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Final Examination Advanced Corporate Financial Management EDHEC Business School Professors Jim Seard Su!mitted B"#$%ahul Pande" Case Questions
(1) What is the appropriate discount rate to use in evaluating the Collinsville Collinsville plant opportunity? What is the cost of equity? What is the after-tax after-tax cost of debt? What weights ought to be applied to each source of capital in calculating the discount rate? The discount rate or Weighted Weighted verage verage Cost of capital to use in evaluating the Collinsville plant opportunity is calculated as WCC! (1-Tax rate) "cost of pretax debt "(#$#%&) % cost of equity"(&$#%&) Where tax rate !' as based on *nancial state+ent of #ixon corporation (&xhibit ,) WCC WCC !1.'/ (s calculated in Wor0sheet- given below)
&a'Calculating the cost of e(uit" The cost of equity is calculated calculated by using the Capital sset 2ricing 2ricing +odel3 Cost of &quity !4f % beta "4is0 pre+iu+ Where 4f is ris0 free rate5 6eta is the sensitivity of the Collinsville plant invest+ent to the +ar0et5 nd ris0 pre+iu+ is expected return on +ar0et portfolio 4is0 free rate5/. 5 is ta0en as 7ong ter+ treasury bond(case) as #ixon is expected to run Collinsville plant for at least ten year. The calculation of ris0 pre+iu+ is based on arith+etic average of spread between 89 2 return and long ter+ :8 ;over ;overn+en n+entt treasu treasury ry 6ond 6ond retur returns ns fro+ fro+ 1/< 1/< to 1/,/ 1/,/ becaus because e = believ believe e that that historical pre+iu+ over extended period is the best esti+ate of the ris0 pre+iu+ loo0ing forward.
Calculation of %is) premium$ &*or)sheet $+'
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#ixon is a diversi*ed che+ical product co+pany and it never produced sodiu+ chlorate. Therefore5 the ris0 associated with its existing business is not applicable to its upco+in upco+ing g future future invest invest+en +entt relat related ed to Collin Collinsvi sville lle plant. plant. 8o5 = loo0 loo0 towar towards ds existing sodiu+ chlorate producers to +easure the syste+atic ris0 in the industry. industry. =n +y anal analys ysis is55 = noti notice ced d that that the the 7arg 7arge e co+p co+pan anie ies s such such as >oo0 >oo0er ers5 s5 2ennwa ennwalt lt55 +erican and err-@c gee will not have the sa+e ris0 as #ixon has because they are diversi*ed diversi*ed che+ical co+panies. co+panies. ;eorgia paci*c paci*c is not considered considered as it a paper and pulp co+pany. Therefore5 = calculate the beta by ta0ing the average of the unlevered beta of 6runswic0 and 8outhern che+icals because they are specialiAed in pro produc ducing ing sodi sodiu+ u+ chlor hlora ate and their heir asso assoc ciat iated busi busine ness ss ris0 ris0 wil will be representative of +ar0et ris0 for a new sodiu+ chlorite producer li0e #ixon.
Assumption considered here# $ Bor +y convenience5 = assu+e that debt carries no +ar0et ris0 (has a beta of Aero)5 the beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio 7 ! u (1% ((1-t) #$&)) Calculate the unlevered beta to re+ove the bene*cial eDect (Tax eDect) gained by adding debt to capital structure. :nlevered 6eta ! levered 6eta$ (1 % (1- tax rate) (#ebt$&quity))
Ad,usting -nlevered Beta for .nancial leverage# $ Calculate the 7evered beta to achieve target leverage ratio of E for #ixon corporation
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&!'Calculating the after$tax cost of de!t s case does not +ention the debt pre+iu+5 which is rate applicable for corporate borrowing above govern+ent borrowing. 8o5 = assu+e that #ixon will borrow the debt at a rate of 11. 5 which is 7ong ter+ 666 corporate bonds rate. fter Cost of #ebt ! (1-tax rate) "Cost of debt .
&C' #ixon target a capital structure with leverage ratio of E percent. #ebt !F.E &quity !F.< Galue Galue (#ebt %&quity) !1 #$#%& !F.E and &$#%&!F.<
Calculation of Discount Factor or *ACC &*or)sheet $/'
() What are the relevant relevant free cash Hows to be used in evaluating evaluating the Collinsville plant5 excluding excluding the invest+ent in the la+inate technology? 2lease clearly show the free cash How in each each year. year. What speci*c reco++endations would you provide to top +anage+ent concerning the esti+ate of the ter+inal value for the plant? 6ased on your analysis5 is the purchase of the Collinsville
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Calculation of Cash 0os 4evenue !2rice of sodiu+ chlorate " 8ales Gariable cost !2ower % ;raphite ;raph ite % salt 9others Bixed cost !7abor % @aintenance % Ithers @anufacturing cost !Bixed Cost %Gariable cost Ither charges ! 8elling % 49# % #epreciation The &6=T (&arning before before inco+e tax) is calculated calculated by subtracting total +anufacturing cost and other charges including depreciation fro+ the total revenue. &6=T !4evenue - @anufacturing cost J Ither charges &arning before interest after tax is calculated as below &6=T ! &6=T " (1 JT) The capital expenditure expenditure consists of expenditure expenditure on new and existing property plant and equip+ent Capex !Ket increase in 229& %depreciation Wor0ing Wor0ing Capital ! Current assets - current 7iabilities ccounts 4eceivables 4eceivables % =nventories J ccount 2ayable Change in Wor0ing Capital ! wor0ing capital between two consecutive year
Cash Blow !&6=T % depreciation - Capital expenditure - change in wor0ing capital
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We can calculate the ter+inal value of plant in two way. Ine way is to operate the plant for for *ve year and sell sell it at at a boo0 value in in *fth years. The other other way is to operate the plan for ten year and scrap the plant once it reaches Aero scrap value. =B #ixon decides to buy this plan with no invest+ent on la+inate technology5 = reco++end that the #ixon would operate this plant for ten year and generate the proLected cashHows. t the end of ten year #ixon can write oD and avail tax bene*ts associated with property5 plant and equip+ent. Bro+ +y calculation5 = can see that total K2G5 -.' +illion :8# as calculated in below wor0sheet-E5 is negative for this proLect if the cost of plant (1 +illion :8#) is ta0en into consideration. =n the absence of any other invest+ent5 the proLect would erode the shareholderMs wealth. >ence it is advised that #ixon should not buy the plant without the la+inate technology. technology.
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(E) What cash Hows are relevant relevant to the valuation of the la+inate la+inate technology invest+ent? (Bor the purpose of answering this question5 you +ay assu+e that #ixon already already owns the Collinsville plant). 6ased on your analysis5 is investing in the la+inate technology econo+ically attractive? =f #ixon owns the Collinsville plant5 the cashHow will be calculated based on la+inated technology. technology. = assu+e that the la+inate technology reduces power costs by F percent between year 1/F and 1//. eli+inates graphite costs between year 1/F and 1// as =t can be installed in the beginning of 1/F for N. +illion. brings tax savings due to depreciation between year 1/F and 1//. • •
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technology or not? 6e sure to explain explain carefully how you arrived arrived at your *nal reco++endations regarding what you believe that #ixon should do. #ixon Corporation is planning to buy a sodiu+ chlorate plant located near Collinsville. The acquisition of the Collinsville plant would support #ixonMs strategy of supplying che+icals to the paper and pulp industry. industry. The plant is currently operated by +erican Che+ical Corporation (+erican)5 who has oDered to sell the plantMs net assets for N1 +illion.
•
•
•
#ixon has several options3 =t can buy the plant5 choose not to install the la+inate technology5 and sell the plant at the end of either or 1F years. =t can buy the plant5 invest in the la+inate technology and operate it for the next ten year. =t can postpone it plan by considering external factors and evaluating the pro*tability of the proLect.
Bro+ +y analysis5 the option of purchasing Collinsville plant with 7a+inate technology is preferable to the option of Collinsville plant without 7a+inate technology. technology. Kow the choice boils down d own to second and third option. The K2G value is positive for proLect with 7a+inate technology if all +y assu+ptions are true. 6ut these assu+ptions are averse to +ar0et ris0 and cost of capital. 8o5 we will test the K2G sensitivity on cost of capital and external factors. •
•
=f the capital is cheap5 the option of invest+ent is attractive. 8o5 = will test the K2G sensitivity to diDerent discount factor. factor. Co+petitive environ+ent is intense in sodiu+ chlorate industry as every corporation is producing the sa+e p roduct5 a perfect co+petition scenario where pro*tability depends on supply and de+and. 8o5 = will test the K2G sensitivity to sales growth and price change.
6y chec0ing these sensitivities5 = notice that the option of purchasing Collinsville plant with 7a+inate technology +ay erode shareholder wealth if Cost of capital increases fro+ 1.'/ to 1 or +ore ( *or)sheet$5 given •
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#iversi*ed Che+ical Co+pany
•
*ea)ness • •
Kew player in sodiu+ Chlorate =ndustry @ar0et is do+inated by three players
8pportunities Iverall5 the sales of sodiu+ chlorate industry increase. 2rice =ncrease over last years (2ositive trend). =ncrease in #e+and. 7a+inate technology will decrease the graphite and power cost. • • • •
2hreats 2ro*t @argins can go down because of e+erging co+petition Capacity utiliAation can be decreased Twelve Twelve existing existing co+petitors co+petitors plus two two new co+petitors •
• •
%ecommendation 6y evaluating the value of the proLect econo+ically5 strategically5 and *nancially5 = reco++ reco++end end that that #ixon #ixon Corpor Corporati ation on should should buy Collin Collinsvi sville lle plant plant with with 7a+ina 7a+inate te technology as this invest+ent will establish its position as a do+inant player in would co+ple co+ple+en +entt #ixons #ixons strate strategy gy of supply supplyin ing g sodiu+ chlorate chlorate industry industry. =t would
che+icals to the paper and pulp industry. #ixon will always have the option of exitin exiting g busine business ss by sellin selling g plant plant if busin business ess turns turns not pro*t pro*tabl able. e. 2urc 2urchas hasing ing Collinsville plant5 as opposed to building a new plant5 is a cheap way to enter in the sodiu+ chlorate business.
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