American Chemical Corporation

I prepared my answers by myself before discussing the case with anyone else. I only consulted other members of this class and this work is my own. Authors: Philip Larson In particular, I consulted Matt Thompson.

American Chemical Corporation Philip Larson

1) Do the circumstances surrounding the sale of the Collinsville plant play any role in your willingness to buy the assets? If so, how, if not, why not? On the one hand, the circumstances of the sale make me less willing to buy. In particular, both Universal and the federal government think that Americans acquisition creates antitrust issues. If this is the case, American could use its market power to change the nature of the market and make Dixons new plant unprofitable by setting lower prices for sodium chlorate in its other plants. On the other hand, the circumstances make me more willing to buy the assets because American has to divest the plant to comply with a court order. Therefore, they have less leverage during the sale because there are only a limited number of purchasers and American must sell. I would be more willing to purchase the plant given that demand for sodium chlorate is expected to continue increasing. On the other hand, power costs which account for the majority of manufacturing costs were rising making it more expensive to produce. 2) Which firms are relevant for obtaining an asset beta for the Collinsville investment? Using the betas, determine the appropriate discount rate for the investment. Evaluate the investment. We are interested in obtaining the asset beta for the Collinsville investment. We can estimate asset betas by 1) looking it up in Bloomberg, 2) finding identical twins and comparing their betas, and 3) un-levering the beta from the company itself. Here, using 2 and 3 we are interested in both the asset beta of Dixon as well as the asset betas of companies whose assets are similar to the project (e.g. companies that own plants that produce Sodium Chlorate). Here, assuming a low grade debt beta of .3, Dixon has an unlevered beta of .73 based on the average debt/equity ratio from 1975-1979.1 However, it is important to note that Dixon has reduced debt in recent years so the unlevered beta goes up to .81 when unlevered using an average debt/equity ratio from 1978&1979 only.2 Looking at identical twins, we look at the financial statements of selected sodium chlorate producers listed in Exhibit 5. Using the estimated debt betas for different types of bonds from our class notes, the unlevered betas for these companies range from .59 to 1.07 with an average of .90.3 However, since we are evaluating the addition of a sodium chlorate plant, the two firms (Brunswick and Southern) who specialize in producing sodium chlorate are likely the best twins. They have betas of roughly .95. However, given Dixons beta of .81 I used an asset beta for the Collinsville investment of .9. Assuming a market risk premium of 8.4% and a riskfree rate of 8.5% (from footnote 2 in the case, long-term treasury bonds of 9.5% minus 1%), this means the equity cost of capital will be 8.5%+.9*8.4% = 16.06%. A range for the equity cost of
1 2 3

See Table 1 in Appendix. See Table 2 in Appendix. See Table 3 in Appendix.

American Chemical Corporation Philip Larson capital using the broader set of identical twins (including all companies in Exhibit 5) would be (9.5%+.59*8.4%, 9.5% + 1.07*8.4%) or (14.5% to 18.5%). Given that the investment project is 100% equity financed, the appropriate discount rate should be in this range. To evaluate the investment using this range of discount rates, we must identify the after-tax cash flows from the investment.4 I first assumed that sales cannot exceed 38000 tons (due to the 40,000 ton capacity constraint and a margin for unsellable output) and a growth rate in price per ton of 8% through 1989. Next, I assumed power cost growth rate of 12%, graphite and salt expense growth rate of 5% annually, and that selling costs would remain roughly .7% of sales. Third, I assumed that NWC would remain at 9% of sales based on AR staying at 10% of sales and Inventory staying at 4.5% of sales. Finally, while the case stated that annual capital expenditure would be within $475k and $600k, the actual CapEx in 1983 and 1984 was $607k and $608k respectively. I therefore assumed an ongoing CapEx of $600k annually from 1985-1989. I have further assumed, per the case, that there is no terminal value because the plant essentially has no salvage value after 1989. With these assumptions, the present value of the total cash flows value the plant at $7.9M.5 Under this valuation, the $12M offer seems high and that Dixon should not make the investment without the laminate technology. Even if we relax the assumptions and use the lower end WACC in our range of 14.5% and assume that capital expenditures will be the low end of the range at $475k per annum after 1984, the deal at $12M would still be dilutive because the DCF value is still only $8.9M.6 At the other extreme, assuming a WACC of 18.5% and capital expenditures of $600k per annum, the plant is only worth $7.5M. While the model above does not account for the return of working capital at the end of year in 1989, the discounted value of this working capital is only worth about $650k and therefore does not substantially alter the analysis. Given this analysis, the deal is dilutive and Dixon should not make the investment. 3) Evaluate the marginal impact of the laminate technology (i.e. net present value of the costs savings and expenses assuming that without laminate, graphite costs go up 5% per year after 1984 and power costs rise 12% after 1984). The laminate technology requires an upfront capital expenditure of $2.25M that can be straight-line depreciated over 10 years. This laminate will eliminate graphite costs completely and reduce power costs by 15-20%. Assuming the laminate could be installed by December 31, 1980 these costs would be incurred/saved starting at the beginning of 1981. This would add a capital expenditure of $2.25M to the end of 1980 and will add $225,000 of additional depreciation per annum to the cash flow analysis done above. With the same assumptions from #2 above, and further
4 5

After-tax cash flows = EBIAT + depreciation investment. See Table 4 for DCF analysis without laminate technology as well as the assumptions for the analysis. 6 See Table 5 for Best Case DCF analysis with modified assumptions for WACC and annual capital expenditures.

American Chemical Corporation Philip Larson assuming power costs reduce by 17.5%, the deal would be valued at $9.6M.7 Therefore, the marginal impact of the laminate technology is roughly $1.7M. Therefore, the addition of the laminate technology does not make the deal accretive at a $12M offer. It is important to note, that even loosening the assumptions by using a WACC of 14.5% and changing ongoing capital expenditures to $475k does not make the deal accretive. The valuation with these assumptions is still only $11.3M, which is not enough to justify the $12M offer.8 Similar to #2 above, while this model does not account for the return of working capital at the end of 1989, including this value is not enough to make the deal accretive. Therefore, even with the laminate technology Dixon should not do the deal for $12M. 4) Should Dixon purchase the Collinsville plant? How much should he be willing to pay? Dixon probably should not purchase the plant unless it believes that the synergies with its existing business will significantly add to the value of the deal. If the laminate technology does not work or is not installed on time, the deal is incredibly dilutive at a $12M offer as shown in #2 above. Per #3 above, the deal is still dilutive at $12M even if the laminate works perfectly and is installed on time. This assessment is valid even under best case analyses that decrease the discount rate to 14.5% and decrease the required ongoing capital expenditures to $475k per annum. Rather, Dixon should not pay more than $9.6M for the plant and should only pay this price if it is assured that the laminate technology will be installed ontime and will have the desired benefits. To protect against the risk that the laminate is not installed on time or does not work as advertised, Dixon may want to structure an offer such that it pays a smaller amount upfront ($7.5M, for example) with an additional payment (e.g. $1.5M, for example) due on January 1, 1981 once the laminate is installed and working properly. 5) Which are the most critical sources of value? (e.g. which assumptions have the biggest impact on your answer?) First, one of the most critical sources of value is the laminate technology. This technology adds about $1.7M in additional value to the deal. Therefore, the assumption that the laminate technology will be installed by January 1st, 1981 and that it will have the desired effect of eliminating graphite costs and cutting power costs is critical to the deal.

7 8

See Table 6 for Expected DCF Analysis Including Laminate Technology. See Table 7 for Best Case DCF analysis that includes the laminate technology.

American Chemical Corporation Philip Larson Second, the WACC is also a critical assumption that has a large impact on the answer. In the scenario without laminate, changing the WACC from 14.5% to 18.5% changes the value of the plant by roughly $1.5M. Similarly, adjusting WACC in the scenario with laminate technology, the same change affects the valuation by approximately $2.5M. Third, the growth rate of the price per ton of sodium chlorate is an incredibly important assumption. If the assumption of 8% is loosened, the difference between using a 6% growth rate and a 10% growth rate in both the laminate and no laminate scenarios affects the valuation by about $2.7M. Fourth, the 12% growth rate in power costs is also an incredibly important one that has a large impact on the valuation. Modifying the growth rate from 8% to 16% changes the valuation by roughly $2.3M in the no laminate example and by about $2.5M in the laminate example. Fifth, the assumption that the plant has no ongoing value after 1989 is critical. If one assumes that the plant can keep producing sodium chlorate at 1989 levels with a moderate terminal growth rate, the deal with laminate quickly becomes accretive.

American Chemical Corporation Philip Larson

Appendix Table 1: Calculating the Un-levered Beta for Dixon (Assuming Firms Debt is Riskfree)
Dixon Corporation Financial Data 1975 7314 12029 0.61 0.39 0.3 1.06 0.60 1976 6836 13268 0.52 0.48 0.3 1.06 0.67 1977 6402 14849 0.43 0.57 0.3 1.06 0.73 1978 6138 17382 0.35 0.65 0.3 1.06 0.79 1979 6113 20831 0.29 0.71 0.3 1.06 0.84 Avg ('75-'79) 6560.60 15671.80 0.44 0.56 0.30 1.06 0.73

Debt Total Liab D/(D+E) E/(D+E) D E U = E * E/(D+E)

Table 2: Calculating the Un-levered Beta for Dixon using only 1978 and 1979 debt/equity data
Dixon Corporation Financial Data 1978 1979 Avg ('75-'79) Debt 6138 6113 6125.50 Total Liab 17382 20831 19106.50 D/(D+E) 0.35 0.29 0.32 E/(D+E) 0.65 0.71 0.68 D 0.3 0.3 0.30 E 1.06 1.06 1.06 U = E * E/ 0.79 0.84 0.81 (D+E)

Table 3: Calculating the Un-levered Beta for Other Selected Large Sodium Chlorate Producers
Pennwalt 1974 0.28 0.72 0.21 1.33 1.02 1975 0.34 0.66 0.21 1.33 0.95 1976 0.33 0.67 0.21 1.33 0.96 1977 0.34 0.66 0.21 1.33 0.95 1978 0.33 0.67 0.21 1.33 0.96 Avg ('75-'79) 0.68 0.21 1.33 0.97

D/(D+E) E/(D+E) D E U = E * E/(D+E) + D * D/(D+E) Kerr McGee

D/(D+E) E/(D+E) D E U = E * E/(D+E) + D * D/(D+E)

1974 0.19 0.81 0.2 1.06 0.90

1975 0.20 0.80 0.2 1.06 0.89

1976 0.24 0.76 0.2 1.06 0.85

1977 0.21 0.79 0.2 1.06 0.88

1978 0.17 0.83 0.2 1.06 0.91

Avg ('75-'79) 0.80 0.20 1.06 0.89

American Chemical Corporation Philip Larson

International Minerals 1974 0.42 0.58 0.21 0.81 0.56 1975 0.38 0.62 0.21 0.81 0.58 1976 0.37 0.63 0.21 0.81 0.59 1977 0.36 0.64 0.21 0.81 0.59 1978 0.32 0.68 0.21 0.81 0.62 Avg ('75-'79) 0.37 0.63 0.21 0.81 0.59

D/(D+E) E/(D+E) D E U = E * E/(D+E) + D * D/(D+E) Georgia-Pacific

D/(D+E) E/(D+E) D E U = E * E/(D+E) + D * D/(D+E) Brunswick Chemical

1974 0.45 0.55 0.2 1.5 0.92

1975 0.42 0.58 0.2 1.5 0.95

1976 0.22 0.78 0.2 1.5 1.21

1977 0.29 0.71 0.2 1.5 1.12

1978 0.29 0.71 0.2 1.5 1.12

Avg ('75-'79) 0.33 0.67 0.20 1.50 1.07

1974 D/(D+E) E/(D+E) D E U = E * E/(D+E) + D * D/ (D+E) Southern Chemicals 1974 D/(D+E) E/(D+E) D E U = E * E/(D+E) + D * D/ (D+E)

1975

1976

1977 0.19 0.81 0.2 1.1 0.93

1978 0.15 0.85 0.2 1.1 0.97

Avg ('75-'79) 0.17 0.83 0.20 1.10 0.95

1975

1976

1977 0.28 0.72 0.2 1.2 0.92

1978 0.21 0.79 0.2 1.2 0.99

Avg ('75-'79) 0.25 0.76 0.20 1.20 0.96

American Chemical Corporation Philip Larson Table 4: Expected DCF Analysis of Investment without Laminate Technology

American Chemical Corporation Philip Larson

Table 5: Best Case DCF Analysis of Investment without Laminate Technology

American Chemical Corporation Philip Larson

Table 6: Expected DCF Analysis Including Laminate Technology

American Chemical Corporation Philip Larson

Table 7: Best Case DCF Analysis with Laminate Technology

American Chemical Corporation Philip Larson