American Chemical Corporation Case study

Final Examination Advanced Corporate Financial Management EDHEC Business School Professors Jim Seard 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 WCC! (1-Tax rate) "cost of pretax debt "(#$#%&) % cost of equity"(&$#%&) Where tax rate !'  as based on *nancial state+ent of #ixon corporation (&xhibit ,) WCC WCC !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





&!'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





Calculation of Cash 0os 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





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.

Cash 0o ithout 1aminate 2echnolog"$&*or)sheet$3'





(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//. • •











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.

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#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. •

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=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 •





#iversi*ed Che+ical Co+pany

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*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 •

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%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.





9P: Sensitivit" ith respect to sales &!eteen +;<4 and+;<;' !" )eeping others factors constant *or)sheet$6





American Chemical Corporation Case study

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