American Chemical Corporation
American Chemical Corporation BY PPAZERTY Bilal Al- Qureshi, Said Business School, University of Oxford 2010 HBS case Number: 9-290-102 Executive Summary The American Chemical Corporation (AMC) is a large, diversified chemical producer. In 1979, AMC was forced to issue a tender to sell a Sodium Chlorate plant, near Collinsville, Alabama. Dixon, a specialty chemicals company, was willing to purchase the aforementioned plant for $12m with the option to invest a further $2. 5m on laminate technology. The subsequent investment in Laminate technology was expected to eliminate graphite costs and reduce power consumption at the Collinsville plant by 15% to 20%. We will evaluate the acquisition of the Collinsville by Dixon at the proposed price. Table 1 identifies the assumptions that have been used for the evaluation of this acquisition. Table 1 Assumptions Reference Laminate Technology reduces power by a mean of 17. % Laminate Technology is depreciated over 10 years Sodium Chlorate price growth is 8%, per annum Power cost (per KWH) growth is 12%, per Plant Life is 10 years pg 3, HBS 9-280-102 Plant Salvage Value is zero Pg 1 , Assessed work Sheet EBIT flat after 1984 Capital Expenditures: $600,000 per annum fter 1984 Net Working Capital Remains flat after 1984 Definition of “Flat” Pg 4 http://www. imf. org/external/pubs/ft/wp/2006/wp06218. pdf 6. 5% is the Equity Risk Premium Slide 21, Risk and Return, class notes- Tax rate 48. 69% http://www. investopedia. om/articles/04/012104. asp Exhibit 7, HBS 9-280-102 pg 4, HBS 9-280-102 Pg 1, Assessed work Sheet From 1984 to 1989, the following growth rates are used Exhibit 8 , HBS 9-280-102 4 year Growth rate is used for Variable Costs Capital investment is based on fgures from 1980-1984 PPE and depreciation is based on figures from 1980-1984 Exhibit 8, HBS 9-280-102 Beta Debt is zero pg 443, Demarzo 2007 Debt to Equity Ratio: 35% : Plant: Valuation starts in 1980 Laminate Tech valuation starts in 1981 pg4, HBS 9-280-102 2 1. Estimate the Cost of Capital Reference: QI . ACC.
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SBS. xls a. Dixon Beta Exhibit 5 identifies the Equity Betas’ of selected Sodium Chlorate producers. Exhibit 7 identifies a beta of 1. 06 for Dixon. However, as previously stated, Dixon is not currently a Sodium Chlorate producer thus the suggested Beta fails to provide an insight into the systematic risk of the project vis-?¤-vis the sodium chlorate industry. We decide against calculating, and thus using the average equity beta of Southern and Brunswick as market representatives, as the cited chemical producers account for 5% of the Southern Eastern US market.
We therefore, calculate the average beta of the sodium chlorate industry by delevering the equity beta of market participants, as identified in Exhibit 7. As a noted market participant; we include American Chemical Corporation (ACC) in our calculations. Specification 11 identifies the formula used to delever: Table 2 presents our findings Table 2 1978 Equity Debt Tax rate ??D ACC . 61 0. 69 0. 39 0. 31 48. 7% 48. 7% 1. 20 1. 33 0. 73 0. 00 48. 7% 1. 06 IMC 0. 99 0. 01 0. 81 0. 80 0. 71 0. 29 1. 07 0. 85 0. 15 1. 1 0. 94 sc 0. 79 0. 21 0. 95 Based on the fgures extracted from Exhibit 1 & 5, a mean ??lJ of . 2 is yielded, suggesting that the related business operations of the selected market participants’ is less volatile than the market thus, in the absence of leverage, the sodium chloride ??lJ is then accordingly adjusted by being factored by Dixons capital structure. Specification 22 identifies the formula used to relever and adjust ??lJ with Dixons apital structure. (2) Dixon seta + ) * BU + . 35/. 65) *. 92 Pg 637, 2007, Demarzo, P et al “Corporate Finance”, Pearson International Pg 443, 2007, Demarzo, P et al “Corporate Finance”, Pearson International 3 b.
Cost of Debt (COD) Dixon is raising debt capital by issuing long3 and short term bonds; an interest rate of 1 1. 25% is used, for both instruments. Specification 3 identifies the formulae to calculate the cost of debt. (3) COST OF DEBT = Mrf 5. 77% = (1-48. 49%) * 11. 25% c. Cost of Equity (COE) We use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. As per our assumptions, our equity risk premium4 is 6. 5%. Our Risk Free rate (Rf) is determined by the yield of a long term government treasury bond, 9. 5% Specification 4 identifies the formulae to calculate the cost of equity. 4) COE = Rf* ??D* ERP 18. 73% = 9. 5% * 1. 42 * 6. 5% d. Weighted Average Cost of Capital (WACC) As per our assumptions the debt structure Juxtaposed with the equity structure is 35%: 65%. The COD calculation factors in the effect of taxation thus, Specification 5 identifies the formulae to calculate the tax adjusted WACC (5) WACC 14. 19% = (35% * 5. 7%) + (65% * 18. 73%) The pre-tax adjusted WACC is 15. 94% nonetheless; for the purpose of valuation we will use 14. 19% e. Cost of Capital, Unlevered In order to remain prudent, we use 6. 5% as the ERP, and 9. % for the Rf Specification 6 identifies the formulae5 to calculate the unlevered cost of capital (6) RIJ = Rf + BIJ * ERP 15. 48 % = 9. 5% + (. 92 * 6. 5%) Thus the unlevered cost of capital, which can be used for APV analysis6, is 15. 48% 3 We understand Long Term to be 15 years or more: http:// www. businessdictionary. com/definition/long-termbond. html 4 The Equity Risk Premium is typically between 4% – 7% http://www. investopedia. com/articles/ 639, 2007, Demarzo, “Corporate Finance” 6 Although not requested, for comparative purposes the RWACC has also been calculated.
The results can be found in QI . ACC. SBS. xls 4 The unlevered, debt free, cost of capital is cheaper than the levered cost of capital 2. Project Cash Flow without Laminate Technology Reference: Q2. ACC. SBS. xls a) Project the incremental cash flows associated with the acquisition of Collinsville Although the attributes relating to the period 1980 till 1984 were readily available rom exhibit 8, our model was developed to be fully computational. Thus, we first computed the operating income, (EBIT) by subtracting7 the cost of goods sold and depreciation from the revenue.
We then calculated the Earnings before interest and after tax with specification 7: (7) EBIAT = * (1 -T) The second phase of our calculation determined the capital expenditure. Capital Expenditures include expenditures on new and replacement property, plant and equipment. Thus, we calculated Capital expenditures by measuring the increase in net property, plant and equipment plus depreciation. Source: Pg174 Copeland et al, 1996) The third phase of our calculation determined the change in working capital between two time periods. In order to do so, we first calculated the working capital.
This was achieved by the summation of Accounts receivables’, inventories less accounts payable. In light of the aforementioned, specification 8 was used to determine incremental cash flows. (8) FCF = EBIAT + DEP – CAPEX – CH in W,’ CAP The cited schema was also applied for the period 1985-1989 however, the following line items had to be forecasted, based on the assumptions cited in table 1 . Forecasted Items Depreciation, Operating Profit, Capex, Accounts receivables’, inventories less accounts payable. Table 3 presents our Incremental Cash Flow (C.
F) results. Table 3 Year FCF ($000) 7 1979 1980 1981 1982 1983 1985 1986 1987 1988 1989 $12,000 $1,206 $1,407 $1891 $2,074 $2,073 $2,214 $2,497 $2,594 $2,890 $3,021 Manufacturing Cost and the “Other charges” as labeled in exhibit 8 5 b) Value of the Collinsville Plant, without laminate technology As per table 4, using the WACC approach, we discount the FCF to Present Value. Table 4 1984 FCF($OOO) $12,000 $1,206 $1,407 $1891 $2,074 $2,073 $2,214 $2,497 $2,594 $2,890 3,021 Discount Rate 1. 00 0. 88 0. 77 0. 67 0. 59 0. 52 0. 45 0. 40 0. 35 0. 30 0. 7 Discount $12,000 $1,061 $1,083 $1,267 $1,224 $1,078 $996 $908 $896 $816 $10,299 The present value of the Collinsville plant, without laminate technology is $10,299,000 3. Project the Incremental Cash Flows associated with the investment in Laminate Technology Reference: Q3. ACC. SBS. xls We consider the cash flows yielded by the installation of laminate technology independent to the cash flows of Collinsville plant. Installation of laminate technology can result in the elimination of graphite costs, and reduction in power consumption by 17. 58%.
Thus, we sum the cited to compute cost savings, and depreciate the investment over 10 years. Table 5 depicts the incremental cash flows associated with this investment. Table 5 Discounted -$2,140 $1,209 $1,402 $1,538 $1,677 $1,830 $1,999 $2,187 $2,394 $2,625 -$1883 $931 $939 $907 $872 $824 $800 $765 $718 $7,465 The present value of the incremental cash flows associated with an investment in Laminate Technology is $7,465,000. 8 Actual power reduction is between 15%-20% however, we will take the mean 6 4. What is the NPV of the acquisition with Laminate Technology Reference: Q4. ACC.
SBS. xls We amalgamate the EBIT and depreciation of Collinsville and Laminate Technology, respectively. We also factor in the investment needed to install the Laminate Technology in to our capital expenditure. The NPV of the total acquisition is $3,880,000 4. b What is the NPV of the acquisition with Laminate Technology, with a 25% probability that the technology fails after the plant has been purchased Reference: Q4b. ACC. SBS. xls We develop a FCF absent of any potential benefits from the installation of Laminate Technology nonetheless; we maintain the following assumptions: ???
The investment value of $2250m is factored in to the capital expenditure Depreciation of Laminate Technology over 10 years Thus the NPV of Collinsville plant, including the expectation of Laminate Technology failing, in conjunction with the aforementioned assumptions is $- 2,904,000, at a 100% failure rate. The NPV of the laminate technology project is $5,582,000, at a 100% success rate. We use specification 9 to calculate the expected return (9)Expect Return = NPV* success NPV Failure (25%) Thus we use the weights identified in table 6 to adjust our Wv’s’. Table 6 Probability Savings NPV Fail 25% -$2,904 Success 75% 100% 5582