Worldwide Paper Company Case Study

WORLDWIDE PAPER COMPANY

Teaching Note

Synopsis and Objectives

Suggested complementary case about capital investment decisions: “The Investment Detective” (UVA-F-0813).

The case is based on an actual investment decision made by a major paper-products company in the 1990s. The numbers and the company name have been disguised at the request of the company. The dates have been revised for pedagogical reasons. The case provides a glimpse into the paper business but is primarily designed to present a straightforward problem in assessing cash flows, cost of capital, and net present value of a capital-investment decision. The case works well for all audiences who are learning the basics of discounted cash flow and investment analysis. I have used it successfully with executives as an in-class exercise following introductory classes on cash flows, discounted cash flow, and cost of capital. I encourage participants to work in groups of two or three to bring together the concepts of the earlier classes in this simple but comprehensive, capital-investment example.

The case touches on the following capital-investment topics:

• Estimation of relevant cash flows (both cost savings and increased revenues)

• Influence of taxes vis-à-vis cost savings and revenues

• Change in net working capital as a cash flow

• Component costs of capital as determined by current market conditions

• Weighted average cost of capital (WACC) as the discount rate for the average investment

Suggested Questions for Advance Assignment to Students

1. What yearly cash flows are relevant for this investment decision? Do not forget the effect of taxes and the initial investment amount.

2. What discount rate should Worldwide Paper Company (WPC) use to analyze those cash flows? Be prepared to justify your recommended rate and the assumptions that you used to estimate it.

3. What is the net present value (NPV) and internal rate of return (IRR) for the investment?

Supporting Spreadsheet Files

For instructors: UVA-F-1372TNX

Please do not share the instructor’s file with students.

Hypothetical Teaching Plan

The following questions form a teaching plan for one 85-minute class.

1. What is the nature of the investment that is under consideration, and what are the sources of value (cost savings and revenue increases)? (10 minutes)

Before jumping into the numbers, it is helpful to ask a student to explain the nature of the investment that is under consideration by WPC. With the ensuing discussion, the nature of the manufacturing operation will become clearer, as will the fact that this is an important and common type of opportunity for a heavy-manufacturing company. Most such investments are cost reductions, with little, if any, impact on revenues. After all, in a high-fixed-cost industry, the company that achieves the highest capacity utilization and the lowest variable cost will have the best return on investment. The paper industry has a long history of over- and undercapacity periods and highly variable pulp prices. It is difficult to earn the cost of capital in the business so that wise use of technology and cost-reducing investments can give a company an edge for a period of time.

It is important that the discussion include the fact that the investment is expected to increase WPC’s revenues because of the new market for selling shortwood. Moreover, students might speculate that the current practice of purchasing shortwood externally might be a significant source of risk for WPC, so that the investment may have the added advantage of reducing cost variation for the company. Thus, students will begin to think in terms of identifying the relevant cash flows as well as considering risk as another dimension of investment decisions. The risk dimension is not quantifiable, however, and, ultimately, will not be directly considered in the analysis that follows. But its value could be the determining factor if the NPV were close to zero.

2. Itemize the cash flows for each of the six years of the investment. (30 minutes)

Most of the students’ preparation time will have been spent developing these numbers. The instructor should expect to devote time as needed to each line item of cash flows. Depending on the experience level of the class, I will offer short lectures on topics such as working capital, relevant cash flow, and the tax impact of depreciation. A convenient way to orchestrate this part of the class is to call on volunteers to give their choices of cash flow. Then move to a different student for the next line item.

3. What are the components of the cost of capital and the weights used to get WPC’s WACC? (20 minutes)

The instructor could use this case as either an introduction to cost of capital or as a reinforcement of a previous lecture or case study on the topic. For students with some familiarity with cost of capital, this analysis for WPC is fairly straightforward. My suggested solution is to use the long-term cost of debt as the cost for the bank debt. An alternative treatment is to compute a weighted average cost of debt with short-term and long-term cost components. This will have only a minor impact upon the WACC.

4. What are the NPV and the IRR of the resulting cash flows? How do you interpret these numbers? (10 minutes)

This completes the analysis and illustrates that the analyst may use either an NPV metric or IRR to select value-adding projects. The instructor should take the opportunity to emphasize the logic of using free cash flows with a WACC and that a positive NPV represents the value created for shareholders.

5. What changes would you make to these base-case numbers? (15 minutes)

This question is primarily intended to show the impact of adding inflation to the cash