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Estimate the cost of equity appropriate for the evaluation of the incremental cash flow associated with the Collinsville investment.

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Introduction

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 Estimate the cost of equity appropriate for the evaluation of the incremental cash flow associated with the Collinsville investment. Estimate the weighted average cost of capital appropriate for discounting the Collinsville plant´s incremental cash flow. Before we start calculating the cost of equity we have to make some assumptions about the market. Beta. In this case we are selling a factory which has only one objective, to manufacture Sodium Chlorate. ...read more.

Middle

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 ?=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: ?levered equity = ?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%. ...read more.

Conclusion

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. ...read more.

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