Q1 Calculate the NPV?

Net Present Value measures the net increase or decrease in the value of the firm by the project which is under consideration. It is calculated as all present value of future cash flows minus cost, i.e. NPV=Present value of future cash flows - cost To calculate NPV, we need Initial Investment (Cost) Required rate of return (on which future cash flows will be discounted) Future cash flows

(a) NPV of modernization the existing paper mill would be

Investment = 154,700,000 Required rate of return =12% Cash flow = 20 year annuity of 40,634,680 NPV = Present value of future cash flows - Investment NPV = 303,518,451.5 - 154,700,000 NPV = $148,818,451.5

(b) NPV of building a new paper mill would be

Investment = 618,800,000 Required rate of return =12% Cash flow = 20 year annuity of 107,728,000 NPV = Present value of future cash flows - Investment NPV = 804,668,222.8 - 618,800,000 NPV = $185,868,222.8 This shows that NPV of new facility is higher than that of modernization the existing facility. So, on NPV base, new facility would be better for the firm

Q2 (a) Calculate the IRR of each investment.

IRR is the internal rate of return, it measures the return that an investment can generate over its life. To calculate IRR, we need Investment Future cash flows

Using the financial calculator, we have calculated the IRR IRR of investment for modernization the existing facility is 26.01% IRR of investment for new facility is 16.60%

(b) Calculate the Payback of each

Payback is the time period in which investment is recovered. As both facilities are annuity, so, its payback can be calculated by dividing the investment by yearly cash flow. Payback of investment for modernization the facility 154,700,000/40,634,680 = 3.807 years Payback of investment for new facility 618,800,000/107,728,000 = 5.744 years

On the basis of IRR and payback, modernization the existing facility would be better option as it gives higher IRR and early payback.

Q3 (a) Do the NPV and IRR methods give the same accept/reject signals?
No, NPV favors the new facility whereas IRR favors the modernization the existing facility.

(b) Explain why the NPV and IRR can give divergent signals when evaluating mutually exclusive alternatives.
Mutually exclusive projects are those, whose decision whether acceptance or rejection depends on each other. If one project of mutually exclusive projects is accepted than other would be rejected. There are two possible reasons for divergent signals when evaluating mutually exclusive alternatives:

1. Investment scale difference 2. Cash flows magnitude and timing difference In this case, both investment scale and magnitude of future cash flows are different. So, this would be the difference.

Q4
If we consider 15 year annuity for modernization the existing facility, its payback would not be affected however, its IRR would decrease by about 1% i.e. 25% and NPV would decrease to 122,057,299.1 but still positive. On the basis of this result, it does not matter much whether existing facility would be for 15 years or 20, because cash flows of latter years has little impact on IRR and NPV and may be no affect on payback. So, it is still better than that of new facility option.

Q5
Based on the calculations, modernization the existing facility would be better option because of its early payback, higher IRR and positive NPV (although less than that of new facility). Based on the information in the case, modernization the existing facility would be again better because new facility location is 15 miles away from the existing facility which would increase the employees' expense and this would be unfair with employees and it may decrease their loyalty for company. So, we recommend to modernize the existing facility.

Q6 (a)
Using the financial calculator, the IRR of this incremental expenditure is 13.26%. This is also known as crossover rate. In mutually exclusive alternatives, if the crossover rate is more than required rate then NPV and IRR methods give different results. However, if crossover rate is less than that of required rate then both NPV and IRR methods give same results.

(b)
On the basis of IRR, proposal will be accepted if its IRR is greater than its cost of capital and rejected if its cost of capital is greater than its IRR. If both proposal have greater IRR than their cost of capital, we would select proposal with higher IRR. In most cases NPV and IRR gives same decision rule where projects are independent of each other (non mutually exclusive projects) but some time in case of mutually exclusive projects as told above NPV and IRR methods give divergent results. In that case, it is possible that a project with higher IRR may have lower NPV. As NPV is calculated on required rate of return and tells net increase in value is considered better than IRR.

Q7
Yearly cash flow is calculated by using the following data Modernization the old mill 154700000 360 1200 282.1 455 19860000 40% SL for 20 years Building a new mill 618800000 360 2200 227.5 455 52200000 40% SL for 20 years

Initial Cost Working days per year Tonnage per day Variable cost per ton Price per ton Fixed cost per year Tax rate Depreciation

Constructing the Income statement (Assuming all produced material will be sold out) Modernization Building a the old mill new mill Tonnage per day*price per ton*days per 196560000 360360000 Sales year 141727200 232380000 Less:FC &VC FC + VC*tonnage per day*days per year 54832800 127980000 EBT EBT*40% 21933120 51192000 Less: Tax 32899680 76788000 FreeCashFlow Initial cost/20 7735000 30940000 *Add:Dep NetCash Flow 40634680 107728000 *Depreciation is added back as it is a non cash expense and generated by the project. Calculations

Q8
To answer Q8 (a) & (b), we have to calculate the cash flows for each project. 1st 5year cash flows would be: Modernization the old mill Building a new mill 196560000 360360000 12125000 21260000 121867200 180180000 30940000 123760000 31627800 35160000 12651120 14064000 18976680 21096000 30940000 123760000 49,916,680 144,856,000

Sales Less: F.C.(dep not included) Less: VC Dep (SL 5 years) EBT Less: tax Free Cash Flow Add: Dep Net Cash Flow

Now, the net cash flows for rest of 15 years would be: Modernization the old mill Building a new mill 196560000 360360000 12125000 21260000 121867200 180180000 62567800 158920000 25027120 63568000 37,540,680 95,352,000

Sales Less: F.C.(dep not included) Less: VC EBT Less: tax Net Cash Flow

Required rate of return and Initial investment is given. Using the financial calculator, NPV would be Q8 (a) NPV IRR Modernization the old mill Building a new mill 170,320,703.2 271,877,229.6 29.98% 19.74%

Q8 (b) NPV (dep SL 20 years) NPV (dep SL 5 years) NPV change NPV change %

Modernization the old mill Building a new mill 148,818,451.5 185,868,222.8 170,320,703.2 271,877,229.6 21,502,251.7 86,009,006.8 14.45% 46.32%

The NPV change would be higher in building a new mill, possible reasons would be the magnitude of early and latter cash flows. Latter cash flows experience greater impact of discount rate rather early cash flows. 5 year depreciation makes early cash flows higher.

Q9
The minimum level of annual production below which each proposal would be rejected can be calculated by calculating minimum cash flow required for each proposal throughout its life i.e. 20 years. For that purpose we have to calculate payment (yearly cash flow) by using financial calculator. FV=0, PV=Investment, I=12%, N=20 & compute pmt= yearly cash flow Modernization the old Mill Building a new Mill 20,711,047.27 82,844,189

Yearly Cash Flow

This is the minimum cash flow required for each proposal to be accepted, to calculate minimum average annual production, we will construct an income statement in reverse order as follow. Modernization the old Mill Building a new Mill 20,711,047.27 82,844,189 7735000 30940000 12976047.27 51904189.09 21626745.45 86506981.82 41486745.45 138706981.8 239946.4746 609701.019 67688900.47 138706981.8 109175645.9 277413963.6

Yearly Cash Flow Less depreciation Net Income EBT (NI/0.6) GP (Add FC) Tonnage per year(GP/P-VC) VC per year Sales

Q10 (a)
No, it is not appropriate to judge different proposals on same discount rate because each proposal has its own cost and WACC which is according to its risk. So, in order to evaluate the proposals, we should compare proposal's own WACC with its IRR. If IRR is greater than that of its WACC ( discount rate) Proposal should be accepted otherwise rejected.

(b)
Yes, it is possible that my decision would be change if both projects have different cost of capital. And also it would be easy to decide whether proposal have greater IRR or Cost of capital. If both projects would have higher IRR than their discount rate than I would select project with higher NPV.