@ fej United States 

Department of 

Agriculture 

Forest Service 

System 6 Alternatives: 

Northeastern Forest An Economic Analysis Experiment Station 

Research Paper 

N E-551 Bruce G. Hansen 

Hugh W. Reynolds 
The Authors 

Bruce G. Hansen, economist, received a B.S. degree in 

economics from Concord College, Athens, West Virginia, in 

1968, and a M.B.A. degree from Virginia Polytechnic Institute 

and State University in 1978. He is currently engaged in research 

on analysis of international trade for hardwood forest products 

at the Northeastern Forest Experiment Station's Forestry Sciences Laboratory, Princeton, West Virginia. 

Hugh W. Reynolds received a B.S. degree in electrical engineering from the University of Minnesota in 1950. For the past 17 

years he has been engaged in research on the use of low-grade 

hardwoods at the Forestry Sciences Laboratory at Princeton. 

Manuscript received for 

publication 17 January 1984. 

Abstract 

Three System 6 mill-size alternatives were designed and 

evaluated to determine their overall economic potential for 

producing standard-size hardwood blanks. The study focused on 

developing standard discounted cash flow measures. Internal 

rates of return ranged from about 15 to 35 percent after taxes. 

Secondary effort was directed at providing accounting cost 

summaries to facilitate cost comparison of standard-size blanks 

with rough-dimension stock. Cost per square foot of blanks 

ranged from about $0.88 to $1.19, depending on mill size and the 

amount af new investment required. 
Introduction 

System 6 is a new technology 

that, when combined with the production of standard-size hardwood 

blanks, provides a way to convert a 

low-grade resource into high-value 

products. A standard blank is a piece 

of solid wood (generally constructed 

from edge-glued pieces) of specified 

length, width, thickness, and quality. 

Specifications for standard-size blanks 

have been developed from an analysis 

of rough-dimension part sizes required 

by 32 major manufacturers of furniture 

and kitchen cabinets. Sizes have been 

determined so that rough-dimension 

parts can be processed efficiently 

from blanks with a minimum amount 

of loss in kerf and end trim. Several 

manufacturers have found System 6 

blanks satisfactory in the production 

of fine solid-wood products. 

System 6 production technology 

has been developed through numerous 

trials conducted at the Northeastern 

Forest Experiment Station's Forestry 

Sciences Laboratory at Princeton, 

West Virginia. However, a thorough 

economic analysis of System 6 is 

needed to see if investment is justified. In this paper we examine three 

alternative plant sizes that represent 

a range in investment and output by 

those who may wish to convert existing dimension operations to the manufacture of blanks, or by those who 

wish to produce blanks for sale on 

the open market. Also,,we discuss the 

many general issues ih investment 

analysis that affect results. 

Additional information on System 6 technology and standard-size 

blanks is found in Araman et al. (1982); 

Reynolds and Gatchell(1982); Reynolds 

and Araman (1983); Reynolds et al. 

(1983); and Reynolds and Hansen 

(1 984). 

Study Design 

Mill Alternatives 

The three options for producing 

blanks with System 6 technology are 

referred to as the standard-mill, the 

mini-mill, and the maxi-mill alternatives. While all three were profitable, 

there were obvious economies associated with increased scale of operation. 

The standard-mill was assumed 

to have a daily input of 16 Mbf (thousand board feet) of 6-foot cants. This 

resulted in production of about 7,200 

ft2 of blanks. Production of the minimill was one-half that of the standardmill, while production of the maxi-mill 

was double that of the standard-mill. 

In each case, we assumed that the 

mill operated 240 days per year, and 

that each Mbf of input resulted in 

450 ft2 of blanks. 

The standard-mill design is shown 

in Figure 1. This mill consisted of a 

resaw mill, a rough mill, and a glue 

room. The design included a forcedair predryer with a capacity of 250 Mbf, 

three kilns with a total capacity of 

60 Mbf, and a boiler. This mill had a 

capability of sustained production 

of 16 Mbf of green cants into 7.2 Mbf 

of C1 F (clear-one-face) panels (blanks) 

with a single shift. The initial investment required for this plant was $1.7 

million excluding working capital 

(Table 1). 

The mini-mill was designed to be 

built adjacent to an existing dimension facility. Another goal was to 

limit the initial investment to about 

$1 million. This goal was partially 

achieved by eliminating the following 

equipment: 

Item Number 

Defect saws 2 

Sorting table 1 

Salvage ripsaw 1 

40-clamp carrier 1 

Cutoff saw 1 

Stacker 1 

Strapping machine 1 

Further reduction in the initial 

cost was obtained by eliminating 

separate kiln facilities and reducing 

boiler size. The prestickered packages of System 6 boards were dried 

with kiln facilities of the dimension 

mill at a marginal cost of $35 per Mbf. 

The mini-mill processed 8 Mbf of 

cants into 3,600 ft2 of blanks daily. 

Maxi-mill production was achieved by 

running the standard-mill on two 

shifts per day. To support the doubling 

of production, additional drying capacity was necessary. This increased 

the initial investment by approximately $300,000 over that required for 

the standard-mill. The maxi-mill proccessed 32 Mbf of cants into 14,400 ft2 

of blanks daily. 

Methods of Analysis 

Discounted cash flow. Our analyses of the System 6 standard-mill, 

mini-mill, and maxi-mill centered on 

the theoretically preferred measures 

of discounted cash flow (DCF): the 

internal rate of return (IRR) and the 

net present value (NPV). These measures assess the relationship between 

initial investment requirements and 

anticipated future after-tax cash 

flows (Appendix A). 

Another measure closely associated with the NPV is the profitability 

index (PI), also known as the benefit1 

cost ratio. This measure expresses 

the NPV in terms of the investment 

base from which it results and allows 

the N PV from different-size investments to be compared. 

Accounting-based cost summaries. In addition to the DCF analyses, we developed accounting-based 

manufacturing cost summaries for 

those who might use System 6 to replace existing dimension production 

facilities. In the case of replacement, 

we cannot account for all circumstances in which DCF analyses are 

used. For example, in developing data 

for such analyses, it is customary to 
'2 

ROUGH MILL 

I I 

FUEL HANWNG 

I I 

I 

I I 

I I 

I I 

I 

I 

! I 

I 

CANT RECOMNG & STORAGE 

I 8 I 

I I 

I I 

L I - 

& - d 

FORCED AIR DRYER 

ROUGH MU 

1 PACK&€- 

2 SarT BIIS (* nq'd) 

3 llOUPCQlMIORS 

4RXMRUW 

5 WI*i aDSxUT SAW 

6PIEQSQIT 

7 O*WORPSIW 

8 PECECQlMIcm 

9 Cn.-Ylm 

10 s0FmMG-m 

11 SALVAOE RPSIWS 

12 PECES BY LEI*iTn 

GLUE ROOM 

1 UIUITIlLE 

2 UUESPIEUIW 

3 Y)CUYPCARRRS 

4 -PLANER 

5 SHII(YIRLPPICXm 

Figure 1.-The standard System 6 mill (input capacity: 16 Mbf per shift). 
Table 1.-System 6 equipment costs for a standardmill 

(prices current: October 1982) 

Item Cost 

Dollars 

Primary processing machinery 

Cant gang resaw: 11 saw (100 hp) 22,000 

Cant cutoff saw: 6 x 25 (15 hp) 9,000 

Receiving deck, unscrambler and conveyors 36,000 

(25 hp total) 

2 manual board stackers at $7,500 each 15,000 

(10 hp total) 

Board conveyors and strapping machine 30,000 

(25 hp total) 

Hoglscreen chip-pac and infloor sawdusUrefuse 48,500 

conveyor (75 hp total) 

Forklift, 4,000 pounds propane 12,500 

Secondary processing machinery 

Package breakdown hoist and 3-way sort 

conveyors (25 hp total) 

Rough planer: 2-side, 4 x 12 spiral knives 

(50 hp total) 

Gang crosscut saw: 5-saw, variable spacing 

(30 hp total) 

Modified gang ripsaw (100 hp) 

Piece convevors and ~iece sort station 

(25 hp 

4 defectina saws at $8.500 each 120 h~ total) 

2 rotary s&ting tables it $4,500 each' 

(10 hp total) 

2 salvage ripsaws withreturn conveyors at 

$8,500 each (50 hp total) 

Forklift, 4,000 pounds propane 

Glue spreader and conveyors and panel layup 

tables (15 hp total) 

Clamp carriers: 80 section at $65,000; 40 section 

at $35,000 (air motors) 

Panel trimsaw: 3-saw variable s~acina - 

(30 hp total) 

Blank ~laner: 2-side, 2 x 30 s~iral knives 

(75 tip total) 

Dust collection system and bins (50 hp total) 

Minicomputer with 250K memory 

530,000 

Dryers, kilns, and boilers 

Boiler, 200 hp and fuel handlinglstorage 300,000 

250 Mbf dryer at $0.60lboard foot capacity 150,000 

3-20 Mbf kilns at $2.70/board foot capacity 162,000 

2-forklifts, 4,000 pounds propane at $12,500 each 25,000 

637,000 

Land 

Improved 8 acres at $12,50O/acre 100,000 

Buildings 

Primary plant 40 x 70 feet = 2,800 ft2 at $24/ft2 67,000 

Secondary plant 40 x 150 feet = 6,000 ft2 144,000 

at $241ft2 

Boiler 40 x 40 feet = 1,600 ft2 at $12.50/ft2 20,000 

Air-dry lumber storage 40 x 60 feet = 2,400 ft2 29,000 

at $12/ft2 

260,000 

Total investment 

Primary plant machinery 173,000 

Secondary plant machinery 530,000 

Subtotal 703,000 

Dryers, kilns, and boilers 637,000 

Buildings 260,000 

assume that complete new facilities 

are to be constructed. This allows us 

to have access to relevant price information. By contrast, those who replace existing facilities will most 

likely convert some portion of their 

existing plant and equipment to the 

System 6 venture. Still other components of the existing facility may 

no longer be necessary; their sale can 

be used to further offset initial investment requirements. Therefore, the 

number of investment requirement 

possibilities can be as large as the 

number of possible investors. 

Similarly, it is difficult to derive 

possible revenues when replacement 

is involved. If products are to be sold 

on the market, we generally can use 

the current market price of the same 

or substitute products to estimate. 

revenues. But when conversion leads 

to "revenues" because of internal 

cost savings, we cannot account for 

the many likely possibilities among 

investors. 

The manufacturing cost summaries follow general accounting 

practice and provide manufacturing 

costs on a square foot of output 

basis. Where costs are comparable 

to those of the process being studied 

for replacement, further individual 

DCF-based investigation of the actual 

costs and revenues involved should 

be undertaken. Help in undertaking 

a study of this nature generally is 

available from university forestry 

extension personnel and personnel in 

the various schools of business, the 

Small Business Administration, and 

private business consultants. The 

computer program by Harpole (1978) 

used in our analyses has been adapted 

to run on all major computer systems. 

Subtotal 

Land 

Total 
lnvestment Parameters 

Initial Costs 

Working capital is an important 

component of the initial cost of each 

alternative. Working capital refers to 

that required to purchase and maintain raw material, work-in-process, 

and finished goods inventories, and 

also to support credit sales to the 

extent that they were made. We assumed a 30-day inventory of raw 

material and a combined amount for 

finished-goods inventory and credit 

sales equal to 30 days' output. These 

requirements were proportional to the 

level of production. 

Variable Operating Costs 

The cost of raw material was 

estimated at $180 per Mbf. This figure 

was based on a cost of approximately 

$45 per cord for low-quality hardwood 

bolts (or about $100 per Mbf). To this 

we added a cost of $50 for sawmilling 

into cants and $30 for transportation 

to the System 6 mill. Each Mbf of 

cants yielded 450 ft2 of blanks. The 

cost of the raw material was independent of the volume purchased. 

We found that the cost of System 6 raw material is unaffected by 

species, as species generally is not a 

consideration in the market for lowgrade roundwood. Thus, the price for 

this material is related directly to the 

cost of manufacture. As a result, 

whether purchasing oak, cherry, or 

another species, the estimated price 

for cants of $180 per Mbf that we 

used in our analyses should hold 

firm. 

Labor costs for millworkers were 

assumed to average $6 per hour. This 

is broken down into a wage of $4.60 

per hour plus mandatory fringes of 

30 percent of $1.40 per hour. We believe this figure is adequate since 

most jobs within the System 6 mill 

require only minimum skills and training. We included a 2-week vacation 

allowance. Another 2 weeks of lost 

time was assumed during which workers were not compensated. Supervisory employees average $10 per 

hour in wages and fringe benefits. 

The standard-mill, including kilns, 

employed 47 people-45 production 

and 2 supervisory. Mini-mill employment consisted of 23 production 

workers and 2 supervisory personnel. 

The maxi-mill labor force was twice 

that of the standard-mill in both production workers and supervisory 

personnel. 

Raw material and labor accounted 

for nearly 85 percent of the total variable cost of the standard- and maxiSystem 6 alternatives. Remaining 

costs were accounted for by utilities, 

supplies, and selling expenses. Minimill raw material and labor costs 

accounted for about 80 percent of the 

total variable cost. The remaininn 

20 percent was utility, supply, seliing, 

and dry-kiln contract costs. Table 2 

includes a detailed breakdown of the 

variable operating costs for each 

alternative. 

Fixed Operating Costs 

Fixed costs for each alternative 

were composed of management and 

administrative costs, insurance costs, 

and maintenance expenses (Table 2). 

In terms of the management and 

administrative staff, the standard-mill 

had an assumed staff of two administrators and one secretary; the mini-mill 

had a staff of one administrator and 

one secretary; the maxi-mill had two 

administrators and two secretaries. 

For all alternatives, insurance 

and maintenance costs were based 

on a percentage of the total cost of 

plant and equipment. Insurance was 

estimated at 2% percent annually. 

Maintenance was estimated at 10 

percent annually and was based on 

initial machinery cost. This allowance 

,would include expenditures for both 

parts and labor. 

Revenues 

Revenue estimates were obtained 

from the assumed sale of blanks on 

the open market at a price of $1.60 per 

square foot (Table 3). This price was 

equal to about 90 percent of the price 

received for rough dimension of similar quality. While mill residues were 

used to fire boilers, about twice as 

much was produced as was used. 

Although we did not include their sale 

in our analyses, it is possible that 

some investors will find a market for 

this surplus material. 

Other Factors Affecting 

lnvestment 

Besides the obvious factors that 

affect investment performanceinitial amount of investment, operating costs, and revenues-others are 

not so obvious. These include the 

time period or useful life of investment; inflation; depreciation; sources 

and costs of funds; tax rates and tax 

credits; and the time required to reach 

full production. Appendix B includes 

a detailed discussion of these issues 

and of our treatment of these factors 

with respect to the System 6 investment opportunity. 

Comparative Cash Flow 

Summaries 

The derivation of net after-tax 

cash flows in most years is straightforward. We subtracted operating 

costs and depreciation from revenues, 

computed taxes, and then added 

depreciation to the after-tax income. 

However, there are some instances 

where other considerations affect 

the net after-tax cash flows. First, 

additional working capital is required 

to cover inventories as the plants 

move to full production. Second, the 

maxi-mill requires additional capital 

investment in year 2 to cover increased 

kiln and boiler capacities. Third, 

Harpole's (1978) cash flow program 

allows for the complete writeoff of 

depreciation in the year it occurs 

whether or not there is sufficient 

income from the project itself. In such 

instances, it is implicitly assumed 

that there is additional income for the 

investor, allowing the complete and 

immediate writeoff to occur. This 

treatment enhances the net after-tax 

cash flow only to the extent of the tax 

benefit derived from depreciation. 

Finally, proceeds from the assumed 

sale of land and from real assets in 

an amount equal to their undepreciated value, plus the return of working 

capital, are added to the operating 

cash flows at the end of year 10. Once 

after-tax net cash flows have been 

determined, the DCF measures are 

calculated. Cash flow summaries for 

the three mill alternatives are included 

in Tables 4-6. The accounting-based 

summaries do not require cash flow 

summaries since they focus on the 

costs occurring in just 1 year at full 

production. 

4 
Table 2.-Variable and fixed operating costs for the 

System 6 mill alternatives 

Cost item Year 1 Years 

Year 3 to 10 

Variable costs 

Raw material 

Labor 

Supplies 

Utilities 

Selling expense 

Drying 

Fixed costs 

Management and admin. 

lnsurance 

Maintenance 

Total 

Variable costs 

Raw material 

Labor 

Supplies 

Utilities 

Selling expense 

Fixed costs 

Management and admin. 

lnsurance 

Maintenance 

Total 

Variable costs 

Raw material 

Labor 

Supplies 

Utilities 

Selling expense 

Fixed costs 

Management and admin. 

lnsurance 

Maintenance 

Total 

MINI-MILL 

STANDARD-MI LL 

MAXI-MILL 

Table 3.-Revenues for the System 6 mill alternatives 

Mill type Year 1 Year 2 Years 

3 to 10 

Mini 691,200 1,382,400 1,382,400 

Standard 1,382,400 2,764,800 2,764,800 

Maxi 1,382,400 2,764,800 5,529,600 
Table 4.-Standard-mill cash flow summary 

Facilities -~. ~. .. 

and working ,qevenues Net after-tax 

Year capital Operating Depreciation cash flow costs 

investment 

Table 5.-Maxi-mill cash flow summary 

Facilities 

and Revenues Net after-tax 

Year ca~ital Operating Depreciation cash flow costs 

investment 

........................................ Thousands of dollars ........................................... 

0 1,857 - 1,857 

1 468 1,382 1,177 168 - 280 

2 31 3 2,765 1,760 253 346 

3 5,530 3,321 259 1,312 

4 5,530 3,321 254 1,309 

5 5,530 3,321 242 1,304 

6 5,530 3,321 88 1,233 

7 5,530 3,321 76 1,228 

8 5,530 3,321 76 1,228 

9 5,530 3,321 73 1,226 

10 5,530 3,321 64 2,309 

Table 6.-Mini-mill cash flow summary 

Facilities 

and Revenues Net after-tax 

Year capital Operating Depreciation cash flow costs 

investment 

Results of Analyses 

Discounted Cash Flow Performance 

The results of the DCF analyses 

of System 6 investment alternatives 

indicate that they are economically 

justifiable. As seen in Table 7, the 

IRR ranged from about 15 percent for 

the mini-mill to 35 percent for the 

maxi-mill. This pattern was similar for 

NPV's and Pl's; both increased with 

the scale of operation. With respect 

to the alternatives we have presented, 

there seemed to be a direct relationship between size and performance. 

And as was readily apparent, the returns to the maxi-mill were considerably better than those to the other 

two. However, we believe that increasing mill size and operation much 

beyond the parameters established 

for the maxi-mill would pressure the 

upper limits of the mill's technological and physical capabilities. Consequently, additional improvement in 

performance is unlikely. 

While all three alternatives 

seemed economically justified under 

the conditions prescribed, we examined performance under changes in 

some of the key inputs: initial investment, sales, price, and fixed and 

variable operating costs. Keep in 

mind that we were not concerned so 

much with increases in sales and 

prices as we were with declines. Conversely, decreases in investment and 

operating costs were not of the same 

concern as were increases. Figures 

2-4 were derived using Harpole's 

(1978) CFA program and depict what 

happened to the internal rate of return 

(IRR) when either a 10- or 20-percent 

increase or decrease was imposed on 

the selected input while all others 

remained unchanged. As can be seen, 

mini-mill IRR was sensitive to any 

increase in cost or decrease in either 

the level of sales or price of blanks. 

A 10-percent change in any one of 

these resulted in an IRR below 15 

percent. 

By contrast, the standard-mill 

offered some security against the 

adverse effects of changes in the 

selected revenue and cost items. For 

this alternative, only a 20-percent 

reduction in the volume of sales or in 

the price of blanks will cause the IRR 

to fall below 15 percent. 
Table 7.-Economic performance criteria 

for the three System 6 

design alternatives 

The maxi-mill was the most certain to earn at least a 15-percent 

return. In fact, in no instance did the 

return fall below 15 percent. The lowest IRR (19 percent) resulted from a 

20-percent drop in the unit price. - - 

Mill type IRR NPV PI 

Percent Thousands of dollars 

Standard 24.5 892 1.48 

Mini 15.0 0 1 .OO 

Maxi 35.0 2,763 2.47 

We did not measure compound 

effects. Certainly, in those instances 

where both volume and price were to 

fall or where several cost items were 

to increase in conjunction with a 

decline in revenues, all alternatives 

would be in jeopardy. 

- - 

PRICE 

SALES 

FIXED 

ZOST 

CACILITIES 

CHANGE (Percent) 

Figure 2.-Sensitivity of IRR to changes in selected inputs: standard-mill. 
PRICE 

SALES 

-20 -10 0 10 20 

CHANGE (Percent1 

Figure 3.-Sensitivity of IRR to changes in selected inputs: mini-mill. 
- 10 0 10 

CHANGE (Percent) 

PRICE 

SALES 

FIXED 

COST 

FACILITIES 

VARIABLE 

COST 

Figure 4.-Sensitivity of IRR to changes in selected inputs: maxi-mill. 
Accounting-Based Cost Estimates 

The accounting cost summaries 

are provided for those investors who 

may look at blanks as a replacement 

for conventional dimension production. As stated earlier, we are unable 

to perform DCF analyses to cover all 

possible differences in the level of 

investment and potential "revenues" 

that might exist among individual 

investors. 

The cost data in Table 8 for the 

three alternative ventures were developed to be generally comparable 

to manufacturing costs information 

provided by the accounting profession. In these summaries, manufacturing costs were broken into three 

components-variable costs, fixed 

costs, and depreciation expense 

which was used to account for the 

building and equipment "used up" in 

the production process. If these costs 

are near those of an existing dimension manufacturer, a more thorough, 

individually tailored, DCF investigation of the System 6 opportunity 

might be warranted. This investigation would focus on the relationship 

between the added (marginal cost) 

investment required and the potential 

cost savings (marginal benefits) to be 

realized over the life of the investment. 

In looking at the accounting 

cost summary, note that depreciation 

was calculated for each of five levels 

of investment, which ranged from 

zero to 100 percent of those estimated 

for a complete new plant and equipment. This was done for two reasons. 

First, it provides a means for more 

accurate comparison of the inflated 

depreciation costs of a plant placed 

in service today with the uninflated 

depreciation costs of one placed in 

service some time ago. Rough comparison can be facilitated by multiplying the total investment cost of a 

complete new facility by the ratio 

between the producer price index 

during the past investment and that 

of the present. Once determined, the 

row in Table 8 representing an investment nearest this amount (i.e., 0, 25, 

50, 75, 100 percent) will be more accurate for cost comparison. Second, the 

different levels of investment can be 

used to evaluate prospective costs 

more accurately where a portion of 

existing plant and equipment are to be 

either used or sold; this reduces the 

amount of new investment required. 

The costs per square foot of C1 F 

standard-size blanks for the standardmill ranged from about $0.94 assumTable 8.-Cost per square foot of C1 F standard-size 

blanks for each System 6 alternative 

given different levels of 

capital investment 

Item Standard Mini Maxi 

------------------- Dollars -------------.----- 

Variable cost 0.792 0.897 0.792 

Fixed cost .I47 .I66 .089 

Total operating cost .939 1.063 .881 

Capital investment cost 

0 percent .OOO .OOO .OOO 

25 percent .025 .032 .015 

50 percent .049 .064 .029 

75 percent .074 .095 .044 

100 percent .098 .I27 .058 

ing no capital investment was required 

to nearly $1.04 for a complete new 

facility. Mini-mill costs were considerably higher starting at about $1.06 

per square foot and ending at $1.19. 

The maxi-mill had the greatest economies, with costs per square foot ranging from approximately $0.88 to $0.94. 

Whether or not these costs are attractive depends on the current costs of 

the individual dimension producer. 

Conclusion 

Each of the three alternative 

operations for producing standardsize blanks from low-grade hardwood 

material seems commercially viable. 

Our treatment of the many elements 

(Appendix 6) considered in an economic analysis tended to impose the 

more stringent assumptions on anticipated costs and revenues. However, 

we could not allow for all situations 

and recognize that for some individuals the situation will differ from that 

which we have described. Sensitivity 

analyses provide an indication as to 

the most critical areas. Those who 

are contemplating an investment in 

System 6 will need to trace our steps 

in determining more exactly the costs 

and revenues they will incur. 

To duplicate results in actual 

production, management will need to 

ensure that the production rates and 

costs established in the analyses are 

maintained, and that the operation is 

kept in production for the prescribed 

time once the mill is operating. The 

latter requirement can be best ensured by developing and maintaining 

a viable market for System 6 standardsize panels. 

Total cost 

Low 

High 
Literature Cited 

*aman, Philip A.; Gatchell, Charles J.; 

Reynolds, Hugh W. Meeting the 

solid wood needs of the furniture 

and cabinet industries: standard. 

size hardwood blanks. Res. Pap. 

NE-494. Broomall, PA: U.S. Department of Agriculture, Forest Service, 

Northeastern Forest Experiment 

Station; 1982. 27 p. 

Gitman, Lawrence, J.; Mercurio, 

Vincent A. Cost of capital techniques used by major U.S. firms: 

survey and analysis of Fortune's 

1000. Financial Management ll(4): 

21 -29; 1982. 

Harpole, George B. A cash flow analysis computer program to analyze 

investment opportunities in wood 

products manufacturing. Res. Pap. 

FPL-305. Madison, WI: U.S. Department of Agriculture, Forest Service, 

Forest Products Laboratory; 1978. 

24 p. 

Reynolds, Hugh W.; Araman, Philip A. 

System 6: making frame-quality 

blanks from white oak thinnings. 

Res. Pap. NE-520. Broomall, PA: 

U.S. Department of Agriculture, 

Forest Service, Northeastern Forest Experiment Station; 1983. 9 p. 

Reynolds, Hugh W.; Gatchell, Charles J. 

New technology for low-grade hard. 

wood utilization: System 6. Res. 

Pap. NE-504. Broomall, PA: U.S. 

Department of Agriculture, Forest 

Service, Northeastern Forest Experiment Station; 1982. 8 p. 

Reynolds, Hugh W.; Hansen, Bruce G. 

A sample plant design for System 6. 

Gen. Tech. Rep. NE-87. Broomall, 

PA: U.S. Department of Agriculture, 

Forest Service, Northeastern Forest Experiment Station; 1984. 8 p. 

Reynolds, Hugh W.; Araman, Philip A.; 

Gatchell, Charles J.; Hansen, 

Bruce G. System 6 used to make 

kitchen cabinet C2F blanks from 

small-diameter, low-grade red oak. 

Res. Pap. NE-525. Broomall, PA: 

U.S. Department of Agriculture, 

Forest Service, Northeastern Forest Experiment Station; 1983. 11 p. 
Appendix A 

The mathematical formula of the 

IRR can be expressed as: 

In essence, the IRR is a rate of 

discount that when divided into the 

net after-tax cash flows (NATCF) of 

each period (i) during the life of the 

investment (N) reduces their sum to 

an amount equal to the initial investment (I,). The IRR is found via an 

iterative process. 

The IRR can be thought of as a 

rate of earnings similar to the simple 

interest earnings of a home mortgage 

loan. I, is essentially the same as the 

original amount of a mortgage loan 

or principal and the NATCFi is comparable to the periodic payments. The 

IRR is comparable to the annual percentage rate of the mortgage loan. 

With any mortgage loan, the payment 

generally contains an amount to 

cover interest on the outstanding 

balance plus a return of principal. At 

the end of (N) payments, the loan is 

completely amortized. So, too, is the 

case with regard to earnings stemming from investment. 

In most mortgage situations, 

payments are equal and of an amount 

sufficiently large to cover interest 

cost plus a portion of principal. However, this need not be the case for the 

same principles of simple interest to 

apply. For example, innovative financing arrangements have evolved that 

are designed to keep payments lower 

during the earlier years of a mortgage 

than what they ordinarily would be if 

equal. This is accomplished through 

what are termed "negative" payments 

to principal. Many investment situations may result in cash flows patterned in this manner. 

The simple interest concept of 

the IRR differs from the concept 

where the IRR is presumed to represent a "compound" or "growth" rate 

of return. This latter concept assumes 

that any intermediate cash flows 

occurring during the life of the investment are reinvested at a rate equal to 

the IRR for the project. Such reinvestment opportunities may not always 

be available. Thus, to the extent that 

the actual rate of reinvestment differs 

from the IRR calculated for the project, the overall rate of "growth" under 

this concept will be affected. 

The NPV formula looks quite 

similar to the IRR, however, there are 

some important differences. 

In this formula, the rate used to 

discount cash flows (r) is assigned. 

As a result, when the initial investment is subtracted from the discounted sum of the cash flows, the 

difference may be positive, negative, 

or zero depending in part on the rate 

of discount used. If the NPV is zero, 

r is equal to the IRR. Usually, r represents the minimum risk adjusted rate 

of return acceptable for investment. 

Consequently, projects with a negative NPV should be rejected. Final 

acceptance of projects with zero or 

positive NPV's (meaning returns 

equal to or above the minimum required) depends on the availability of 

funds and alternative opportunities. 

The discount rate should reflect 

the after-tax, weighted average cost 

of capital. By using a weighted average, implicit recognition is given to 

the overall debtlequity structure. 

In our studies of System 6 alternatives, we used a discount rate of 

15 percent when deriving the NPV for 

each investment. This rate is consistent with that generally used by industry during the early 1980's (Gitman 

and Mercurio 1982). Obviously, no two 

investments need have the same 

capital structure or the same component costs. Therefore, we recognize 

that 15 percent may not be appropriate to all investors; however, it is 

important to note that the IRR sets an 

upper limit for the cost of capital 

below which any rate of discount 

used will result in a positive NPV 

estimate. 

The final measure used in our 

analyses is the profitability index (PI). 

This measure also is known as the 

benefitlcost ratio and is derived as: 

PI = NPV + I, 

10 

This measure provides a look at 

the discounted returns (NPV) in terms 

of the investment on which it is based. 
Appendix B 

The following are less obvious 

factors involved in investment analyses that are not directly related to any 

particular investment, but that influence the results of such studies. In 

most instances, our approach in 

handling these factors resulted in a 

more conservative estimate of performance than had some other course 

been taken. 

Time Period 

In our analyses we have assumed 

a 10-year period over which to evaluate the investment. This period is 

fairly standard and can be supported 

rather easily. 

First, and perhaps most important in supporting this choice, the 

discounted value of the dollar at 

current interest rates after 10 years 

makes up a relatively small percentage of the total revenue resulting from 

investment. For example, if we were 

to receive a dollar each year for the 

next 20 years and were to discount 

the value to the present using a discount rate of 10 percent, the dollars 

received after the tenth year would 

account for just 28 percent of the 

total. If a 20-percent rate of discount 

were used, the dollars received after 

the tenth year would be worth even 

less, only 14 percent of the total. 

A second point that may be used 

to support the 10-year period relates 

to obsolescence. While it is possible 

that many plant facilities will last 

well beyond 10 years, they may become 

outmoded by advancing technology. 

Third, the longer the period forecast for investment, the less reliable 

are the estimates made of the costs 

and revenues to be expected, and the 

greater is the degree of uncertainty 

that enters into the evaluation. 

Finally, revenues lost by assuming the cessation of business activity 

in 10 years are partially offset by the 

assumed sale at the end of year 10 of 

land, real assets at their remaining 

undepreciated value, and the return 

of working capital reSulting from the 

liquidation of inventories. 

Inflation 

Inflation has proven to be persistent, highly volatile, and unpredictable. Consequently, it is an extremely 

difficult issue to deal with. While it 

might be prudent to expect a continuation, we can only guess at the rate 

of inflation over the next 10 years. It 

is near impossible to accurately predict individual increases in the various 

cost and revenue items. An alternative 

sometimes used is to assume a uniform rate of increase in both costs 

and prices. Yet, this actually has the 

effect of accenting performance. And 

if the rate is overspecified, predicted 

performance may not be realized, the 

consequences of which may be extremely detrimental. Recognizing 

these difficulties, we have chosen to 

disregard inflation in costs and revenues and to assume constant costs 

and prices (i.e., constant net revenues) over the life of investment. 

It is argued that if inflation is 

disregarded in determining future 

costs and revenues, the inflationary 

component of the cost of capital or 

discount rate should be similarly 

disregarded. We believe that to do 

this may be dangerous, especially if 

an investment is made today using a 

fixed inflated financial obligation 

and, subsequently, inflation is brought 

under control. Also, even what is 

referred to as the "real" rate of interest has itself become increasingly 

unstable in recent years. By using 

current capital cost estimates against 

the likelihood of constant costs and 

revenues, we better protect the investor against the negative risks of 

investment. And if a uniform rate of 

inflation does prevail, the consequence is that investment performance will exceed our estimates. 

Depreciation 

Depreciation, or capital recovery, 

is recognized in discounted cash flow 

analyses as it provides a shield from 

taxation for a portion of income equal 

to the amount of investment in buildings and equipment. DCF techniques 

recognize the time value of money; 

thus, the more accelerated the depreciation writeoff, the greater the benefits in tax-sheltered income. We use 

the recently legislated Accelerated 

Cost Recovery schedules for building 

and equipment capital cost recovery. 

Consequently, the full value (basis) 

of equipment is written off in 5 years. 

Building recovery during the first 10 

years is based on full value and is 

allotted according to the 15-year 

schedule allowances for real assets 

placed in service during the sixth 

month of the tax year. The remaining 

value of these assets (27 percent of 

their cost) is recaptured through 

their assumed sale at the end of the 

tenth year. 

Conversely, accounting theory 

recognizes depreciation as an expense and as a means to apportion 

that part of the building and equipment investment "used up" in the 

manufacturing process. Therefore, in 

constructing the accounting-based 

manufacturing cost summaries, we 

have chosen to apportion building 

and equipment costs equally over the 

10-year period through depreciation 

calculated on a 10-year straight-line 

basis. 

Sources of Funds 

Confusion can sometimes arise 

as to the earnings potential of an 

investment vis-a-vis other alternatives 

available to an investor because of 

the inclusion or exclusion of debt and 

equity considerations in the investment analysis. Consequently, it is 

necessary that we clarify our approach. We do not directly consider 

the sources of capital that might 

make up the initial investment because of the likelihood that each 

investor will have a different set of 

financial arrangements, that is, different amounts of debt and equity and 

different component costs. Rather, 

our analyses focus on the returns to 

the overall sum of investment dollars. 

This is not to say, however, that 

the results of individual financial 

arrangements cannot be discerned 

or used to evaluate the results of 

the System 6 analyses. To the contrary, by using the concept known as 

"weighted average cost of capital" 
(WACC), individual investors can 

determine the overall return on investment (discount rate) that would be 

required to repay debt plus interest 

costs and equity plus a desired profit. 

Likewise, knowing the IRR of an investment and the proportion and cost 

of debt used, the return to equity 

(profit) can be approximated. 

The WACC takes the following 

form: 

WACC PdCd (1 - t) + (1 - Pd) Ce 

where P, = the proportion of the total 

investment financed by debt capital 

C, = the interest cost of debt capital 

t = the tax rate 

(1 - P,) = the proportion of the total 

investment financed by equity 

capital 

C, = the desired return (profit) to be 

earned by equity capital. 

To use the WACC in determining 

the returns to equity, the following is 

used: 

IRR - PdCd (1 - t) C, n 1 - Pd 

Generally, if the IRR exceeds the 

after-tax cost of debt, then the return 

to equity will exceed the IRR. This is 

due to the leverage effect gained by 

employing debt capital. Conversely, 

if the IRR should lie below the aftertax cost of debt, the returns to equity 

will be less than the overall returns 

(IRR) to the project. 

Theoretically, returns to equity 

can be quite large in cases where the 

IRR exceeds the after-tax cost of debt 

and where debt is a significant proportion of the overall investment. In 

reality, overall indebtedness usually 

is kept at reasonable levels and rarely 

exceeds 50 percent of the total capitalization of a particular firm. 

In calculating the NPV, we used 

a discount rate based on an annual 

WACC of 15 percent. The WACC was 

based on a hypothetical financial 

arrangement calling for equal parts of 

debt and equity financing. The beforetax cost of debt was set at 18.5 percent and the desired rate of earnings 

on equity at 20 percent. 

Taxes and Investment Tax Credits 

For taxable income, we apply the 

Federal corporate maximum rate of 

46 percent. However, we do not include state and local taxes. Even so, 

we believe this approach generally 

will overstate the tax burden of most 

corporate investors. 

We chose to exclude the investment tax credit from our evaluations 

because it has a history of change, 

and because it is dependent on the 

past and current earnings of individual investors. By not including the 

investment tax credit, we have understated the return likely to be realized 

by most investors. 

Phase In to Full Production 

We believe it is realistic to assume that full production will not be 

reached in the first year of operation. 

Mechanical difficulties, problems 

stemming from labor and supervisory 

inexperience, and a host of other 

factors undoubtedly will arise. To 

account for these eventualities, we 

have constructed DCF analyses to 

allow for a gradual move to full production. For each alternative, full 

one-shift production is not reached 

until the second year. First-year revenues are determined at one-half the 

full one-shift level, and cost generally 

at three-fourths the full one-shift level. 

Maxi-mill full two-shift production is 

not reached until year 3. If you, the 

potential investor, can accelerate the 

move to full production, so much 

the better. But if fult production is not 

achieved in the period used in our 

studies, performance will fall short of 

our estimate. 
Hansen, Bruce G.; Reynolds, Hugh W. System 6 alternatives: an 

economic analysis. Res. Pap. NE-551. Broomall, PA: U.S. 

Department of Agriculture, Forest Service, Northeastern 

Forest Experiment Station; 1984. 14 p. 

Three System 6 mill-size alternatives were designed and evaluated to determine their overall economic potential for producing 

standard-size hardwood blanks. Internal rates of return ranged 

from about 15 to 35 percent after taxes. Cost per square foot of 

blanks ranged from about $0.88 to $1.19, depending on mill size 

and the amount of new investment required. 

ODC 836.1:651.7 

Keywords: Low-grade hardwood utilization; blanks; dimension 

stock; investment analysis; discounted cash flow; 

internal rate of return 

a US. GOVERNMENT PRINTING OFFICE: 1984-705-0291532 
Headquarters of the Northeastern Forest Experiment Station are in 

Broomall, Pa. Field laboratories are maintained at: 

Amherst, Massachusetts, in cooperation with the University of 

Massachusetts. 

Berea, Kentucky, in cooperation with Berea College. 

Burlington, Vermont, in cooperation with the University of 

Vermont. 

Delaware, Ohio. 

Durham, New Hampshire, in cooperation with the University of 

New Hampshire. 

Hamden, Connecticut, in cooperation with Yale University. 

Morgantown, West Virginia, in cooperation with West Virginia 

University, Morgantown. 

Orono, Maine, in cooperation with the University of Maine, 

Orono. 

Parsons, West Virginia. 

Princeton, West Virginia. 

Syracuse, New York, in cooperation with the State University of 

New York College of Environmental Sciences and Forestry at 

Syracuse University, Syracuse. 

University Park, Pennsylvania, in cooperation with the 

Pennsylvania State University. 

Warren, Pennsylvania.