Research Proposal on "Capital Budgeting the Projected Free Cash Flows"

Research Proposal 7 pages (2188 words) Sources: 5 Style: MLA

[EXCERPT] . . . .

Capital Budgeting

The projected free cash flows are the net income plus depreciation, less changes in working capital and capital expenditures (Investopedia, 2009). The free cash flows for Northwestern as a standalone business are found in Exhibit A.

Using the figures in Exhibit A as a starting point, we then make adjustments based on the value we feel that Nelson can bring to Northwestern, plus the value that Northwestern will bring to Nelson. A couple of assumptions go into these figures. First, reducing the cost of goods sold at Northwestern will begin as of 1994, moving from 90% to 85%. Second, the reduction in selling, general and administrative expenses will also begin in 2004 with a reduction to $10 million, with the $7.5 million target being achieved in 2005.

The revised free cash flow is detailed in Exhibit B. This does not include other potential new benefits, such as reduced cost of goods sold at Nelson. This was not included for a couple of reasons. One is that any decrease in price to Nelson lowers Northwestern's profit, resulting in a breakeven transaction for the parent company; the other is that Northwestern last year only supplied 2.6% of Nelson's raw goods, so this is calculation would not impact the decision to make this deal. As we can see, the revised free cash flow from the purchase of Northwestern is $78.45 through 2006.

2) These assumptions are not realistic. Revenue growth at Northwestern is not stable. The sales growth projections assume a steady-state growth rate but there is little to back up such an assumption. What we know of the political environment is that the industry hopes for the Clinton administration to lend it some support. However, there is no evidence that this will occur. Moreover, because such support would be subject to the provisions of the U.S.-Canada Free Trade Agreement, it is reasonable to assume that even if the political will does exist to make changes, it will be a slow process.

The assumptions are also optimistic about the state of the economic environment. At this point, the lumber business has struggled, as a consequence of a sluggish housing market. The housing market is sluggish as a result of the savings & loan failures that plagued the Bush administration of the time. In the wake of this scandal, mortgage markets tightened considerably. New regulations were being enacted to shore up the mortgage-lending business but these regulations were more likely to restrict new home construction than to spur another growth phase. Indeed, the strong growth in housing construction that had fueled lumber industry growth was the result of market failure, and could not be expected to repeat any time soon.

Moreover, the assumptions of sales growth are based on the optimistic view that the recent fourth-quarter uptick in sales is a sign of recovery. That is a spurious assessment at best -- one quarter does not a recovery make. Lastly, the market for paper products is still in a slump. This will make it difficult for Northwestern to attain the sales projections.

The projections with respect to internal cost-cutting are reasonable. Managerial inertia has caused Northwestern to fail to reduce costs, as has the lack of a good manager besides Watson. Thus, Nelson's professional management can reasonably be expected to step in and improve organizational efficiency. They will need to completely remove the existing management teams, however, if they are to avoid the same resistance to change that plagues these mills during the Watson era.

In addition to the sales considerations and the cost-cutting considerations, there are other important strategic considerations as well.

One of these is the operational fit between Nelson and Northwestern. There are several surface-level fit issues, such as operating in approximately the same business, having an existing relationship and working in geographic proximity. However, these are the same sorts of considerations that led to Northwestern purchasing these mills in the first place. The independence and unique cultures of these mills made them difficult to assimilate, which resulted in most of these purchases being poor value for Northwestern. Therefore, Nelson must carefully consider whether they have the in-house talent to either bring the different mills in line, or to replace the Northwestern managers they expect to fire. There ability to achieve their cost-cutting objectives is dependant on their ability to overtake operations of these mills.

Overall strategic fit is another consideration. Nelson's competitive advantage has traditionally been its lack of vertical integration, which has allowed it to shop around for quality and well-priced pulp. Nelson feels the need to guarantee itself a supply of pulp, but there are two important considerations. One is that Northwestern was a $19 million supplier for Nelson last year, good enough for 2.6% of its cost of goods sold. At the most, Northwestern was 6.1% of Nelson's cost of goods sold, three years ago. The other consideration is that the pulp supply concerns are temporary. They are related to domestic supply concerns, not worldwide supply concerns. There is no guarantee that the potential supply issue will not work itself out. Moreover, Nelson has not considered the price elasticity for its paper products -- they may be able to pass along price increases to their customers anyway. All of these considerations may make this purchase a poor strategic fit.

Strategic fit aside, it is recommended that the projections with respect to sales and cost reductions are tested for sensitivity, as they can be reasonably expected to fall short of the estimations. We will want to have a sense of how the free cash flow projections look under a more pessimistic outlook in order to get a better sense of the value and riskiness of this project.

3) To determine the terminal growth rate for Northwestern, we must take a number of factors into consideration. The first is that at the end of 1996 we are assuming they have operated at capacity for two full years. The mills are small, but not necessarily modern. Thus, they will begin to become inefficient, which will lead to closure. Also, the firm will not be able to maintain 4% price increases. It is expected, therefore, that over time anywhere from 5-10% of capacity will be lost from Northwestern's assets each year, as mills become unviable. We will assume the high end for the sake of being conservative with our calculations. The prices charged will be volatile, since this is a commodity product. Thus, we should again err on the side of caution and assume only a 2% increase in price in our calculation of terminal growth rate. This will give us an 8% decline in revenue each year going forward after 1996.

Part II

4) To calculate the weighted average cost of capital requires the cost of debt and the cost of equity, weighted by the firm's capital structure (Investopedia, 2009). The prevailing cost of debt for Baa bonds is 8.98%. To calculate the cost of equity, we require the firm's beta (1.01), the risk-free rate (3.45%) and the historic market return rate, which is often taken to be a 7% premium over the risk free rate (since the historic market return is not given). The firm's existing capital structure is 28.3% debt and 71.7% equity. Therefore, the cost of equity will be:

Ra = 3.45 + (1.01)(7) = 10.52%.

The WACC will then be (.717)(10.52)+(.283)(8.98) = 7.542 + 2.541 = 10.08 or approximately 10.1%.

5) To compute the NPV, we must discount the estimated future cash flows, including the terminal value. The calculation for 1993-1996 gives us a net present value of $59.59. This must then be combined with the NPV of the terminal value. This begins with the value of the free cash flows in 1996, which are $25.95 million. We then divide this by the discount rate -- expected growth rate (Damodaran, no date).

$25.95 / (10.1 + 8) = $143.37

Thus, we get a terminal value of $143.37. This gives us a total NPV for the purchase of $202.96 million.

6) It is important to conduct a sensitivity analysis on the valuation conducted, to see how changes in each of the assumptions will affect the final calculation (Breierova & Choudhari, 1996). The sensitivity to the discount rate is not significant. For each 1% change in the discount rate, the value of Northwestern moves by $10 million. Given that the valuation is over double the asking price, changes in the discount rate will not change the investment decision.

The decision is not sensitive to the estimates of the first four years. Although the sales estimates are in all likelihood optimistic given the economic, political and strategic circumstances, the assets of Northwestern would need to have a substantial negative net income before the viability of the project came into question. At zero net income, the purchase is still good. The expected cost savings are another key variable to test. If these are reduced to zero (SGA expense remains at present levels), this shaves about thirty million dollars… READ MORE

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