Case: AMERICAN CHEMICAL CORPORATION

1. Executive Summary

Dixon, an American specialty chemical producer, wants to buy Collinsville plant from American Chemical Corporation, another typical chemical company in 1979. Dixon wants to diversify its product line buy acquiring the aforesaid plant, which produces sodium-chlorate to supply to paper producers in Southeastern part of the US. This plant initially cost 12 mln. USD and additional 2,25 mln. USD needed to buy laminate technology to increase efficiency and profitability of the plant in order.

Dixon has conducted thorough marketing research for the industry providing cash flow analysis on purchase of the plant. The cash flow analysis based with and without laminate technology cases, where the company should decide whether it should go on further to buy that plant and technology.

2. Calculating of WACC

2.1 Assumptions for calculations in the case:

l Plant life is 10 years (p.4)

l Salvage value of plant is 0 (p.4)

l Book value of plant at end of 1979 is 10.6 million (=12 million purchase price - 1.4 million working capital)

l Tax rate is 48% (calculated from Exhibit 7)

l For the period from 1980 to 1984: all data of sales, depreciation and manufacturing and other costs are given in the case (Exhibit 8)

l For the period from 1984 to 1989 we use the below assumption:

- Price growth rate is 8% (p.4)

- Power cost growth rate is 12% (p.4)

- Net working capital is always 9% of sales (Exhibit 8, current asset and liability items remain historical to sales)

- PPE and depreciation are based on historical data in 1980-1984 period (Exhibit 8)

- Capital investment are based on historical data in 1980-1984 period (Exhibit 8)

- Variable and fixed costs: we use 4-year average growth rates calculated based on Exhibit 8. So non-power variable cost growth rate is 11%, fixed cost growth rate is 6%, selling expenses growth rate is 7% and R&D expenses growth rate is at 5%

- To use this 4-year average growth rates, we assume that the scale of operations of this plant is constant so we need to adjust such cost growths to account for inflation. If the scale increases we should consider growths in costs on percentage of sale basis.

2.2 Cost of capital:

a. Calculate beta β of sodium chlorate:

The β of Dixon is 1.06 (Exhibit 7). This beta may be irrelevant to the project to buy Collinsville plant because Dixon produces specialty chemical products but never produce sodium chlorate. The systematic risk of the project could be the risk of the production of sodium chlorate in the industry.　Therefore, we calculate beta of the project based on the beta of the sodium chlorate industry.

We do not simply use the beta of Brunswick and Southern, 2 firms purely produce sodium chlorate, because they are small in the industry and their stocks might not be traded largely on the market. Hence, we decide to calculate the beta of all firms that produce sodium chlorate to see the trend of beta of all firms in the market since we believe that such trend can be a benchmark for calculating the beta of sodium chlorate for Dixon’s project.

The average beta is calculated from the formula: β_asset = β_equity / [1+ (1-t)*D/E], where D is debt, E is equity and t is tax rate. To simplify the calculation, we assume that all these firms have tax rate at 48% and β_debt is zero. The detailed calculation is provided in the Appendix 1. From the table, we notice that the betas of 3 diversified chemical producers American Chemical, Kerr-McGee and Int. Minerals and Chemicals (Ga is a paper company and Pennwalt is a large diversified chemical producer) is less than the market beta (1.00). We also observe that the two pure play firms (last 2 rows) have higher beta than the market beta. Thus, sodium chlorate may have higher beta than other chemical products. Because sodium chlorate is totally new to Dixon, we assume that Dixon plays the role of a pure sodium chlorate producer and consider the average of the beta of Brunswick and Southern as the beta for Dixon in this project. This beta is β=1.09. The beta 1.09 seems more reasonable as Dixon may have more risk to take the project than other companies who already produce this product for a long time.

Now, Dixon needs to re-lever this beta by using its own target capital structure (35%, p.4). The formula for re-levered beta is: β_{levered equity} = β_asset * [1+ (1-t)*D/E] = 1.09*[1+(1-0.48) *0.35/0.65] = 1.40.

b. Weighted average cost of capital (WACC):

Cost of equity: in the case, the yield on Tbonds is 9.5% (p.4). We assume that it is the risk free rate. We use the historical equity risk premium 8.4% stated on the Table 9.2, page 247 of the textbook. According to the CAPM method, the cost of equity for this project is 9.5%+1.38*8.4% = 21.26%.

Cost of debt: because there is little information about Dixon’s debt provided on the case, we assume that all debt Dixon intends to borrow is used in the acquisition of Collinsville plant at 11.25%. We also assume that debt is issued at par. The after-tax cost of debt is (1-0.48)*11.25% = 5.85%.

WACC: we use Dixon’s 35% target level of debt-to-asset ratio in acquiring the plant to calculate cost of capital. WACC = D/V*After-tax cost of debt + E/V*Cost of equity = 0.35*5.85%+0.65*21.26% = 15.87% @ 16%. Therefore, the WACC for Collinsville’s plant cash flow is nearly 16%. We use this cost of capital to calculate NPV of the project.

3. Calculating NPV

To calculate the NPV for the project we have observed two cases during the investment: purchasing the plant without laminate technology and with laminate technology.

3.1 Without laminate technology

We have calculated NPV on the basis of the current cash flow provided in appendixes of the case and information provided in case material. So we have used the data in Exhibit 8 and projected cash flow from 1980 to 1984, and we have calculated cash flow to 1989 based on our assumptions aforesaid. For further details please refer to Appendix 2.

It had resulted on NPV being negative – 3,703 thousand USD.

3.2 With laminate technology

Case defines us some cost reductions and benefits such as graphite cost elimination, tax benefits and power cost savings, since 2,25 mln. USD worth of laminate technology is bought and installed. So we had calculated additional NPV, which has derived from cost savings and tax benefits we have out of buying the additional laminate technology. Our assumption is NPV with laminate technology = NPV without laminate + NPV additional savings.

From this approach we have calculated Additional NPV of 6,634 thousand USD in Appendix 3.

So NPV with laminate technology is -3,703+6,634=2,931 thousand USD.

4. Sensitive analysis

In order to see whether the project is viable in case of negative changes in variables, we have conducted sensitive analysis having one of major variables such as sales growth rate, which can be reflected by different reasons such as decrease in demand, production slowdown, economic recession and etc. We have tried other possible valuables, but they occasionally did not have much effect on the project outcomes.

We wanted to know what is the rate of growth rate should be in both cases (without and with laminate technology) so that the company will have Zero NPV. Using Solver function in Excel, we found that in case of Zero NPV without laminate technology sales growth rate should kept up around 14% and with laminated technology growth rate should not go down of around 2% level (Please see Appendix 4).

5. Strategic and economic benefits

Besides increasing shareholders wealth, company gets some strategic and economic benefits, such as:

- Increase in product range

- Larger market share in paper industry

- Opportunities to enter new market

- New market development and competition reduction

- Enhancement of relationships with current customers

- Development of new technology

By acquiring Collinsville plant, Dixon could complement its strategy of supplying chemicals products to the paper and pulp industry. It can use the existing sales force to market products to save selling costs. Dixon will add a new product in its existing product mix.

Laminate technology would allow company to considerably cut power cost and completely eliminate graphite costs. By gaining technological savvy, the company can use the same practices in other plants and reduce production costs.

Company has developed the relationships with Collinsville existing customers. It is 6 more times cheaper to retain existing customer than acquire a new one. Buying plant, company will not incur potential marketing costs in initial selling of new products.

The company is better off buying the plant than building from the scratch a new one. Usually, plants are costly to build. Also, the company can reduce competition in the market. Buying a plant would be the best entry strategy for company. Building a plant would take a year, and market is changing rapidly, so Dixon could lose market potential if it takes a long time to build a new plant.

Laminate technology makes the Collinsville plant acquisition attractive on economic grounds. In acquisition negotiation, Dixon should make a clause in the acquisition agreement, which protects the Dixon in the case that the laminate technology fails to produce the desired results. This clause should include that in the case the laminate technology fails, American Chemical Corporation should compensate Dixon for installation charges. 　

6. Recommendations

Based on our analysis, we would like to make recommendations as follows:

Most fundamentally, a firm that is operating in the interests of its shareholders should try to accept all projects that increase the wealth of the shareholders. In case of Collinsville, we use NPV to approach to our recommendations.

Based on our calculation, without the laminate addition, the NPV of Collinsville turns out to be negative (-3,703 thousand USD). Under this circumstance, we recommend not to invest in this project since it is against shareholders interests.

But at the same time new Laminate Technology would allow company to considerably cut power cost and completely eliminate graphite costs. Additional $2.25 mln. USD is needed to install this new technology. We consider this technology as a subproject attached to Collinsville and calculate its NPV. The NPV of this new technology is 6,634 thousand USD. That means, by using laminate technology, NPV of Collinsville will change to 2,931 thousand USD. Under this new circumstances, our recommendation is to invest in Collinsville because it will not only increase the wealth of the shareholders, but also complement its strategy of supplying chemicals products to the paper and pulp industry.