American Chemical/ Dixon Essay
Dixon Corporation, a U. S. -based chemical company, is mulling on buying a plant from American Chemical Corp. American Chemical’s Collinsville plant makes sodium chlorate for the paper and pulp industry. Dixon will have to pay $12 million as purchase price for the plant. It may also pay $2. 25 million to complete the laminate technology developed by the plant’s research and development staff, which is expected to improve the plant’s efficiency. Dixon already has transacted business with some of American Chemical’s major customers.
Dixon, however, believes that the acquisition will enable it to widen product lines and penetrate the paper and pulp industry. Analysis To determine the economic feasibility of the acquisition, we can compute for the NPV of the acquisition, with or without the new technology. The NPV will show whether the Collinsville purchase will increase shareholder’s wealth or lead the company to insolvency. Under the net present value method, the weighted average cost of capital is used as the discount rate to calculate the present value of future cash inflows.
Hence, for the case study, we will compute for the WACC, prepare projected cash flows then compute the NPV. Solution WACC The all-equity beta (? ) of Dixon is
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We assume that we could have a beta of 1. 9 for the production of sodium chlorate, basing from the betas of other chemical firms. We could re-lever Dixon’s beta by using its 35% target capital structure. Using the formula, levered equity = all-equity * [1+ (1-t)*D/E] = 1. 09*[1+(1-0. 48) *0. 35/0. 65], we’ll have a levered of 1. 40. We compute for the WACC, the required rate of return for equity, using the Capital Asset Pricing Model.
We use the 9. 5% yield on Treasury bonds, and the 8. 4% equity risk premium. Using the formula r = rf + leveredRP, we get 9. 5%+1. 40*8. 4% = 21. 26%. We presuppose that the Dixon’s debt will solely be used for the Collinsville acquisition. Assuming debt at 11. 25%, we can compute the after-tax cost of debt as (1-0. 48)*11. 25% equaling 5. 85%. We can now compute for the weighted average of the costs of debt and equity funds, noting that target debt-to-equity ratio is 35%. The WACC, using the formula WACC = D/V*After-tax cost of debt + E/V*Cost of equity = 0. 35*5. 85%+0.
65*21. 26% = 16%. Cash Flow We use the historical cash flow for 1980 to 1984, and projected cash flow for 1985 to 1989, using this information:
– Historical data will be used for property plant and equipment and depreciation costs.
– Prices increase 8% annually
– Power expenditures increase 12% each year
– Net working capital is 9% of revenues – we use the average figures for 1980 to 1984 to project other costs – non-power variable costs rate is 11% per year, selling expenses increase 7%, fixed cost increase 6%, R&D expenses at 5%. Given figures and other assumptions are:
– plant’s life is 10 years and its salvage value is zero. – book value of the plant is $10. 6 mill, assuming a $1. 4 mill. Working capital – company’s tax rate is 48% NPV We can now determine whether the investment, i. e. , the Collinsville acquisition, increases value of the business or shareholders’ wealth. We do that by computing its NPV. We actually have two options if we pursue the acquisition, include or exclude the laminate technology. Net present value = Present value of the expected cash flows – Cost of the project = -Initial Investment + CF1/(1+r)1+ CF2/(1+r)2+ CF3/(1+r)3+ CF4/(1+r)4.
Using our projected cash flows, and the WACC (cost of capital), we will yield an NPV of ($3,700) or negative $3,700. Given that the laminate technology is expected to give cost savings, including elimination in graphite costs and a 15% to 20% reduction in power costs, and tax benefits, we assume that NPV with the new technology is equal to NPV (without laminate) + NPV (cost savings). The NPV from additional savings is $6,600. So NPV with laminate technologies is -$3,700 + $6,600 = $2,900. Justification Under the NPV rule, an investment is viable if its NPV is positive, but is not should be rejected if negative.
If Dixon pursues the acquisition of the Collinsville plant absent the new technology, it will have negative NPV. This means that the company will actually reap more returns by investing in government bonds. Investing in government bonds is also not as risky as the acquisition since there is assurance that the govt. bonds will be repaid while there is no assurance that the acquisition will improve Dixon’s revenues. The acquisition under the circumstances would only cause the company to be saddled by debt, without receiving an equivalent amount of cash to offset its initial investment costs or to make debt payments.
On the other hand, if we pursue the acquisition and include the laminate technology, we will have positive NPV. This means that, if our projections are accurate, the investment is viable and will increase the company’s assets, thus shareholder’s wealth. The present circumstances also weigh in favour of the acquisition – Dixon already did business with some of the Collinsville plant’s major customers, hence, it need not expend marketing costs to woo the existing clients of the plant. The acquisition will also have a potential for growth.
While the company has already been consistently profitable, the purchase of the Collinsville plant will allow it to penetrate the paper and pulp market. Hence, aside from improving shareholders’ wealth, the acquisition will allow Dixon to, among other things, provide more products to existing customers, get a bigger market share, gain new businesses and customers, and reduce competition. However, it is worthwhile to note that without the laminate technology, NPV was negative, but with the laminate technology, NPV was positive.
The NPV substantially increased due to the assumption that the new technology provides $2. 25 million in cost savings. Conclusion Using the NPV method, we have determined that buying the Collinsville plant together with the laminate technology will allow Dixon to increase value to shareholders and explore new opportunities. Among other things, it will be able to extend its market to the paper/pulp industry. It is also expected to improve production costs with the laminate technology and save on additional costs.
Given Dixon’s historical growth and consistent profitability, the shareholders have high expectations. Hence, we have to emphasize that the attractiveness of the project was dependent on the projections that the laminate technology will bring $2. 25 million in savings. But what if the promised cost savings are not achieved? The viability of the new business will certainly depend on this. As CEO of Dixon, I will pursue the acquisition only after I have studied the reliability and functionality of the laminate technology.