Worldwide Paper Company Case Study

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flows. Students should recognize that adding an inflation effect should have been part of the base-case analysis. Leaving inflation out of the cash flows creates an inconsistency in the analysis of using a nominal WACC to value real cash flows. Because inflation is “automatically” in the discount rate, it should also be included in the cash flows. As time permits, the instructor may want to discuss a host of other sensitivity questions such as the impact of a change in inflation, a change in net working capital requirement, salvage values, and so on. Students should get the message that a good analyst recognizes that cash flows and discount rates are estimates and a careful analysis requires understanding which estimates are the most critical to the final outcome.

Case Analysis

Cash flows

Discussion question 1

Exhibit TN1 presents the itemized cash flows. I strongly recommend that the instructor fill in the various cash flows by asking successive students to present a cash flow to be recorded on the board. It will likely take two boards of line items to capture all the items listed in Exhibit TN1. The instructor may want to put the investment outlays on the first board and the rest of the cash flows on the second board. Students should be asked to fully explain the timing and amount of each cash flow and why it is relevant to the decision. The relevance of most cash flows is apparent, but students need to be reminded constantly that only the incremental cash flows should be considered in a capital-investment analysis.

Starting with the capital-investment outlays, we see that the capital outlay is relatively straightforward as a 2007 expenditure of $16 million and a $2 million outlay in 2008. Determining how to represent the timing of these cash flows, however, is often challenging for most students. The instructor should use the case scenario to illustrate the importance and convenience of the end-of-the-year cash-flow convention. In truth, the $16 million outlay will occur throughout calendar year 2007, and the remaining $2 million will occur in the first couple of months of 2008. The challenge is how to represent these cash flows appropriately for purposes of a DCF analysis. There is a compelling argument for selecting the midpoint of each year as the “collection point” for that year’s cash flows. This approach, however, leads to a somewhat inconvenient “half-year” discounting, with the first cash flow discounted half a year, the next cash flow discounted 1.5 years, and so on.

The end-of-the-year convention simply assumes that all cash flows occur at one-year intervals. Typically, we assume that the first outlay occurs “today,” with the next year of cash flows occurring one year from today. Importantly, such an assumption does not alter the IRR calculation, which depends only on the relative placement of cash flows. Moreover, the NPV of a project is reduced or increased only by the cost of capital for half a year, one way or the other, by assuming, for example, an end-of-the-year rather than the more accurate half-year convention. The NPV will be slightly higher or lower, but the cash-flow convention will not change a positive NPV into a negative one (or vice versa), and so the go/no-go information provided by NPV is not compromised. Thus, for the rest of my analysis, I compute NPV as of the end of 2007, assuming the first cash flow of −$16 million occurs exactly at that point in time.

Students often either ignore or incorrectly compute net working capital (NWC). Because NWC keys off sales, it is best to do revenues before filling in working-capital outlays. The case states that revenues will begin at $4 million for 2003 and grow to a constant $10 million over the next five years. Because NWC is 10% of sales, it is instructive to show NWC for each year and then convert it into cash flow by differencing each year, as shown in Table 1:

Table 1. Annual NWC.

2007 2008 2009 2010 2011 2012 2013

Sales revenue 0 4,000 10,000 10,000 10,000 10,000 10,000

NWC (10% of sales) 0 400 1,000 1,000 1,000 1,000 1,000

NWC = Cash flow 0 400 600 0 0 0 0

It is important for students to understand why the change in NWC and not NWC itself is a cash flow to the company. This point can be driven home with any number of simple examples. Accounts receivable and inventory afford the easiest examples, including reducing receivables amounts to collecting from customers, which clearly converts the receivables balance into cash for the company. Conversely, if the company chooses not to collect, receivables rise and represent a conversion of cash into a receivables balance. This is just as much a use of cash as buying longwood equipment, except that it is not depreciable and has less obvious long-term benefits. Extending credit is likely to be a competitive response as a way to price-compete, but carrying receivables beyond what is necessary to compete should be analyzed like any other cash flow.

The remainder of Exhibit TN1 presents the operating cash flows. Revenues, cost of goods sold (COGS), and selling, general, and administrative (SG&A) are straightforward entries. The operating savings, however, may be a difficult item for students to handle. They sometimes find it perplexing that WPC appears to be saving relatively more in 2008 ($2.0 million) than in subsequent years ($3.5 million). After all, sales are only $4 million in 2008, compared with $10 million thereafter, which makes $2.0 million appear too high for 2008. The key insight for understanding the cost-savings component is that it is not necessarily tied to the production of shortwood that is sold externally. Rather, the operating savings relate to the cost reductions for the wood used internally in the production of the mill’s pulp. Prescott is apparently assuming that he will devote more production capacity in the first year to internal needs than he will in subsequent years, which is entirely plausible.

Depreciation is computed as straight line over the six-year life, and taxes are 40% of the taxable income. The treatment of depreciation to arrive at an after-tax cash flow is an important item for students to understand fully. I always prefer to subtract the depreciation expense from taxable income just as it would be done on an income statement. To arrive at cash flow, however, the depreciation expense must be added back to the net operating profit