Final Examination

Advanced Corporate Financial Management

EDHEC Business School
Professors Jim Seward
Submitted By:-Rahul Pandey
Case Questions

(1) What is the appropriate discount rate to use in evaluating the Collinsville
plant opportunity?
What is the cost of equity?
What is the 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 Average Cost of capital to use in evaluating the
Collinsville plant opportunity is calculated as
WACC= (1-Tax rate) *cost of pretax debt *(D/D+E) + cost of equity*(E/D+E)
Where tax rate =48 % as based on financial statement of Dixon corporation (Exhibit
7)
WACC =15.49% (As calculated in Worksheet-2 given below)

(a)Calculating the cost of equity

The cost of equity is calculated by using the Capital Asset Pricing model:
Cost of Equity =Rf + beta *Risk premium
Where Rf is risk free rate,
Beta is the sensitivity of the Collinsville plant investment to the market,
And risk premium is expected return on market portfolio

Risk free rate,9.5 %, is taken as Long term treasury bond(case) as Dixon is expected
to run Collinsville plant for at least ten year. The calculation of risk premium is
based on arithmetic average of spread between S& P return and long term US
Government treasury Bond returns from 1926 to 1979 because I believe that
historical premium over extended period is the best estimate of the risk premium
looking forward.

Calculation of Risk premium- (Worksheet -1)

Dixon is a diversified chemical product company and it never produced sodium
chlorate. Therefore, the risk associated with its existing business is not applicable to
its upcoming future investment related to Collinsville plant. So, I look towards
existing sodium chlorate producers to measure the systematic risk in the industry. In
my analysis, I noticed that the Large companies such as Hookers, Pennwalt,
American and Kerr-Mc gee will not have the same risk as Dixon has because they
are diversified chemical companies. Georgia pacific is not considered as it a paper
and pulp company. Therefore, I calculate the beta by taking the average of the
unlevered beta of Brunswick and Southern chemicals because they are specialized
in producing sodium chlorate and their associated business risk will be
representative of market risk for a new sodium chlorite producer like Dixon.

Assumption considered here: -

For my convenience, I assume that debt carries no market risk (has a beta of zero),
the beta of equity alone can be written as a function of the unlevered beta and the
debt-equity ratio
L = u (1+ ((1-t) D/E))

Calculate the unlevered beta to remove the beneficial effect (Tax effect) gained by
adding debt to capital structure.
Unlevered Beta = levered Beta/ (1 + (1- tax rate) (Debt/Equity))

Adjusting Unlevered Beta for financial leverage: -Calculate the Levered beta
to achieve target leverage ratio of 35 % for Dixon corporation

Levered Beta = Unlevered Beta* (1 + (1- tax rate) (Debt/Equity))

Cost of equity=Risk free rate +Beta*(Rm-Risk free rate)

20.68% (As calculated in Worksheet -2)
 (b)Calculating the after-tax cost of debt

As case does not mention the debt premium, which is rate applicable for corporate
borrowing above government borrowing. So, I assume that Dixon will borrow the
debt at a rate of 11.25 %, which is Long term BBB corporate bonds rate.

After Cost of Debt = (1-tax rate) *Cost of debt

5.85%

(C) Dixon target a capital structure with leverage ratio of 35 percent.

Debt =0.35
Equity =0.65
Value (Debt +Equity) =1
D/D+E =0.35 and E/D+E=0.65

Calculation of Discount Factor or WACC (Worksheet -2)

(2) What are the relevant free cash flows to be used in evaluating the Collinsville
plant, excluding the investment in the laminate technology? Please clearly
show the free cash flow in each year. What specific recommendations would
you provide to top management concerning the estimate of the terminal
value for the plant? Based on your analysis, is the purchase of the Collinsville
plant, in the absence of any other investment considerations such as the
laminate technology, economically worthwhile?

The calculation of cash flow for Collinsville plant, excluding Laminate technology
from 1981 to 1989, is based on given information in case, and assumptions.
Calculation of Cash flows

Revenue =Price of sodium chlorate * Sales

Variable cost =Power + Graphite + salt &others
Fixed cost =Labor + Maintenance + Others
Manufacturing cost =Fixed Cost +Variable cost
Other charges = Selling + R&D + Depreciation

The EBIT (Earning before income tax) is calculated by subtracting total

manufacturing cost and other charges including depreciation from the total
revenue.
EBIT =Revenue - Manufacturing cost Other charges

Earning before interest after tax is calculated as below

EBIAT = EBIT * (1 T)

The capital expenditure consists of expenditure on new and existing property plant
and equipment
Capex =Net increase in PP&E +depreciation

Working Capital = Current assets - current Liabilities

Accounts Receivables + Inventories Account Payable
Change in Working Capital = working capital between two consecutive year

Cash Flow =EBIAT + depreciation - Capital expenditure - change in working

capital

Total NPV = Initial investment + Present value of all cash flows discounted at
WACC
We can calculate the terminal value of plant in two way. One way is to operate the
plant for five year and sell it at a book value in fifth years. The other way is to
operate the plan for ten year and scrap the plant once it reaches zero scrap value.
IF Dixon decides to buy this plan with no investment on laminate technology, I
recommend that the Dixon would operate this plant for ten year and generate the
projected cashflows. At the end of ten year Dixon can write off and avail tax benefits
associated with property, plant and equipment.

From my calculation, I can see that total NPV, -5.45 million USD as calculated in
below worksheet-3, is negative for this project if the cost of plant (12 million USD) is
taken into consideration. In the absence of any other investment, the project would
erode the shareholders wealth. Hence it is advised that Dixon should not buy the
plant without the laminate technology.

Cash flow without Laminate Technology-(Worksheet-3)

 (3) What cash flows are relevant to the valuation of the laminate technology
investment? (For the purpose of answering this question, you may assume
that Dixon already owns the Collinsville plant). Based on your analysis, is
investing in the laminate technology economically attractive?

If Dixon owns the Collinsville plant, the cashflow will be calculated based on
laminated technology. I assume that the laminate technology
reduces power costs by 20 percent between year 1980 and 1989.
eliminates graphite costs between year 1980 and 1989 as It can be installed
in the beginning of 1980 for $2.25 million.
brings tax savings due to depreciation between year 1980 and 1989.
will be depreciated as based on straight line depreciation.
Other assumptions remain the same.

Cash flow with Laminate Technology-(Worksheet-4)

The NPV for Collinsville plant with laminate technology is 3.466 million USD.It
suggests that the use of Laminate technology drives cost down and increases
the revenue. From the first Look,12 Million USD investment in plant and 2.25
million USD investment in Laminate technology seem to be an attractive deal as
it would increase the shareholder wealth. But we need to look at other external
factor that can impact the profitability of this project, and test the sensitivity of
NPV with different discount factor.

(4) What steps should Dixon take with respect to these investment opportunities
to enhance shareholder wealth? That is, should the company acquire the
Collinsville plant, or not? If it buys the plant, should it invest in the laminate
 technology or not? Be sure to explain carefully how you arrived at your final
recommendations regarding what you believe that Dixon should do.

Dixon Corporation is planning to buy a sodium chlorate plant located near

Collinsville. The acquisition of the Collinsville plant would support Dixons
strategy of supplying chemicals to the paper and pulp industry. The plant is
currently operated by American Chemical Corporation (American), who
has offered to sell the plants net assets for $12 million.

Dixon has several options:

It can buy the plant, choose not to install the laminate technology, and sell
the plant at the end of either 5 or 10 years.
It can buy the plant, invest in the laminate technology and operate it for the
next ten year.
It can postpone it plan by considering external factors and evaluating the
profitability of the project.

From my analysis, the option of purchasing Collinsville plant with Laminate

technology is preferable to the option of Collinsville plant without Laminate
technology. Now the choice boils down to second and third option. The NPV value is
positive for project with Laminate technology if all my assumptions are true. But
these assumptions are averse to market risk and cost of capital. So, we will test the
NPV sensitivity on cost of capital and external factors.

If the capital is cheap, the option of investment is attractive. So, I will test the
NPV sensitivity to different discount factor.
Competitive environment is intense in sodium chlorate industry as every
corporation is producing the same product, a perfect competition scenario
where profitability depends on supply and demand. So, I will test the NPV
sensitivity to sales growth and price change.

By checking these sensitivities, I notice that the option of purchasing Collinsville

plant with Laminate technology may erode shareholder wealth if
Cost of capital increases from 15.49 % to 21 % or more (Worksheet-5 given
at end)
Sales drop from 38000 unit to 32000 unit or less between 1984 and 1989 if
new entrants or existing competitors gain market share (Worksheet-6 given
at the end).
Price change drop from +8% to +2% or less between 1984 and 1989 if supply
exceed demand (Worksheet-7 given at the end).

SWOT Analysis for Dixon Corporation to evaluate its capabilities of

running business in Sodium chlorate industry

Strengths

Entering sodium chlorate industry improves its relationship with pulp and paper
customers N
Can uses existing sales network to increase the sales of Collinsville plant
 Diversified Chemical Company

Weakness

New player in sodium Chlorate Industry

Market is dominated by three players

Opportunities
Overall, the sales of sodium chlorate industry increase.
Price Increase over last years (Positive trend).
Increase in Demand.
Laminate technology will decrease the graphite and power cost.

Threats
Profit Margins can go down because of
emerging competition
Capacity utilization can be decreased
Twelve existing competitors plus two new
competitors

Recommendation
By evaluating the value of the project economically, strategically, and financially, I
recommend that Dixon Corporation should buy Collinsville plant with Laminate
technology as this investment will establish its position as a dominant player in
sodium chlorate industry. It would complement Dixons strategy of supplying
chemicals to the paper and pulp industry. Dixon will always have the option of
exiting business by selling plant if business turns not profitable. Purchasing
Collinsville plant, as opposed to building a new plant, is a cheap way to enter in
the sodium chlorate business.

Checking NPV Sensitivity with respect to discount rate by keeping

others factors constant
Worksheet-5
 NPV Sensitivity with respect to sales (between 1984 and1989) by
keeping others factors constant
Worksheet-6

NPV Sensitivity with respect to price change (between 1984 and1989) by

keeping others factors constant
Worksheet-7