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CAPITAL BUDGETING

In December 2019, Bob Prescott, the controller for the BlueRidge Mill, was considering the addition of new on-site long-woodwoodyard. The addition would have two primary benefits: toeliminate the need to purchase short-wood from an outside supplierand create the opportunity to sell short-wood on the open market asa new market for Worldwide Paper Company (WPC). The new woodyardwould allow the Blue Ridge Mill not only to reduce its operatingcosts but also to increase its revenues. The proposed woodyard willutilise new technology that allows tree-length logs, calledlong-wood, to be processed directly, whereas the current processrequired short-wood, which had to be purchased from the ShenandoahMill.

This nearby mill, owned by a competitor, has excess capacitythat allows it to produce more short-wood than it needs for its ownpulp production. The excess is sold to several different mills,including the Blue Ridge Mill. Thus, adding the new long-woodequipment would mean that Prescott would no longer need to use theShenandoah Mill as a short-wood supplier and that the Blue RidgeMill would instead compete with the Shenandoah Mill by selling onthe short-wood market. The question for Prescott was whether theseexpected benefits were enough to justify the $18m capital outlayplus the incremental investment in working capital over thesix-year life of the investment.

Construction would start within a few months, and the investmentoutlay would be spent over two calendar years: $16m in 2020 and theremaining $2m in 2021. When the woodyard begins operating in 2021,it would significantly reduce the operating costs of the mill.These operating savings would come mostly from the difference inthe cost of producing short-wood on-site versus buying it on theopen market and were estimated to be $2m for 2021 and $3.5m peryear thereafter.

Prescott also planned on taking advantage of the excessproduction capacity afforded by the new facility by sellingshort-wood on the open market as soon as possible. For 2021, heexpected to show revenues of approximately $14m, as the facilitycame on-line and began to break into the new market. He expectedshortwood sales to reach $20m in 2022 and continue at the $20mlevel through 2026. Prescott estimated that the cost of goods sold(before including depreciation expense) would be 75%.

In addition to the capital outlay of $18m, the increasedrevenues would necessitate higher levels of inventories andaccounts receivable. Therefore the amount of working capitalinvestment each year would equal 15% of incremental sales for theyear. At the end of the life of the equipment, in 2026, all thenetworking capital on the books would be recoverable at costfully.

Taxes would be paid at a 30% rate, and the equipmentdepreciation is to be calculated on a straight-line basis over thesix-year life to zero balance. However, the new equipment isestimated to have a salvage value (scrap value) of $3m at the endof its life. WPC’s accountants have told Prescott that depreciationcharges could not begin until 2021, when all the $18m had beenspent and the equipment is in service.

WPC has a company policy to use 15% as the hurdle rate for suchinvestment opportunities. The hurdle rate is based on the study ofthe company’s cost of capital conducted 5 years ago.

Required:

1. Prepare cash flow statement/s and compute the NPV and IRR ofthe proposed project. Comment on the feasibility of theproject.

2. Outline reasons why Prescott may be uneasy using the 15%hurdle rate for a discount rate.