The paper company Wernham Hogg is contemplating upgrading one of its paper plants. The CEO, Mr. Brent,
Question:
The paper company Wernham Hogg is contemplating upgrading one of its paper plants. The CEO, Mr. Brent, has to decide whether it is worthwhile investing in this upgrade.
Currently, the plant is expected to operate for another 10 years and then be closed down. The plant accounts for revenues of 1000 per year, and costs are 80% of revenues. Without the upgrade, revenues and costs are expected to remain constant until Year 10, and there is no inflation. The plant holds an inventory of 250, has accounts receivable outstanding of 100, and accounts payable outstanding of 100. Inventory, accounts receivable, and accounts payable are also expected to remain constant for the remaining life if no upgrade is made. The plant is already fully depreciated and has zero salvage value. The firm faces a marginal corporate tax rate of 30%. The discount rate is 8%.
The upgrade will increase the efficiency of the plant in a number of ways. First, costs will be re- duced to 65% of revenues. Second, due to lower purchase costs and better inventory management, there will be immediate, one-time reductions of inventory and accounts payable by 20%. Third, the upgrade requires an up-front investment today of 600, which will be depreciated linearly over the 10-year remaining life of the plant. The upgrade will have no impact on sales or accounts receivable.
What is the NPV of the upgrade? Should Mr. Brent implement the upgrade?