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Lahore School of EconomicsAdvance Corporate Finance Case Study: Knight International Submitted to: Dr. Nawazish Mirza Submitted by: Ali Nawaz M. Amir Wazir Shahzeb Ahmed Huma Ijaz Sidra Arshad Zahra Ali The main issue that been discussed here is weather to renovate the old production facility or to build a new one as the exiting production facility will reduce its capacity significantly in the coming years.5 billion sales in recent year. . is one of the largest producers of paper and pulp with 3. Another controversy pointed out by a member of EC was that 20 years was a relatively longer time for a modernized old facility. some EC members considered that relocating the facility would make employees lose their jobs although it would be creating more managerial positions but the change in the location would not be feasible for all employees some who were with the company for more than a decade thus some allowance is necessary. variable cost was increased thus the after-tax cash flows were decreased. The initial controversy arose as the management of the old facility. considering 15 years was more realistic option. The company flourished in its initial years but reluctance of company’s top management to decentralize led to hiring of Andy Kurzer as a chairman who changed the budgeting procedures of the company and made a 6-person Expenditure Committee who would decide on projects costing more than 2 million. Moreover. estimated the production tonnage per day more than facility could produce. a century old company that believes in community work and corporate social responsibility. lower variable cost thus higher after-tax cash flows but then after discussion it was unanimously tonnage per day was decreased. who had doubts about the new facility.Introduction Knight International. But in the end they decided to go with 20 years. it is therefore expected to add value to the facility and will therefore increase the wealth of the owners and since our goal is to evaluate so to increase owner wealth.072.547.537. As NPV is the difference between the market value of a project and its cost and it is worked out as positive for both New facility and Revised-Old facility projects i.537.614 $204. Existing paper mill 26. NPV is a direct measure of how well New facility project will meet our goal.00 $333.74 Question No. Explain why the NPV and IRR methods can give divergent signals when evaluating mutually exclusive alternatives. Existing paper mill 3.000 44.384. Calculate the payback of each.000 $2. Do the NPV and IRR methods give the same accept/ reject signals? They are mutually co related because i.603% b.653.e. 2 a.537.548 b.600 $893. NPV is Positive ii. IRR is greater than 12% b.262. Calculate the IRR of each investment. .680.82.81 New paper mill 5.367.02 & 163.000 $884. Calculate the NPV of building a new paper mill.000.614 Question No.000. Initial investment Operating Cash Flow (each year) Total Cash Inflow PVCF at 12% NPV (PVCF-initial investment) 680.262. 204. Calculate the NPV of modernizing the existing paper mill.Question No.614. 3 a. Initial investment Operating Cash Flow (each year) Total Cash Inflow PVCF at 12% NPV (PVCF-initial investment) -170.009% New paper mill 16.548 $163.000.262. 1 a.000 118. Question No. Building a new mill requires $510 million more than modernizing the old mill but will generate an extra $73. 6 a.7 .000 Questions No.268. the numbers are worked out as 16. Cash flow for 20 Years Cash flow for 15 Years Difference $893.072. Evaluate the argument that “assuming a 20-year horizon for this project adds $44.For IRR. 4 Suppose that the appropriate life of a modernized factory is 15 instead of 20 years. It provides us information to go for Revised-Old facility but its NPV numbers are lesser than new facility.804.730. Question No.400 in yearly cash flow. Incremental IRR 13. 5 Based on your calculations in the previous questions and information in the case.26% b.268.000 $223.000 to the yearly cash flows. suggest a decision rule for the IRR in evaluating mutually exclusive alternatives with different initial costs.603% for new facility and 26.000 $669.653. what decision do you recommend? Justify your answer. Project A – NPV positive with higher value – IRR greater than 12% Question No. Based on your answer in part (a). Calculate the IRR on this incremental expenditure.009% for Revised –Old facility.600 times 5 or $223. Compare your answer to the 12 percent required return. 600 Depreciation 8. Operating Cash Flow= NI + Depreciation NI 36. 8.000 1-20 years 118.000 1-20 years 44.600 (b) Building a new mill.153.384. Operating Cash Flow= NI + Depreciation NI 84.500.653. .Use the information in Exhibit 2 to explain how the yearly cash flow estimate was obtained for: (a) Modernizing the old mill.000.000 Question No.000 Depreciation 34.384. 9 . As NPV of 5 years is low so the difference is greater Question No.000 44.698 12.537.000 $685.916 New paper mill project is showing larger NPV difference because of these two reasons: 1.703 Difference=107.614 NPV (5 years)=5.211% (b) Which of these two projects will have the larger NPV change? Why? Existing paper mill NPV (20 years)=163.561.845 New paper mill NPV (20 years)=204.703 $55.653.000 127.000.698 Difference=199.384.698 $5.000 510.000.975.000 $225.703 21.266% 680.600 $350.000 $591.561.129.Suppose depreciation is over 5 years instead of 20 years: (a) How would the NPV and IRR of each project be affected? Explain briefly.768. Cash flow return of new paper mill is higher 2.561. Existing Paper Mill Initial investment Operating Cash Flow (each year) Total Cash Inflow (for 5 years) Scrap Value PVCF at 12% NPV (PVCF-initial investment) IRR New Paper Mill Initial investment Operating Cash Flow (each year) Total Cash Inflow (for 5 years) Scrap Value PVCF at 12% NPV (PVCF-initial investment) IRR 170.000 118.500.132.262.000.129.548 NPV (5 years) = 55.129.920. does your answer to 10 (a) affect your choice in question 5? No.000.600 170.694 667 Question No.200 40 20 500 1.How low can average annual production go before each proposal is unexpected? Tonnage per day B New Facility (Revised) Old Facility 1. The starting period for both the projects is same (b) How.000 170.000 Project 3 (Revised) Old Facility Tax rate (%) Project Length (Years) Price per ton ($) Tonnage per day B 40 20 500 1.000.000.200 40 20 500 2.000 . For like comparison we have to use the same discount rate. if at all. 10 (a) Is it appropriate to use the same discount rate to evaluate both proposals? Explain your position. we would not change our decision Annexure Given information EXHIBIT 2 Information on Renovation and New Facility Project 1 Project 2 New Facility (Original) Old Facility A After-tax cost ($) 680. 000 42.824.500.42 37.367.600 12% 360 Income statement for Project 1.000 19.360.384.68 44.000 Formula =Price per ton *Tonnage per day*days =Tonnage per day*Variable cost per ton*days =Sales-VC =Fixed operating cost per year -Depreciation Other Expenses Depreciation 34.000 310 21.000 $2.000 .000 14.93 118.000.500.384.600 12% 360 SL 20 8.000 56256000 Gross Profit-Total expenses EBIT*40% Net Income 84.680.89 50.653.000 290 21.New Facility Income Statement Sales 396000000 Cost Of Production Variable Cost 198000000 Gross Profit 198000000 Expenses Fixed Expenses Operational Cost without Depreciation 23.000.360.824.981.384.000 EBIT-Tax Year Operating Cash Flow Total Cash Inflow 0 -680000000 1 118.384.000 given Total Expenses 57.000 72.Variable cost per ton ($) Fixed operating cost per year ($)C Fixed operating cost per ton ($)C Depreciation Method Depreciation life (years) Depreciation per year ($) Depreciation per ton ($) After-tax cash flow ($) Required Return Days 250 57.76 67.640.000 Operational Cost without Dep+ Dep EBIT Tax 140.000 Cash flow for 20 years 118.52 SL 20 34.360.000 12% 360 SL 20 8. 603% Payback 5.730. 12% NPV $204.000 given PVCF $884.262.000 Other Expenses =Fixed operating cost per year -Depreciation .000 73.000.262.e.74 IRR formula plus operating cash flow in IRR formula INITIAL INVESTMENT/OPERATING CASH FLOW Incremental Cost Incremental Cash flow 510.324.Initial Investment NI+Dep 680.000.400 Incremental IRR 13.614 required rate of return i. Income Statement for (Revised) Old Facility Income Statement Sales 216000000 =Price per ton *Tonnage per day*days Cost Of Production Variable Cost 133920000 Gross Profit 82080000 =Tonnage per day*Variable cost per ton*days =Sales-VC Expenses Fixed Expenses Operational Cost without Dep 13.614 PVCF-initial investment IRR 16.26% Note: Operating cash flow is same for 20 years growth rate and/or inflation rate is not given in data set. Depreciation 8.256.824.000 24102400 Gross Profit-Total expenses EBIT*40% Net Income 36.000 given Total Expenses 21.500.600 EBIT-Tax .000 Operational Cost without Dep+ Dep EBIT Tax 60.153.