had a company policy that is to use its corporate cost of capital of 15% to

analyze the investment opportunities. This outdated WACC had lead to a negative NPV

of $2.14 million where the result caused the company chose to let go the opportunity of

adding the woodyard. This is the wrong investment decision for the company indeed.

3.1.3 Opportunity
WPC might be able to enjoy the less operating cost due to having the new

machine as the company can eliminate the need to purchase shortwood from an outside

supplier. The new woodyard would increase the sales of the company as it utilizes new

technology that allowed tree-length logs to be processed directly and sell the excess

production to several different mills.This will made WPC to be independence from the

supplier and able to compete with its rival, Shenandoah Mill.

3.1.4 Threat
WPC will have to compete with its rival, Shenandoah Mill in term of intangible

resource such as technology as well as reputation. As WPC new woodyard is still new in

the view of their customers, hence they will choose a more stable producer in order to

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assure their process of manufacturing. The sales of the company might not able to

compete with its rival in short-term period.

4.0 COST OF CAPITAL (WACC)

4.1 Value of debt

On a market value basis, Worldwide Paper Company debt is worth $3000million ($500

millions + $2500 millions) which is the contribution of Bank loan payable (LIBOR +

1%) and the long-term debt. The calculation will be showed as below:

Market Value of Debt (D) = Bank loan payable + Long-term debt

= $500 millions + $2500 millions

= $3000 millions

4.2 VALUE OF EQUITY

For calculating the value of equity, we will took the current shares outstanding and the

recent market value per share. Therefore the market value of equity is $12000 million

(500 million * $24). The calculation will be showed as below:

Market Value of Equity (E) = Stock Price X Number of Share Outstanding

= $24.00 X 500 million

= $12000 million

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4.3 Weight of equity and debt

The weights of debt and equity are calculated using the market values of debt and equity

as follows:

Weight of Debt (WD) Weight of Equity (WE)

WD = ___ D_ __ WE = ___ E_ __

E+D E+D

= _ 3000___ = _ 12000___

3000 + 12000 3000 + 12000

= 20% = 80%

4.4 Cost of debt

The financial data of Worldwide Paper Company already showed that the bond rating is

"A". We would take 10 years corporate bonds which are rated "A" in bond rating which

is 5.78% while the Bank loan rates (LIBOR) is shown as 5.38%. Therefore the

calculation for cost of debt is showed as below:

RD = Bank loan payable + Long-term debt

= 500 / 3000 * (5.38%+1%) + 2500 / 3000 * 5.78%

= 5.88%

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4.4 Cost of equity

The cost of equity is calculated based on the CAPM method. This is because the data

already given the values of market risk premium, beta and government bonds. For the

Rf (risk free rate) we used 10 years Government bonds. This is because we used 10

years corporate bonds, in order to match them. Beta was given as 1.10. Market risk

premium is given as 6.0% based on historical average. The calculation will be showed

as below:

Rf = 4.60% (10 years yield)

MRP = 6.0% (historical average)

Beta = 1.1

= 4.60% + 1.1 ( 6.0%)

= 11.20%

4.5 Cost of Capital (WACC)

Cost of capital is the required rate of return which is necessary used to make a capital

budgeting project. Cost of capital includes the cost of debt and the cost of equity.

Weighted Average Cost of Capital (WACC) is the overall cost for the firm to run

new wood yard project. Weight Average Cost of Capital (WACC) defined as the

proportion of each type of capital to total capital in the percentage terms. WACC is the

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calculation of a firm's cost of capital in which each category of capital is

proportionately weighted which contain common stock, preferred stock, bonds and any

other long term debts. Normally the WACC should be after tax WACC.

Based on WPC calculation, it showed that the company’s WACC computation is

15% when she inserts all her assumption in the WACC formula. However, we have

clarified that the assumption is not really correct in the above. This is because the

company have not change its cost of capital for 10 years, while the WACC was

computed with using the 30-years Treasury bond which shown not match for the yield

period. Therefore we recalculate the value of WACC. After calculating all the thing

(market value of debt and equity, weighting for debt and equity, cost of debt and cost of

equity), we insert all our findings in WACC formula. Weighted Average Cost of Capital

(WACC) for Worldwide Paper Company calculation is shown below:

= 5.88% * ( 1 - 40% ) * 20.00% + 11.20% * 80.00%

= 9.67%

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5.0 Cash Flow Analysis
(in $million)
2007 2008 2009 2010 2011 2012
2013 Terminal
Value
Revenue 4.00 10.00 10.00 10.00 10.00 10.00
GOGS (3.00) (7.50) (7.50) (7.50) (7.50) (7.50)
SG&A (0.20) (0.50) (0.50) (0.50) (0.50) (0.50)
Reduces in
Operating cost 2.00 3.50 3.50 3.50 3.50 3.50
Earnings Before
Depreciation and
Taxes 2.80 5.50 5.50 5.50 5.50 5.50
Depreciation (3.00) (3.00) (3.00) (3.00) (3.00) (3.00)
Earnings
BeforeTaxes (0.20) 2.50 2.50 2.50 2.50 2.50
Tax (0.08) (1.00) (1.00) (1.00) (1.00) (1.00)
Net Operating
Profits after tax (0.12) 1.50 1.50 1.50 1.50 1.50
Investment in fixed (16.00)
asset (2.00) 0.00 0.00 0.00 0.00 0.00 1.08
NWC Investment 0.00 (0.40) (1.00) (1.00) (1.00) (1.00) (1.00)
∆ NWC (0.40) (0.60) 0.00 0.00 0.00 0.00 1.00
Depreciation 3.00 3.00 3.00 3.00 3.00 3.00
Operating Cash
Flows 0.48 3.90 4.50 4.50 4.50 4.50 2.08

Table 2

Cash flow can be defined as the way of money moves in and out of the business.

Cash inflows mean that it can be reinvested while cash outflows mean that paying out

the money. Cash flow is also a way that been use in making an analysis on the financial

problem which faced by the company.

According to the table above, first we have to determine the amount of cash that

inflow and outflow of the company. In this case, the investment outlay or investment in

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the fixed assets would be spent over the two calendar years, $16 million in year 2007

and the remaining $2 million in year 2008. The business operation begins in year 2008.

Prescott expected that the revenues are $4 million in year 2008 and he expected

shortwood sales reached to $10 million in year 2009 and continue through year 2013.

Prescott estimate that the cost of goods sold (before including depreciation expenses)

would be 75% of revenues. Selling, general and administration (SG&A) would be 5%

of revenues.

In addition, operating savings were estimated $2 million in 2008 and $3.5

million per year thereafter. It takes from the different in the cost of producing

shortwood on site versus buying it on the open market. Then we will get the earnings

before depreciation and taxes (EBDT) by minus revenues with COGS and SG&A and

add with operating costs.

An adjustment for the incremental changes in taxes should be included that

reflect the fact while depreciation is considered an expense from the accounting

perspective which does not involves any cash flows. Although depreciation is not a cash

flow item, but it will affect the cash flow and it lowers profit in which it turns lower

taxes. Depreciation is calculated in a straight line basis over six years with a zero

salvage. Depreciation equal to initial depreciable value divide by depreciable life. It

charges begin in year 2008 when all the $18 million had been spent and machinery was

in service.

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 Next we will get the net operating profits after tax. The net operating profits after

tax is getting from using the earnings before depreciation and taxes minus the

depreciation and tax. The tax rates have been given 40% in the data.

The net working capital (NWC) investment each year is equal to 10% of

incremental revenues for the year. At the end of the investment, in 2013, all the net

working capital would be recoverable. While for the capital investment, only 10% or

$1.8 million (before taxes) would be recoverable. Therefore the terminal value would be

$2.08 million {capital investment (after taxes) $1.08 million [ $1.8 * (1 - 40%) ] plus

the net working capital recoverable $1 million}.

Finally, to compute operating cash flow, we will sum up the net operating profit

after tax, investments in fixed assets, changes in net working capital and depreciation.

6.0 Net Present Value (NPV)

The net present value (NPV) of an investment proposal is a capital-budgeting

decision criterion defined as the present value of the free cash flows after tax less the

project’s initial outlay.

The project’s net present value gives a measurement of the net value of an

investment proposal in terms of today’s dollars. Because all cash flows are discounted

back to the present, comparing the difference between the present value of the annual

free cash flows and the investment outlay is appropriate. The difference between the

present value of the annual free cash flows and initial outlay determines the net value of

accepting the investment proposal in terms of today’s dollars. If the net present value

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(NPV) of a prospective investment is a positive number or equal to zero, the investment

is deemed to be desirable. On the other hand, if the net present value turns out to be a

negative number, then the investment is deemed to be undesirable. This accept-reject

criterion can be stated as:

NPV ≥ 0.0 : Accept

NPV < 0.0 : Reject

There are several advantages of using net present value (NPV) method, because

NPV gives important to the time value of money and given high priority for the

profitability and risk of the projects. Another advantage of the NPV method is that

allows for easy comparisons of potential investments. As long as the NPV of all options

are taken at the same point in time, the investor can compare the magnitude of each

option. When presented with the NPV’s of multiple options, as an investor sure will

choose the option with the highest NPV because it will provide the most additional value

for the firm and consistent with the goal of maximizing the shareholders’ wealth.

There are a number of disadvantages to NPV. The first disadvantage is that NPV

is difficult to use and only accurate as the inputted information. It requires that the

investor know the exact discount rate, the size of each cash flow, and when each cash

flow will occur. Often, this is impossible to determine. Furthermore, the NPV is only

useful for comparing projects at the same time, it does not fully build in opportunity cost

of not having the capital to spend on future investment options. Another issue with

relying on NPV is that it does not provide an overall picture of the gain or loss of

executing a certain project. To see a percentage gain relative to the investments for the

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project, internal rate of return (IRR) or other efficiency measures are used as a

complement to NPV. NPV can be very useful for project appraisals, however if the

project is for something that is not expected gain large profit, it may not be the best

method to use. NPV higher, it shows the project more profitable. Ultimately, each

different project will have to be evaluated carefully before determining whether or not to

use the net present value.

Net present value New Woodyard of Worldwide Paper Company

Net present value (NPV) is a formula used to determine the present value of an

investment by the discounted sum of all cash flows received from the project. The

formula for the discounted sum of all cash flows can written as

C1 C2 CT or NPV  C 
T
Ci
NPV  C0  
1  r 1  r  2
 ... 
1  r  T 0 
i 1 1  r 
i

-C0 = Initial investment

C = Cash Flow

r = Discount Rate

T = Time

In the formula above, -C0 is the initial investment, which is a negative cash flow

showing that money is going out as opposed to coming in. Considering that the money

going out is subtracted from the discounted sum of cash flows coming in, the net present

value need to be positive in order considered a valuable investment

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 In the case of Worldwide Paper Company we performed calculations to decide

whether they should accept a new project or not. First of all, we calculated the NPV by

using the 15% discount rate. Table 3 shows the result computed with outdated cost of

capital gives a negative NPV of $2.14 million. We found that the discount rate of 15% was out

dated and insufficient. Therefore, we recalculate the discount rate.

Required rate of return 15.00%

Year Cash Flow PVIF Present Value of Cash Flow
0 (16.00) 1.0000 (16.00)
1 0.48 0.8696 0.42
2 3.90 0.7561 2.95
3 4.50 0.6575 2.96
4 4.50 0.5718 2.57
5 4.50 0.4972 2.24
6 4.50 0.4323 1.95
7 2.08 0.3759 0.78
NPV (2.14)
Table 3

The new weighted average cost of capital (WACC) that we have been computed

for Worldwide Paper Company is 9.67%. In order to calculate a more accurate NPV for

the project, we decided to use the rate of 9.67% as the required return. From table 4, by

using this new discount rate, we got a positive NPV which is $0.72 million. If Worldwide Paper

Company has more than one project investment, then the firm has comparison with other

available investments. In financial theory, if there is a choice between two mutually exclusive

alternatives, the one yielding the higher NPV should be selected. But in this case, Worldwide

Paper Company just only got New Woodyard project investment, thus, our conclusion is to

accept this project because got a positive NPV, which means that Worldwide Paper Company

can gain profit in this project.

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 Required rate of return 9.67%
Year Cash Flow PVIF Present Value of Cash Flow
0 (16.00) 1.0000 (16.00)
1 0.48 0.9118 0.44
2 3.90 0.8314 3.24
3 4.50 0.7581 3.41
4 4.50 0.6913 3.11
5 4.50 0.6303 2.84
6 4.50 0.5747 2.59
7 2.08 0.5241 1.09
NPV 0.72
Table 4

7.0 Internal Rate of Return (IRR)

The internal rate of return refers to a capital-budgeting decision criterion that

reflects the rate of return a project earns. For computation purposes, the internal rate of

return is defined as the discount rate that equates the present value of the project’s future

cash flows with the project’s initial cash outlay.

n
FCFt
IRR :   IO
t 1 1  IRR  t
FCFt = the annual free cash flow in time period t (this can take on either positive or

negative

value)

IO = the initial cash outlay

n = the project’s expected life

IRR = the project’s internal rate of return

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 The decision criterion is accepted the project if the internal rate of return is

greater than or equal to the required rate of return, because the firm is earning that its

shareholders require. On the other hand, reject the project if the internal rate of return is

less than the required rate of return, because this will decrease the firm’s stock price.

This accept-reject criterion can be stated as:

IRR ≥ required rate of return : Accept

IRR < required rate of return : Reject

There are some advantages and disadvantages by using IRR method. First

advantage is IRR is the perfect use of time value of money theory. Besides that, it is also

a good method of capital budgeting in which all the cash flows are equally important.

Moreover, if IRR is higher than its cut off rate (cost of capital), then it will give

maximum profitability to shareholders. On the other hand, the disadvantage by using

IRR method is IRR requires a complicated calculation that can only be solved through

trial and error or a computer spreadsheet. Also, if just want to choose one of two

projects, IRR may not be the best method to determine which one to choose due to IRR

is not helpful for comparing two mutually exclusive investments.

In this case of Worldwide Paper Company, we have computed the internal rate of

return (IRR) that shown in table below.

Required rate of return 9.67%

Year Cash Flow PVIF Present Value of Cash Flow
0 (16.00) 1.0000 (16.00)
1 0.48 0.9019 0.43
2 3.90 0.8134 3.17
3 4.50 0.7336 3.30

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 4 4.50 0.6616 2.98
5 4.50 0.5967 2.69
6 4.50 0.5382 2.42
7 2.08 0.4854 1.01
NPV 0.00
IRR 10.88%
Table 5

To get the present value of free cash flows each year, we just multiply the cash

flow and the present value interest factor (PVIF). For computing the IRR, we are using

the goal seek function in Microsoft Excel. It is more simple and accurate compare with

using trial and error method. Goal seek ask us to change the value of one cell to make

the value of another cell (called the target cell) equal to specific value. We use the goal

seek to change the required rate of return to set the NPV equal to zero. At last, we are

getting the result which shows that the IRR is 10.88%. The updated WACC is 9.67%, it

shows that the project is fulfill the acceptation criteria in IRR method, because the IRR

of the project is greater than the required rate of return (WACC) of the project. Thus, our

conclusion is to accept this project because compared with the required rate of return,

the IRR is larger. This mean that Worldwide Paper Company is earning more the rate

that its shareholders require, hence, it will give maximum profitability to shareholders.

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8.0 Conclusion and Recommendation
Refer to our problem, there is enough expected benefit to justify the $18 million

capital outlay plus the incremental investment in working capital over the six year life of

the investment based on the analysis of operating cash flow. Other than this, the current

cost of capital which calculates by us is 9.67%.

In a nutshell, we recommend that Worldwide Paper Company should accept the

project based on the following reasons. First of all, we calculate the cost of capital

(WACC) by using the 10- year Treasury bond in order can match with the yield period

which is also 10 years. From the calculation, we get 9.67% for cost of capital which is

lower than the cost of capital done by the Worldwide Paper Company. Secondly, we use

the cost of capital which is 9.67% to calculate the net present value. Using this discount

rate, we get a positive NPV which is $0.72 million. Based on the accept-reject criteria,

we should accept the project when the NPV is greater or equal to zero or in other words

is in positive value. Thus, the company should accept this project because get a positive

value. This also means that Worldwide Paper Company can gain profit in this project.

Last but not least, from the analysis of internal rate of return (IRR), we get 10.88%

which is higher than the require rate of return (WACC) of the project. The spread

between IRR and the required rate of return is 1.21%. That means we can earn extra

more 1.21% as extra revenue. Moreover based on accept- reject criteria, we should

accept the project if the IRR is greater or equal to the required rate of return. Thus, the

company should accept the project.

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