Bob Prescott, the comptroller for the Blue Ridge Mill, was weighing the pros and cons of adding 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 purchases shortwood from the Shenandoah Mill, which is a direct competitor. If Blue Ridge Mill decides to utilize longwood woodyard then the company would decrease its WACC from 15% to 9.77%. Blue Ridge Mill can then make better investment decisions with a lower WACC. The new woodyard would begin in 2008 where an investment outlay of $18 million would be spent over calendar years 2007 and 2008.
Before making a capital budget decision we must ignore any sunk costs and include both opportunity costs and side effects. Capital budgeting must be done on an incremental basis and Worldwide Paper Company did not have any sunk costs. In order to analyze the capital budgeting process for this case, I took Sales Revenue and found the difference from operating expenses and cash flows to get operating cash flows. It is imperative to calculate the Net Present Value for this project before making any sort of capital budgeting decision. When calculating the Net Present Value, we used the WACC rate of 9.77% and came up with NPV of $720,000. The initial conclusion is to accept this project as long as everything stays the same, and that they should evaluate themselves yearly as things may change. Blue Ridge Mill should take into account the depreciation expense per year when making an educated capital budgeting decision.
Depreciation generated cash flows should be included in this project for many reasons. The depreciated generated cash flow gives us a better understanding of the financial breakdown of the project and tells the investor whether or not it is a good investment. The depreciation expense is consistently $3 million from 2008 to 2013 because the straight-line depreciation has zero salvage value. Also, depreciated generated cash flows help us determine the non-operating or terminal cash flow for this project and purchase of longwood woodyard. In 2007 there wasn’t any depreciation charges because Worldwide Paper Company wanted to get a good grasp on how inflation would affect Prescott’s analysis. Depreciation charges did not begin until 2008 where all of the $18 million was spent and the machinery was working correctly.
The beta is 1.1 and the bond rating for this project is A which tells us that this project looks like it has minimal risk from the outside. In order to adjust for project risks one can increase the required rate of return discount factor for the projects cash flow. This will essentially reduce the value of future cash flows. If Prescott is believes that there is a risk that future payments will not be paid then he can reduce cash flows from an expected loss percentage. If WPC believes the project is going to be delayed before launch then they can delay cash flow payments for a year. Another way WPC can adjust for risks by subtracting the start up costs from the projects estimated Net Present Value. Lastly, WPC can adjust for project risks by generating cash reserves in case there are hidden costs within the project. Project risks are very hard to predict but every investor should always try to account for them.
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