# Greenworld Case SOLUTION

November 20, 2017 | Author: MahamIbrahim | Category: Internal Rate Of Return, Net Present Value, Financial Economics, Business Economics, Economies

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FORT GREEN WORLD MAHAM IBRAHIM L1F11BBAM2024 AHSAN EJAZ L1F11BBAM2164 SUBMITTED TO : PROF. EESHA TARIQ SECTION : B SUBJECT : FINANCIAL ANALYSIS

QUESTION 1 (A) Calculation of NPV of modernizing the existing paper mill: If actual cash flows are used Investment required for the modernization = \$154,700,000 Required rate of return = 12% Yearly cash flow after tax deduction = \$40,634,680 (for 20 years) Net present value = C0 + present value of all future cash flows of 20 years NPV = 303,518,451.5 - 154,700,000 NPV = \$148,818,451.5 (B) Calculation of NPV for building a new paper mill Investment required for the modernization = \$618,800,000 Required rate of return = 12% Yearly cash flow after tax deduction = \$107,728,000 ( for 20 years) NPV = 804,668,222.8 - 618,800,000 NPV = \$185,868,222.8

With Incremental Cash Flows (A) Calculation of NPV of modernizing the existing paper mill: Investment required for the modernization = \$154,700,000 Required rate of return = 12% Yearly cash flow after tax deduction = \$40,634,680 (for 20 years) Incremental cash flow= \$ 40,634,680- \$ 11,422,320 = \$29,212,360 Net present value = C0 + present value of all future cash flows of 20 years

Casio calculator a) Cash button b) I% = 12% c) Cash= D.editor x

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29,212,360

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d) NPV = solve e) NPV = \$ 63,500,076.15 (B) Calculation of NPV for building a new paper mill Investment required for the modernization = \$618,800,000 Required rate of return = 12% Yearly cash flow after tax deduction = \$107,728,000 ( for 20 years) Incremental cash flow =\$107,728,000 - \$ 11,422,320 = \$ 96,305,680 Net present value = C0 + present value of all future cashflows of 20 years Casio calculator a) Cash button b) I% = 12% c) Cash= D.editor x

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-618,800,000

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d) NPV = solve e) NPV = \$ 100,549,850 This shows that NPV of new paper mill is higher than that of modernization of the existing facility. Thus, using NPV rule demonstrates that new facility is better for the firm.

QUESTION 2: With Incremental Cash flows (A) Calculation of IRR of each investment  IRR of Modernization of existing mill :

Using the Casio calculator where the cash flows and the initial investment was entered we move on to the IRR = solve IRR = 18.219%  IRR of new paper mill: Using the Casio calculator where the cash flows and the initial investment was entered we move on to the IRR = solve IRR = 14.531% According to IRR rule the firm should invest in the modernization of the existing paper mill as it has a higher IRR . (B) Calculation of the payback period of each investment  Payback period of Modernization of existing mill : Initial investment / annual cash flows = \$154,700,000/\$40,634,680 = 3.807 years  Payback period of new paper mill: Initial investment / annual cash flows = \$618,800,000/\$107,728,000 = 5.744 years According to payback rule the investment made in the modernization of existing paper mill will be recovered earlier then the investment in the new paper mill.

IRR With Actual Cash flows

 IRR of Modernization of existing mill : Investment= \$154,700,000 Cash flows= \$40,634,680 IRR = SOLVE IRR=26.01%  IRR of New Paper Mill Investment= \$618,800,000 Cash flows= \$107,728,000 IRR= SOLVE IRR= 16.60%

QUESTION 3: (A) NPV and IRR methods give the same accept / reject signals: No, NPV and IRR methods do not give the same accept/ reject signals. NPV accepts the investment in building a new paper mill while IRR method accepts the investment in the modernization of the existing paper mill. (B) NPV and IRR methods can give divergent signals when evaluating mutually exclusive alternatives: In mutually exclusive projects, all projects serve the same purpose and therefore such projects cannot be undertaken simultaneously. In case of mutually exclusive projects only one project can be accepted and the others are to be rejected. In case of such projects the cash flows of one project can actually be adversely affected by the acceptance of the other project.

The reason that NPV and IRR methods are giving different decisions for the projects, building of new paper mill and modernization of existing paper mill are:  The investment scale is different for both the projects. Building a new paper mill requires higher investment as compared to the other project.  The cash flows are also different of both the projects. The cash flow of building a new paper mill is \$67,093,320 more than the cash flow of the modernization of existing paper mill. Thus, the magnitude of cash flows is also the reason of divergent signals.

QUESTION 4: If the life of modernized paper mill becomes 15 years the payback period as calculated in Question 2 part b would not change and would remain 3.807 years but the NPV if calculated would change. Investment required for the modernization = \$154,700,000 Required rate of return = 12% Yearly cash flow after tax deduction = \$40,634,680 (for 15 years) Net present value = C0 + present value of all future cash flows of 15 years Casio calculator a) Cash button b) I% = 12% c) Cash= D.editor x X 1

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d) e) f) g)

NPV = solve NPV = \$122,057,300 IRR = solve IRR = 25.384%

If Incremental Cash Flows are Used: Casio calculator a) Cash button b) I% = 12% c) Cash= D.editor x x 1

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d) e) f) g)

NPV= solve NPV=\$ 44,261,425.38 IRR= solve IRR = 17.118%

The NPV decreases with the decrease in number of years but still remain positive. Similarly there is a decrease in IRR with the change in number of years. The IRR has decreased round about 1.1% as compared to previous IRR calculation with 20 years cash flows. Thus, it shows the effect of latter cash flows on IRR and NPV is less and early cash flows have greater effect on IRR and NPV. Therefore it’s a better option to choose modernization of existing paper mill as it has a lower payback, positive NPV and higher IRR and the employees only have to cover 15 miles to reach it. 

According to the statement the yearly cash flows if multiplied by 5 give a large cash flow that is actually affecting the NPV but in reality the effect is very little and 5 years can also be omitted.

QUESTION 5: 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.

QUESTION 6: (A) Casio calculator a) Cash button b) I% = 12% c) Cash= D.editor x X 1

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d) IRR = solve e) IRR = 13.258% 13.258% is the crossover rate of both the projects where there NPV = \$126,379,470. If we compare this rate to the required return 12% we will accept the project because the rate at which the NPV of both the projects becomes equal is more than the required return. Further if the cash flows have been overestimated this may be causing the result of IRR to be 13.248% that is only 1.25% more than required return may be the actual cash flows are lower which may lower the IRR to 12% or even lower than that that can actually make the project unacceptable. (B) If we explain the decision rule for IRR in case of mutually exclusive alternatives, we accept a project which has IRR greater than its cost of capital, and If both the projects have IRR greater than their cost of capital than we select the project having the highest IRR. In mutually exclusive alternatives normally IRR and NPV give divergent signals which means if IRR accepts a project, NPV rejects that project. Thus in this case NPV should be used as a primary rule. On the other hand if these projects would have been independent projects, IRR and NPV would have given same answers. Normally in case of independent projects if NPV accepts the project than IRR also gives the same decision. And In such projects we can accept all the projects if there are no constraints.

QUESTION 7: Data required for calculating the yearly cash flow Modernization of existing

Building new paper mill

Initial Cost

paper mill (\$) 154,700,000

(\$) 618,800,000

Price per ton

455

455

Working days in a year

360 days

360 days

Tonnage per day

1200

2200

Variable cost per ton

282.1

227.50

Fixed operating cost per

19,860,000

52,200,000

year SL value

20 years

20 years

Depreciation per year

7,735,000

30,940,000

Tax rate

40%

40%

Income statement for calculation of the operating cash flow: Modernizing existing

Building new building

facility Sales (Price per ton x number of

455 x1200 x360= \$196,560,000

455 x2200 x360= \$360,360,000

(\$19,860,000)

(\$52,200,000)

282.1 x 1200 x 360=

227.5 x 2200 x 360=

(\$121,867,200)

(\$180,180,000)

EBT

\$54,832,800

\$ 127,980,000

Less: 40% tax

(\$ 21,933,120)

(\$ 51,192,000)

Net income

\$ 32,899,680

\$ 76,788,000

\$ 7,735,000

\$ 30,940,000

Net operating cash flow

\$ 40,634,680

\$ 107,728,000

tons x no. of days in a year) Less: Fixed cost per year (includes depreciation) Less: variable cost per year

QUESTION 8: (A) Calculating operating cash flows 1st 5year cash flows would be: Modernization the old mill Building a new mill Sales \$196,560,000 \$360,360,000 Less: F.C.(dep not included) (12,125,000) (21,260,000) Less: VC (121,867,200) (180,180,000) Dep (SL5 years)=initial (30,940,000) (123,760,000) investment/5 EBT 31,627,800 Less: tax (12,651,120) Free Cash Flow 18976680 Add: Dep 30940000 Net Cash Flow 49,916,680 Now, the net cash flows for rest of 15 years would be:

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

196560000 (12,125,000) (121,867,200) 62567800 (25,027,120) 37,540,680

35,160,000 (14,064,000) 21096000 123760000 144,856,000

Building a new mill 360360000 (21,260,000) (180,180,000) 158920000 (63,568,000) 95,352,000

Required rate of return and Initial investment is given. Using the financial calculator, NPV would be Q8 (a)

Modernization the old mill

Building a new mill

NPV IRR (B) Q8 (b) NPV (dep for 20 years) NPV (dep for 5 years) NPV change NPV change %

170,320,703.2 29.98%

271,877,229.6 19.74%

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%

If Incremental Cash flows are used with Depreciation being Charged for First 5 Years for Modernized Mill Incremental cash flow for first 5 years of modernized mill = \$ 49,916,680 - \$11,422,320 = \$38,494,360 Incremental cash flow for last 15 years of modernized mill =\$ 37,540,680 -\$ 11,422,320 = \$ 26,118,360 Casio calculator a) Cash button b) I% = 12% c) Cash= D.editor x X 1

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d) e) f) g)

NPV = solve NPV = \$ 85,002,327.86 IRR= solve IRR = 21.5224%

Incremental cash flow for new paper mill Incremental cash flow for first five years = \$ 144,856,000 - \$ 11,422,320 = \$ 133,433,680 Incremental cash flow for last 15 years = \$ 95,352,000- \$11,422,320 = \$ 83,929,680 Casio calculator

a) Cash button b) I% = 12% c) Cash= D.editor x X 1

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133,433,680

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83,929,680

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d) NPV = solve e) NPV = \$ 186,558,850 f) IRR= solve

g) IRR = 17.4369%

NPV of project with 20 year

Modernized mill \$ 63,500,076.15

New mill \$ 100,549,850

depreciation NPV of project with 5 year

\$ 85,002,327.86

\$ 186,558,850

depreciation IRR of project with 20 year

18.219%

14.531%

depreciation IRR of project with 5 year

21.5224%

17.4369%

depreciation Change in NPV \$ 21,502,251.71 \$ 86,009,000 Change in IRR 3.3034% 2.9059% NPV change in % 33.86% 85.54% By using incremental cash flows also we get to know that the percentage change in NPV of new mill project is higher. 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.

QUESTION 9: For calculating the cash flow where the annual production is minimum which makes the project unacceptable we calculate the payment through annuity formula: PV= C x ((1-(1+r)-n)/r) R= 12% n= 20 Calculation of Cash Flow Cash Flows

Modernization of existing mill 154,700,000/((1-(1+0.12)-20)/0.12)

Building New Mill 618,800,000/((1-(1+0.12)-20)/0.12)

=\$ 20711047.27

= \$ 82844189.09

Minimum annual production Modernization of existing mill Operating cash flow Less: depreciation Net Income EBT Add Fixed Cost Gross profit Tonnage per year Add Variable Cost = tonnage

Building New Mill

\$ 20,711,047.27 (\$7,735,000) 12,976,047.27 \$ 21,626,745.45 \$ 19,860,000 \$ 41,486,745.45 239,946.47455 \$ 67,688,900.47

\$ 82,844,189.09 (\$30,940,000) 51,904,189.09 \$ 86,506,981.82 \$ 52, 200,000 \$ 138,706,981.8 609,701.019 \$ 138,706,981.8

\$ 109,175,645.9

\$ 277,413,963.6

per year x variable cost per ton Sales

Modernization of existing mill: Net income = (EBT – EBT x40%) =EBT (1-(1 x 40%)) EBT= Net Income/ (1-(1 x.4)) = 12,976,047.27/ (1-(1 x .4)) = \$ 21626745.45 Building new paper mill Net income = (EBT – EBT x40%) =EBT (1-(1 x 40%)) EBT= Net Income/ (1-(1 x.4)) = 51,904,189.09/ (1-(1 x .4)) =\$ 86506981.82

Tonnage per Year: Gross profit = Tonnage per year (price per ton (sales) – variable cost per ton) Modernized existing mill tonnage per year= \$ 41486745.45/ (455- 282.1) = \$ 239946.4746 New mill tonnage per year =\$ 138706981.8/ (455- 227.5) = \$ 609701.019

QUESTION 10: (A) No, it is not appropriate to judge different proposals on same discount rate because each proposal has its own cost and cost of capital which is according to its risk. So, in order to evaluate the proposals, we should compare proposal's own cost of capital with its IRR. If IRR is greater than that of its cost of capital 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. Change in cost of capital can also change the decision we made on the basis of IRR in question 5 of selecting the project of modernization of existing mill. If both projects would have higher IRR than their discount rate than I would select project with higher NPV.