FIN 486 Week 2 Capital Investment Decisions Example

A Georgia Plant and the Option to Double It: Discounted Cash Flows, a Twenty-Year Life, Strategic Fit and the Value of Waiting on Phase Two at Lakeshore Packaging

[Student Name]

University of Phoenix

FIN/486: Strategic Financial Management

Week 2 Assignment

[Instructor Name]

[Date]

Lakeshore Packaging, the plant and all figures are composites written for a model paper; methods and research findings come from the sources listed.

Lakeshore Packaging, the composite Wisconsin molded fiber maker diagnosed in Week 1, earns about 15 percent on capital in its food service line, far above its 8.6 percent cost of capital. Its plants are full, and three restaurant chains have asked for more supply in the Southeast, where Lakeshore ships from Wisconsin at high freight cost. Management proposed a $180 million plant near Macon, Georgia, with land and utilities sized for a second phase of equal capacity later. A plant that serves the company's best business seems an easy yes, but it still has to pay for its capital, and the land for a second phase creates a decision worth valuing on its own. This paper analyzes both.

The Cash Flows

The plant would cost $180 million, spent mostly in the year before operations. Revenue would ramp from about $90 million in its first year to $170 million in its second and about $210 million in its third, then grow about 2 percent a year with prices. Operating margin before depreciation would start at 10 percent during startup, reach 16 percent in year two and 18 percent from year three, close to the line's existing plants. Depreciation over the plant's life is about $18 million a year. Working capital of about 12 percent of revenue must be funded as sales grow. Maintenance capital is $2 million a year at first and $4 million once the plant is fully running. Freight savings on existing customers are counted, since they are incremental: shipping a truckload of trays from Wisconsin to Atlanta costs about three times as much as shipping it from Macon, and those savings belong to the plant decision.

The Discount Rate

Lakeshore's average cost of capital is 8.6 percent. The plant serves food service customers, the company's lowest-risk line, but adds startup risk and a new region. Management used 9.5 percent, close to one point above the average, to reflect those risks.

Net Present Value Over Twenty Years

Free cash flow after tax is slightly negative in year one, about $13 million in year two, $24 million in year three and rises gradually to about $33 million by year ten, continuing to grow with prices through year twenty, with salvage value of $30 million at the end. Discounted at 9.5 percent, the plant creates about $60 million of value, and its cash flows equal a return of roughly 13 percent a year. Simple payback takes about eight years.

Why the Horizon Matters

An earlier draft used a perpetual terminal value at year ten, which produced a net present value of about $143 million, with the terminal value supplying more than the entire result. Over ten years alone, with only a modest salvage value, the net present value was negative. Plants do not last forever without reinvestment, so the twenty-year life is the more defensible basis. The comparison shows how much a valuation can depend on assumptions about the distant future.

Sensitivity to the Ramp

If revenue reaches only 80 percent of plan at every stage, net present value falls to about $14 million, still positive but thin. If margins stall at 15 percent, it falls to about $20 million. Together, the two problems push it to about negative $17 million. The project survives either problem alone but not both together, which points to the importance of the chains' volume commitments.

The Option to Expand

In year four, Lakeshore could spend about $200 million to double the plant if Southeast demand proves strong. Building both phases now would commit capital before demand is known. Valuing phase two at year four in two equally likely scenarios: with strong demand, its cash flows are worth about $308 million, a net present value of about $108 million at that time; with weak demand, about $188 million, a loss of about $12 million. Committing today would be worth about $33 million in present value. Holding the option and building only if demand is strong is worth about $38 million, because the weak-demand loss is avoided. The flexibility itself adds about $4 million, and the option as a whole adds about $38 million to the decision to build phase one.

Real Options in Context

Myers (1977) described much of a firm's value as coming from growth opportunities, options to invest in the future, rather than from assets in place. Dixit and Pindyck (1994) showed that when investments are irreversible and uncertain, the ability to wait for information has value that standard net present value ignores. Lakeshore's purchase of land sized for two phases is a small cost that creates a valuable option.

Strategic Fit

The plant fits the Week 1 diagnosis. It expands the food service line, which earns well above its cost of capital, and reduces freight costs that weigh on margins. It does not commit capital to custom packaging, the line that destroys value. It also strengthens Lakeshore's position against larger paper companies entering the market, because regional plants near customers are hard to replicate quickly.

What Practitioners Weigh

Graham and Harvey (2001) reported that discounted cash flow rules dominate how chief financial officers screen projects, and that a substantial share also consider real options at least sometimes. Lakeshore's board asked for both, plus a clear statement of what must go right.

Conditions

The plant should proceed if the three chains sign supply agreements covering at least 60 percent of first-phase capacity for five years, which protects against the weak ramp, and if construction bids confirm the $180 million estimate within 10 percent.

Conclusion

The Georgia plant adds about $60 million of value over a twenty-year life and creates an option to expand worth about $38 million. Its value depends on a reasonable ramp, which customer commitments can secure. Building phase one now and deciding on phase two in year four aligns the investment with the company's strongest business.

References

Dixit, A. K., & Pindyck, R. S. (1994). Investment under uncertainty. Princeton University Press.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(2), 147-175. https://doi.org/10.1016/0304-405X(77)90015-0