James River Paper is considering to build a new lumber plant that uses some rece
ID: 2778990 • Letter: J
Question
James River Paper is considering to build a new lumber plant that uses some recently developed technology that will greatly reduce production costs. James River must buy land for the plant and construct it. You have been employed as a consultant for James River’s VP of Finance to help with this decision. You estimate that the acquisition cost of the land is $10 million, assuming that you acquire the required land immediately. Construction of the factory building and installation of the equipment is expected to take two years and cost $35,000,000 (payable $15 million today, and $10 million at each of year 1 and 2). The cost of the buildings and equipment will be depreciated on a straight-line basis over 20 years. The plant starts to operate and generate sales revenue from year 3. Depreciation will also begin in year 3. Estimated annual sales are 15,000,000 square feet of lumber in each of the first ten years the plant operates. You expect that the quantity produced will decline by 3% per year beginning in the eleventh year of operation. The price of lumber today is $13.65/sq. foot. James River faces a 35% marginal tax rate. The engineering staff has provided you with some preliminary cost estimates for the project. Fixed costs to run the plant for one year will be $25,000,000 when the plant starts operation. According to the engineers, additional estimated costs of production are expected to be $14 per square foot once the plant is operating – $12.75 of this cost is actually incremental to firm, and $1.25 of this estimate is allocated overhead (i.e., costs that would be incurred by James River regardless of whether the new plant is built but which have been assigned to the proposed new plant). In addition, James River spent $3 million over the past year fine tuning the new technology after it bought the domestic rights to the technology from a Dutch firm two years ago for $1 million. Prices in the economy are expected to increase at 3.5% per year indefinitely. This figure affects output prices, variable input costs, and the fixed costs of operating the plant. Fixed costs are independent of the level of output but are not constant across time. At the end of year 2, accounts payable for James River is expected to increase by $2 million, and inventory is expected to increase by $4 million. These additional amounts will allow James River to begin operation of the plant during year 3. Once the project begins full scale operations, net working capital (cash balance + accounts receivable + inventory – accounts payable and other payables) is expected to have a stable relationship with yearly sales that call for net working capital to be 4% of sales in each year. James River expects to recover the remaining working capital at the end of the project in the year after operation ceases. Additional capital expenditures of $5 million will be necessary in the 5th, 10th, and 15th years of operation for this project ($5 million in each of these three years). This additional capital expenditure will be depreciated on a 5-year straight-line basis. Deprecia¬tion for these assets will begin in the first year after the expenditures. While the value of the land and buildings at the end of the project’s life is highly uncertain, the VP of Finance expects that the value should be at least the original $10 million invested in the land adjusted for inflation over the life of the project. Assume sale of the project will occur in the year after the last year of operation. The required return for this project is 9%.
Prepare a project analysis for the Vice President of Finance of James River Paper under the above instructions. Calculate the NPV and internal rate of return. What is your recommendation for this project? Discuss.
Explanation / Answer
Calculation of Total Cash Flows of the project year Land machinery Technology Inc in WC Addl Capex Op Cash Flow Recovery of WC Salvage Value Total Cash Flows Disc Factor Disc Flows 0 -10000000 -15000000 -4000000 -29000000 1 -29000000 1 -10000000 -10000000 1.09 -10900000 2 -10000000 -6000000 -16000000 1.1881 -19009600 3 -2773333 -15666681 -18440014 1.295029 -23880352.89 4 -307067 -15558765 -15865832 1.41158161 -22395916.31 5 -317814 -5000000 -15447072 -20764886 1.538623955 -31949350.79 6 -328937 -15331469 -15660407 1.677100111 -26264070.07 7 -340450 -15211821 -15552271 1.828039121 -28430159.98 8 -352366 -15087985 -15440351 1.992562642 -30765865.75 9 -364699 -14959814 -15324513 2.171893279 -33283206.48 10 -377463 -5000000 -14827157 -20204621 2.367363675 -47831685.35 11 -390675 -14689858 -15080533 2.580426405 -38914204.35 12 -404348 -14547753 -14952101 2.812664782 -42055248.38 13 -47231 -15026603 -15073834 3.065804612 -46213429.74 14 -47417 -15563470 -15610887 3.341727027 -52167323.97 15 -47605 -5000000 -16159306 -21206910 3.64248246 -77245798.17 16 -47793 -16815128 -16862921 3.970305881 -66950954.67 17 -47981 -17532025 -17580006 4.32763341 -76079822.57 18 -48171 -18311150 -18359321 4.717120417 -86603128.22 19 -48361 -19153730 -19202091 5.141661255 -98730648.16 20 -20061062 12340263 10000000 2279201 5.604410768 12773578.22 Discount rate = 9% Net Present Value -875897188 As the NPV is negative and also the operating cash flows are negative throughout the life of the project, the project is not acceptable Calculation of operating Cash Flow year Sales in units Sales Price Addl Cost Alocated Cost Sales Value Addl Cost Allocated Fixed Costs Depreciation EBT Tax Net Income Operating Flow 3 15000000 14.62 12.75 1.25 219333319 191250000 18750000 25000000 2058824 -17725505 0 -17725505 -15666681 4 15000000 15.13 13.20 1.25 227009985 197943750 18750000 25875000 2058824 -17617589 0 -17617589 -15558765 5 15000000 15.66 13.66 1.25 234955334 204871781 18750000 26780625 2058824 -17505895 0 -17505895 -15447072 6 15000000 16.21 14.14 1.25 243178771 212042294 18750000 27717947 3058824 -18390293 0 -18390293 -15331469 7 15000000 16.78 14.63 1.25 251690028 219463774 18750000 28688075 3058824 -18270644 0 -18270644 -15211821 8 15000000 17.37 15.14 1.25 260499179 227145006 18750000 29692158 3058824 -18146808 0 -18146808 -15087985 9 15000000 17.97 15.67 1.25 269616650 235095081 18750000 30731383 3058824 -18018638 0 -18018638 -14959814 10 15000000 18.60 16.22 1.25 279053233 243323409 18750000 31806982 3058824 -17885981 0 -17885981 -14827157 11 15000000 19.25 16.79 1.25 288820096 251839728 18750000 32920226 3058824 -17748682 0 -17748682 -14689858 12 15000000 19.93 17.38 1.25 298928800 260654119 18750000 34072434 3058824 -17606577 0 -17606577 -14547753 13 14550000 20.63 17.99 1.25 300109568 261683703 18187500 35264969 3058824 -18085427 0 -18085427 -15026603 14 14113500 21.35 18.61 1.25 301295001 262717353 17641875 36499243 3058824 -18622294 0 -18622294 -15563470 15 13690095 22.10 19.27 1.25 302485116 263755087 17112619 37776716 3058824 -19218129 0 -19218129 -16159306 16 13279392 22.87 19.94 1.25 303679933 264796919 16599240 39098902 3058824 -19873952 0 -19873952 -16815128 17 12881010 23.67 20.64 1.25 304879468 265842867 16101263 40467363 3058824 -20590848 0 -20590848 -17532025 18 12494580 24.50 21.36 1.25 306083742 266892946 15618225 41883721 3058824 -21369974 0 -21369974 -18311150 19 12119743 25.35 22.11 1.25 307292773 267947174 15149678 43349651 3058824 -22212553 0 -22212553 -19153730 20 11756150 26.24 22.88 1.25 308506579 269005565 14695188 44866889 3058824 -23119886 0 -23119886 -20061062 Change in working Capital year Sales WC (4% of Sale) change 2 60,00,000 3 219333319 8773333 2773333 4 227009985 9080399 307067 5 234955334 9398213 317814 6 243178771 9727151 328937 7 251690028 10067601 340450 8 260499179 10419967 352366 9 269616650 10784666 364699 10 279053233 11162129 377463 11 288820096 11552804 390675 12 298928800 11957152 404348 13 300109568 12004383 47231 14 301295001 12051800 47417 15 302485116 12099405 47605 16 303679933 12147197 47793 17 304879468 12195179 47981 18 306083742 12243350 48171 19 307292773 12291711 48361 20 308506579 12340263 Cost of equipment & Buildings 35000000 Depreciation 2058823.529 Esitmated Annual Sale 150,00,000 square feet for 10 years Rate of decline from 11th year 3% Fixed Costs 25000000 Sales Price today 13.65 Sales Price after 2 years 14.62 Additional Estimated Cost 12.75 Allocated Overhead 1.25 growth rate of prices 3.50% 0.035 Technology cost 1000000 Fine tuing of technology 3000000 Total Technology cost 4000000 Increase in accounts payable 2000000 increase in inventory 4000000 Increase in WC endof year 2 6000000 Networking capital (year 3 onwards) =4% 0.04 of sales Additional Capex 5000000 in 5th, 10th and 15th year Depreciation on Additional Capex 1000000 Salvage Value 10000000
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