You have an opportunity to buy the Newton Falls Paper mill for $15 million. If y

Question

You have an opportunity to buy the Newton Falls Paper mill for $15 million.  If you buy the facility your plan is to produce one or more specialty papers where you believe the margins are higher.  You would also like to update and modernize the mill.  To do this you will have to purchase two new paper machines for $1.5 million each and a new computer system for another $1 million.

You expect revenues to be:

$6 million year 1

$8 million year 2

$9 million year 3 and ongoing.

You expect your variable costs to equal 20% or revenues and your fixed costs to equal $4.5 million (depreciation expense is not included in this estimate of fixed costs).

the cost of equity is 11.64%. Assume a tax rate of 35%.

1.       

Should you purchase the mill and implement your plan of producing different paper?  What is the NPV?  

Explanation / Answer

Initial investment = 15+1.5*2+1 = 19 mn

depreciation 20, 32, 19.2, 11.52, 11.52, 5.76

cash flow 1st yr = (.8*6-4.5-19*.2)*1+19*.2 = .3 mn, PV = .3/1.1164 = .2687 mn

2nd yr = (.8*8-4.5-.32*19)*1+.32*19 = 1.9 mn , PV = 1.9/1.1164^2 = 1.5244 mn

3rd yr = (.8*9-4.5-.192*19)*1+.192*19= 2.7, PV = 2.755/(1.1164^3) = 1.9799 mn

4th year = (.8*9-4.5-.1152*19)*.65+.1152*19 = 2.52108 mn, PV= 2.52108/1.1164^4= 1.62295mn

5th year = (.8*9-4.5-.1152*19)*.65+.1152*19 = 2.52108 mn, PV= 2.52108/1.1164^5= 1.4537mn

6th year= (.8*9-4.5-.0576*19)*.65+.0576*19 = 2.13804mn, PV= 2.13804/1.1164^6= 1.1043mn

7th year 1.755 mn, PV = 1.755/(.1164*1.1164^6) = 7.787mn

NPV = -19+.2687+1.5244+1.9799+1.66695+1.4537+1.1043+7.787 = $-3.215 mn

NPV is negative, he should not invest....

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