Capital Budgeting the Projected Free Research Proposal

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But even with no cost savings whatsoever, this project has a positive NPV.

We can see, therefore, that the greatest area of sensitivity is with the terminal value. The terminal value at present is worth $143 million of the NPV. If we break down the variables that go into the terminal value, however, we notice that the cost savings are critical. If SGA expense is not reduced, then the terminal value is reduced to $67 million and the total NPV for the entire project ends up being $98 million. This figure is less sensitive to the change in cost of goods sold.

We should also consider testing combined sensitivity of our shakiest projections. Sales may not live up to expectations and cost savings might not occur. If we assume no net income and no additional cost savings, the project will have an NPV. If we assume that our expectations for these will be cut in half, the project has an NPV of $121million. This is significantly lower than the original projection, but still well above the $95 purchase price.

7) If I were CEO of Nelson, I would approve the purchase, based on its positive net present value. I would, of course, seek a lower price, to reduce the risk to our company. The project clearly has a high NPV, but more importantly it withstands our sensitivity analysis. It would take a doomsday scenario for this purchase to have a negative NPV. That is something we can assume with any capital investment. The most important sensitivity analysis, where we scaled back our most optimistic scenarios, had this with a positive NPV by around $35 million.

The main value in Northwestern is in overhauling the existing businesses. We feel that the current management team has been inefficient, but we are comfortable with the fact that they were ready to move on. We will need to invest in bringing in our own people but we feel that in doing so, we will be able to enhance the value of the existing Northwestern operations to a degree that justifies the cost.

The most important caveat is that we do not fully understand how this will impact Nelson and our strategic goals.

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We understand that at present we would like to secure a reliable source of wood chips. This would result in us increasing our reliance on Northwestern. As a consequence, we feel comfortable that the business will continue to be viable for many more years. Even taking a conservative estimate with respect to the terminal growth rate, we feel that the value of the ongoing Northwestern business is substantially higher than the current asking price. The fact that management of Northwestern has been so rigid in the past, yet the company has continued to be profitable throughout that period, we feel is an indicator of the strength of that business.

We see that the company, despite slow housing starts and poor management, was still profitable the past couple of years. When housing starts are high, the company is very profitable. With our cost-cutting expertise and better management, we are comfortable that we can extract significant value from Northwestern. Even if we meet more resistance than anticipated, the deal is still going to be profitable under almost any circumstance.

Exhibit A:

Northwestern Projected Free Cash Flows

(Millions of $)

1993

1994

1995

1996

Net Income

4.4

5.4

6.8

7.3

+Depreciation

6.3

6

5.7

5.5

-change working capital

1.5

3

3

1.5

-capital expenditures

2.5

5

5

7.3

Free Cash Flow

6.7

3.4

4.5

4

Exhibit B: Revised Free Cash Flows

Northwestern Projected Free Cash Flows

(Millions of $)

1993

1994

1995

1996

Net Income

4.4

5.4

6.8

7.3

+Depreciation

6.3

6

5.7

5.5

-change working capital

1.5

3

3

1.5

-capital expenditures

2.5

5

5

7.3

Free Cash Flow

6.7

3.4

4.5

4

+ Reduction in SGA Exp

0

11.9

13

13.65

+ Reduction in COGS

0

5

8

8.3

Revised Free Cash Flow

6.7

20.3

25.5

25.95

Exhibit C: Terminal Value and NPV Calculation

Terminal Growth.....

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