Corporate Financial Management

| February 25, 2015

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1. Assignment 2: Individual/Team Project
Assignment 2 may either be completed individually or in teams of two. This Assignment 2 must be submitted to your Programme Manager in hard copy and

also via Blackboard. See Grade Descriptors on page 24.
Case Study: Larry Paper Company (LPC)
This case study is taken from Robert, F., Kenneth, M. and Michael, J. (2010), Case Studies in Finance: Managing for Corporate Value Creation,

McGraw-Hill Education, ISBN 9780071267526.
In December 2006, Bob Lim, the controller for the Blue River Mill (BRM), was considering the addition of a new on-site longwood woodyard. The addition would have two primary benefits: (1) eliminate the need to purchase shortwood from an outside supplier and (2) create the opportunity to sell

shortwood on the open market as a new market for Larry Paper Company (LPC). Thus, the new woodyard would allow the BRM not only to reduce its operating costs, but also to increase its revenues. The proposed woodyard utilised new technology that allowed tree-length logs, called longwood, to be processed directly, whereas the current process required shortwood, which had to be purchased from a nearby mill. The Shenton Mill, which was owned by a competitor, had excess capacity that allowed it to produce more shortwood than needed for its own pulp production and to sell the excess production to several different mills, including the BRM. Thus, adding the new longwood equipment would mean that Bob would no longer need to use the Shenton Mill as a shortwood supplier and that the BRM would instead compete with the Shenton Mill by selling on the shortwood market. The question for Bob was whether these expected benefits were enough to justify the $18-million capital outlay plus the incremental investment in working capital over the six- year life of the investment.

Construction would start within a few months, and the investment outlay would be spent over two calendar years: $16 million in 2007 and the remaining $2

million in 2008. When the new woodyard began operating in 2008, it would significantly reduce the operating costs of the mill. These operating savings

would come mostly from the difference in the cost of producing shortwood on-site versus buying it on the open market, and were estimated to be $2.0

million for 2008 and $3.5 million per year thereafter. Bob also planned on taking advantage of the excess production capacity by selling shortwood on the

open market as soon as possible. For 2008, he expected to show revenues of approximately $4 million as the facility came on-line and began to break into

the new market. He expected shortwood sales to reach $10 million in 2009 and continue at the $10 million level through 2013. Bob estimated that the cost

of goods sold (before including deprecation expenses) would be 75% of revenues and SG&A would be 5% of revenues.
In addition to the capital outlay of $18 million, the increased revenues would necessitate higher levels of inventories and accounts receivable. The total net

working capital (NWC) would average 10% of annual revenues. Therefore, the amount of NWC investment each year would equal 10% of incremental

sales for the year. At the end of the life of the equipment, in 2013, all the net working capital would be recoverable, whereas only 10%, or $1.8 million

(before taxes), of the capital investment would be recoverable.
Taxes would be paid at a 40% rate, and depreciation was calculated on a straight- line basis over the six-year life, with zero salvage. LPC accountants had told Bob that depreciation charges could not begin until 2008, when all the $18 million had been spent and machinery was in service. Because he did not
have a good feel for how inflation would affect his analysis, Bob had decided not to include it.
LPC had a company policy to use its corporate cost of capital (15%) to analyse such investment opportunities. Unfortunately, the company had not
changed its cost of capital for 10 years, and Bob felt uneasy using an out-dated figure. He was particularly uncomfortable with the 15% figure because it
was computed when 30-year Treasury bonds were yielding 10%, whereas they were currently yielding less than 5%. To estimate LPC�s current weighted
average cost of capital, Bob had gathered the information presented in figure 1.
Exhibit 1 Cost of Capital Information
Interest Rates: December 2006
Bank loan rates (LIBOR) Market risk premium
1-year 5.38% Historical average 6.00%
Government bonds Corporate bonds (10-year maturities)
1-year 4.96% Aaa 5.37%
5-year 4.57% Aa 5.53%
10-year 4.60% A 5.78%
30-year 4.73% Baa 6.25%
Larry Paper Company Financial Data
Balance-sheet accounts ($ millions)
Bank loan payable (LIBOR + 1%) 500
Long-term debt 2,500
Common equity 500
Retained earnings 2,000
Per-share data
Shares outstanding (millions) 500
Book value per share $5.00
Recent market value per share $24.00
Bond rating A
Beta 1.10
Tax rate 40%
Assume you are an external consultant engaged by Larry Paper Company (LPC) to evaluate the proposed project. You are required to write a project
report (maximum 2,000 words) to discuss and analyse the following key issues:
(a) What is the nature of the investment that is under consideration and what are the sources of value?
(b) What discount rate should Larry Paper Company (LPC) use to analyse those cash flows? Justify your recommended rate and the assumptions that you
used to estimate it.
(c) Calculate the net present value (NPV) and internal rate of return (IRR) for the investment. How do you interpret these numbers?
(d) Should Larry Paper Company (LPC) invest in the project? On what basis did you make your investment decision?
(e) Conduct a sensitivity analysis of the key value drivers and interpret your results. Although it is not explicitly stated in the case, it appears that the costs and revenues are stated in current-dollar terms, which is to say that they are not adjusted for inflation.
Your report should:
� Have a table of contents, introduction, main body & conclusion. (No executive summary is needed).
� Show the details of the calculations in the appendix.
� Within the body of your report, analyse the key figures calculated in your appendix.
� Please include a bibliography if you use any other references other than your textbook and the study guide.
Assessment of your assignment will take into account:
� Relevance of your answer to the questions set.
� Clarity of expression.
� Supporting documentation for arguments: for example presenting your calculations in your appendix and then citing and discussing key figures in your

� Logical planning and sequence.
� Comprehensive coverage.
Also, marks will be allocated for presenting your report professionally including:
� The use of logical headings and sub headings that are numbered and also referenced through a table of contents.
� The overall presentation, including correct grammar, spelling and punctuation.
This project requires the students to apply the capital budgeting techniques in decision-making.
The aim of the Assignment Two is to assess the student�s ability to meet all module learning outcomes detailed in part two. Strong analytical skills are
required to complete this task.
This Assignment 2 must be submitted to your Programme Manager in hard copy also via Blackboard. See the deadline in table 2B. It is the student�s
responsibility to retain a copy of any submitted assessment/project work. Please read the Grade Descriptors in the Assignment Two Grade Descriptor table.

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