Lahore School of Economics

Advance 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

Introduction
Knight International, a century old company that believes in community work and corporate social
responsibility, is one of the largest producers of paper and pulp with 3.5 billion sales in recent year. The
company flourished in its initial years but reluctance of companys 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. 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.
The initial controversy arose as the management of the old facility, who had doubts about the new facility,
estimated the production tonnage per day more than facility could produce, lower variable cost thus
higher after-tax cash flows but then after discussion it was unanimously tonnage per day was decreased,
variable cost was increased thus the after-tax cash flows were decreased. Another controversy pointed out
by a member of EC was that 20 years was a relatively longer time for a modernized old facility;
considering 15 years was more realistic option. But in the end they decided to go with 20 years.
Moreover, 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.

Question No. 1
a. Calculate the NPV of modernizing the existing paper mill.
Initial investment
Operating Cash Flow (each year)
Total Cash Inflow
PVCF at 12%
NPV (PVCF-initial investment)

-170,000,000
44,653,600
$893,072,000.00
$333,537,548
$163,537,548

b. Calculate the NPV of building a new paper mill.

Initial investment
Operating Cash Flow (each year)
Total Cash Inflow
PVCF at 12%
NPV (PVCF-initial investment)

680,000,000
118,384,000
$2,367,680,000
$884,262,614
$204,262,614

Question No. 2
a. Calculate the IRR of each investment.
Existing paper mill 26.009%
New paper mill 16.603%
b. Calculate the payback of each.
Existing paper mill 3.81
New paper mill 5.74
Question No. 3
a. Do the NPV and IRR methods give the same accept/ reject signals?
They are mutually co related because
i. NPV is Positive
ii. IRR is greater than 12%
b. Explain why the NPV and IRR methods can give divergent signals when evaluating mutually
exclusive alternatives.
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.e. 204,262,614.02 &
163,537,547.82, 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, NPV is a direct
measure of how well New facility project will meet our goal.

For IRR, the numbers are worked out as 16.603% for new facility and 26.009% for Revised Old
facility. It provides us information to go for Revised-Old facility but its NPV numbers are lesser than
new facility.

Question No. 4
Suppose that the appropriate life of a modernized factory is 15 instead of 20 years. Evaluate the argument
that assuming a 20-year horizon for this project adds $44,653,600 times 5 or $223,268,000 to the yearly
cash flows.
Cash flow for 20 Years
Cash flow for 15 Years
Difference

$893,072,000
$669,804,000
$223,268,000

Questions No. 5
Based on your calculations in the previous questions and information in the case, what decision do you
recommend? Justify your answer.
Project A

NPV positive with higher value

IRR greater than 12%

Question No. 6
a. Building a new mill requires $510 million more than modernizing the old mill but will generate
an extra $73,730,400 in yearly cash flow. Calculate the IRR on this incremental expenditure.
Compare your answer to the 12 percent required return.
Incremental IRR
13.26%
b. Based on your answer in part (a), suggest a decision rule for the IRR in evaluating mutually
exclusive alternatives with different initial costs.

Question No.7

Use the information in Exhibit 2 to explain how the yearly cash flow estimate was obtained for:
(a) Modernizing the old mill.
Operating Cash Flow= NI + Depreciation
NI

36,153,600

Depreciation

8,500,000

1-20 years

44,653,600

(b) Building a new mill.

Operating Cash Flow= NI + Depreciation
NI

84,384,000

Depreciation

34,000,000

1-20 years

118,384,000

Question No. 8.

Suppose depreciation is over 5 years instead of 20 years:

(a) How would the NPV and IRR of each project be affected? Explain briefly.
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

170,000,000
44,653,600
$350,768,000
127,500,000
$225,561,703
$55,561,703
21.266%

680,000,000
118,384,000
$591,920,000
510,000,000
$685,129,698
$5,129,698
12.211%

(b) Which of these two projects will have the larger NPV change? Why?
Existing paper mill
NPV (20 years)=163,537,548
NPV (5 years) = 55,561,703
Difference=107,975,845

New paper mill

NPV (20 years)=204,262,614
NPV (5 years)=5,129,698
Difference=199,132,916

New paper mill project is showing larger NPV difference because of these two reasons:
1. Cash flow return of new paper mill is higher
2. As NPV of 5 years is low so the difference is greater

Question No. 9

How low can average annual production go before each proposal is unexpected?

Tonnage per day B

New Facility

(Revised) Old Facility

1,694

667

Question No. 10
(a) Is it appropriate to use the same discount rate to evaluate both proposals? Explain your position.
For like comparison we have to use the same discount rate. The starting period for both the
projects is same
(b) How, if at all, does your answer to 10 (a) affect your choice in question 5?
No, 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 ($)
680,000,000
170,000,000

Project 3
(Revised)
Old Facility

Tax rate (%)

Project Length (Years)
Price per ton ($)
Tonnage per day B

40
20
500
1,200

40
20
500
2,200

40
20
500
1,600

170,000,000

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
57,360,000

290
21,824,000

310
21,824,000

72.42

37.89

50.52

SL
20
34,000,000
42.93
118,384,000
12%
360

SL
20
8,500,000
14.76
67,981,600
12%
360

SL
20
8,500,000
19.68
44,653,600
12%
360

Income statement for Project 1- New Facility

Income Statement
Sales

396000000

Cost Of Production
Variable Cost

198000000

Gross Profit

198000000

Expenses
Fixed Expenses
Operational Cost without Depreciation

23,360,000

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

34,000,000

given

Total Expenses

57,360,000

Operational Cost without Dep+ Dep

EBIT
Tax

140,640,000
56256000

Gross Profit-Total expenses

EBIT*40%

Net Income

84,384,000

EBIT-Tax

Year
Operating Cash Flow
Total Cash Inflow

0
-680000000

1
118,384,000
$2,367,680,000

Cash flow for 20 years

118,384,000

Initial Investment

NI+Dep
680,000,000

given

PVCF

$884,262,614

required rate of return i.e. 12%

NPV

$204,262,614

PVCF-initial investment

IRR

16.603%

Payback

5.74

IRR formula plus operating cash flow in IRR

formula
INITIAL INVESTMENT/OPERATING
CASH FLOW

Incremental Cost
Incremental Cash flow

510,000,000
73,730,400

Incremental IRR

13.26%

Note: Operating cash flow is same for 20 years growth rate and/or inflation rate is not given in data
set.

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

13,324,000

Other Expenses

=Fixed operating cost per year

-Depreciation

Depreciation

8,500,000

given

Total Expenses

21,824,000

Operational Cost without Dep+ Dep

EBIT
Tax

60,256,000
24102400

Gross Profit-Total expenses

EBIT*40%

Net Income

36,153,600

EBIT-Tax