Executive Summary:

Blue Ridge Mill is a wood factory owned by Worldwide Paper Company and supplies wood mush for the company for usage in paper production. Blue Ridge Mill bought its wood supply from Shenandoah Mill’s extra production of shortwood that was processed from its longwood supplies. In 2006. Bob Prescott. the accountant for Blue Ridge Mill. was sing a undertaking that would give Blue Ridge Mill the capableness to treat longwood into shortwood. which would extinguish the demand to buy from Shenandoah Mill. every bit good as compete with Shenandoah Mill in the shortwood market.

Undertaking Overview:

The undertaking would supply Blue Ridge Mill with a new longwood pace. giving the factory the ability to bring forth shortwood. a needed input for paper production. from longwood. The undertaking would besides merchandise extra shortwood that would let Blue Ridge Mill to sell shortwood as an extra gross beginning. viing with their current shortwood provider. Construction for undertaking would get down in 2007 and production would get down in 2008. The undertaking will be $ 18 million. with $ 16 million in 2007 and an extra $ 2 million in 2008. The $ 18 million investing will be depreciated utilizing the straight-line method for six old ages and a nothing salvage value. Although. the equipment is believed to be able to be sold at the terminal of the undertaking for $ 1. 8 million.

The chief intent of the undertaking is to salvage on operational costs by bring forthing shortwood. The cost nest eggs is estimated to be $ 2 million in the first twelvemonth and $ 3. 5 million in the undermentioned five old ages. In add-on. the longwood pace would supply adequate capacity to let Blue Ridge Mill to sell shortwood on the market. Bob Prescott confidently estimates that shortwood gross revenues in 2008 will be $ 4 million. and will increase to $ 10 million in the staying five old ages. There are besides disbursals from the new shortwood gross revenues every bit good as revenue enhancement disbursals.

Cost of goods sold ( COGS ) is estimated to be 75 % of the new shortwood gross. In add-on. Gross saless. General and Administration ( SG & A ; A ) disbursals are estimated at 5 % of the extra gross. Blue Ridge Mill will besides necessitate to put working capital as gross revenues addition. The extra on the job capital required is estimated at 10 % of the alteration in grosss from the old twelvemonth. However. the investing in working capital is to the full recovered at the terminal of the undertaking. Finally. the income revenue enhancement rate for the company is 40 % of net incomes. Table 1 below shows all of the incremental hard currency flows as a consequence of this undertaking.

Table 1: Longwood Yard Project Free Cash Flows
Discount Rate:

The internal rate of return ( IRR ) from the free hard currency flows of the undertaking based on the estimations given by Bob Prescott is 11. 30 % . which is lower than the company’s published hurdle rate of 15 % . However. that hurdle rate was calculated 10 old ages ago when the 30 twelvemonth Treasury Bond was about 10 % . more than dual current involvement rates ( see table 2 below ) . Therefore. it is recommended that a leaden mean return rate ( WACC ) be calculated and used as that hurdle rate. In order to cipher the WACC. the cost of debt and the cost of equity must be calculated foremost based on the information provided by the instance. The involvement rates and market hazard premium are found in Table 2. and the company’s balance informations. bond evaluation. Beta. and revenue enhancement rate are found in Table 3. It is assumed that the debt and equity listed in Table 3 represents all of the debt and equity for the company.

The cost of debt is the leaden mean cost of each debt held by the company. Table shows two debts to include: a bank loan collectible at 6. 38 % ( LIBOR + 1 % ) and Long Term debt. LIBOR is a floating involvement rate that changes daily. However. since the bank loan is merely a little part of the entire debt. the drifting LIBOR will be ignored and treated as a fixed LIBOR. Since the company has a Bond Rate of A. the company’s long term debt is at 5. 78 % . As a consequence. the cost of debt is 5. 88 % and is calculated as follows:

The cost of equity can be calculated by utilizing the capital plus pricing theoretical account ( CAPM ) . CAPM requires that a market hazard free rate. the market hazard premium. and the beta for the company. The market hazard premium ( 6 % ) and the company beta ( 1. 1 ) is given straight and can be seen in tabular arraies 2 and 3 below. Government bonds are used for the hazard free rate. Since 10 twelvemonth corporate bonds are used for the cost of debt. the 10 twelvemonth Treasury Bond of 5. 60 % will be selected as the hazard free rate. The 10 twelvemonth bonds are besides a good lucifer for the undertaking continuance. which is between 5 and 10 old ages. The cost of equity of 11. 20 % is than calculated as follows:

With the cost of debt and the cost of equity calculated. the WACC is calculated below. The cost of debt is farther discounted by one minus the revenue enhancement rate since the involvement paid on debt is treated as an disbursal prior to being taxed.

Table 2: Interest Rates December 2006

Table 3: Company Financial Information

Using the deliberate WACC and the company’s hurdle rate for this undertaking. under Bob Prescott’s cost nest eggs and extra grosss premise. the project’s IRR is now greater than the hurdle rate. Furthermore. the net nowadays value ( NPV ) . payback period and the extra value added to the net incomes per portion ( EPS ) are shown in Table 4 below. Using merely these figures. the undertaking should be accepted. However. anterior to doing that determination. the basal premises should be examined closer.

Table 4: Undertaking Performance

Sensitivity Analysis:

Gross saless demand for the surplus produced shortwood and the nest eggs in operations costs due to the undertaking were both estimations and may non fit the existent values in the old ages to come. These two values where adjusted to execute a sensitiveness analysis on how these alterations influence the NPV. Table 4 shows the consequence of the sensitiveness analysis. The Gross saless Demand is represented in the first column and ranges from $ 0 to $ 12 million. Valuess from $ 0 to $ 4 million are used for all six old ages. For values greater than $ 4 million. $ 4 million is used for the first twelvemonth. and the larger figure is used for the staying five old ages. Operation nest eggs is shown as per centums across the top row. These represent per centum alterations to the sum estimated in the base instance. For illustration. -10 % means that alternatively of a nest eggs of $ 2 million in the first twelvemonth and $ 3. 5 million in the staying old ages. the accomplished nest eggs are $ 1. 8 million in the first twelvemonth and $ 3. 15 million in the staying old ages. Positive per centums mean that nest eggs were greater than the expected sum.

Table 4 shows the end product of the sensitiveness analysis in NPV ( in 1000000s ) . The negative values are filled with a light ruddy. The positive NPVs that are less than the base instance are filled in light green. the base instance is green. than NPVs greater than the base instance are dark green. The tabular array shows that if operations nest eggs are as expected ( 0 % alteration ) than the gross revenues would hold to be 60 % less than expected before the undertaking becomes a negative NPV undertaking.

If operations nest eggs are 10 % less than expected. than new gross revenues with have to be 40 % less. Presumably. Bob Prescott has really good informations on the operations nest eggs and the existent is within 10 % of the estimated. than the gross revenues informations can be off every bit much as 40 % before this becomes a negative undertaking. However. because there are possible negative values in the sensitiveness analysis ( particularly at $ 4 million in gross revenues ) . there is still risk in holding a negative NPV undertaking.

A coveted piece of information that would be utile in this determination would be to cipher expect values for operations nest eggs and gross revenues demand. Table 5 show an illustration of utilizing possible results and their chances to cipher the expected values. To do the illustration complete. the expect values where inputted into the theoretical account and undertaking public presentation is shown as portion of Table 5.

Table 4: Sensitivity Analysis Table – Various Additional Shortwood Revenues vs. per centum alterations to operation nest eggs with ensuing NPV

Table 5: Example of ciphering expected values for gross revenues and nest eggs. along with the public presentation outputs with the expected values

Other Hazards:

To do a concluding determination on whether to accept the longwood pace undertaking. other hazards can be considered. Particularly. what are the hazards if the undertaking is non accepted? One hazard flexible joints on the fact that Blue Ridge Mills will still be depended on Shenandoah Mill for the supply of shortwood. There are two hazards. First. there is a supply deficit hazard. Shenandoah may happen other ways to utilize their shortwood. which would cut down the extra sum they use for gross revenues. If Blue Ridge Mills does non have adequate supplies. than they will non be able to supply the company with the volume required. which could cut down the sum of paper production. ensuing in a loss of gross revenues. Another hazard with Shenandoah Mill is the hazard of shortwood monetary value additions. This could go on if another consumer of shortwood enters the market. If shortwood monetary values addition. net income borders for Worldwide Paper will diminish.

Another hazard to see is the paper industry market. If Worldwide Paper Company’s paper gross revenues volume diminutions. Blue Ridge Mill’s production will necessitate to decelerate down every bit good. This is because they merely supply one merchandise to one client. Worldwide Paper. The longwood pace undertaking would assist Blue Ridge Mill diversify and cut down that hazard.

Both of these hazards could be quantified and added to the model’s sensitiveness analysis if more fiscal information and shortwood market informations where available. This could be done by ciphering the expected values of the impact of shortwood supply deficits and diminutions in the paper market. These expected values would so be added as an addition in one-year undertaking value. increasing the undertaking hard currency flows through the life of the undertaking. As a consequence. the sensitiveness analysis would demo that the undertaking will supply positive NPV through greater decreases of the operations nest eggs and new shortwood grosss than what is shown on table 4. giving a stronger instance for credence.

Decision:

Although the initial response would hold been to reject the undertaking based off of the undertaking non run intoing the company’s published 15 % hurdle rate. measuring the 10 twelvemonth old hurdle rate reveals that this rate is about 8 % excessively high based on 2006 Treasury Bond rates. Using the updated hurdle rate of 7 % . the undertaking does excel this rate with an 11. 2 % IRR and provides Blue Ridge Mill with a $ 2. 64 million NPV return on the undertaking investing.

Preforming a sensitiveness analysis on the estimated nest eggs and extra grosss of the undertaking shows that the project’s rate of return remains above the 7 % hurdle rate for most of the sensible decreases in those input variables. Sing the hazards of Blue Ridge Mill’s shortwood supply of either addition in monetary values or supply deficits adds farther value to the undertaking. Another hazard that adds value to the undertaking is the variegation the undertaking creates. which could function to protect Blue Ridge Mill from downswings in the paper market. As a consequence. Worldwide Paper Company should accept the longwood pace building undertaking at Blue Ridge Mill.