Nova Chemicals received an unsolicited offer of $160.0 million for the Industrial Products Division (IPD) from United Chemicals. The purpose of this memo is to evaluate the offer, and consider the implications of the sale or retention of IPD on the 5-year

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Summary & Recommendations

Recently, Nova Chemicals received an unsolicited offer of $160.0 million for the Industrial Products Division (IPD) from United Chemicals. The purpose of this memo is to evaluate the offer, and consider the implications of the sale or retention of IPD on the 5-year financing needs of Nova. We recommend the following actions:

Negotiate with United Chemicals for a selling price of $185.0 million, which is in the middle of a valuation range of $164 - $208 million, and in line with the market’s valuation of IPD
Assuming the sale of IPD, Nova should raise $185 million of equity to meet residual funding needs
If IPD is retained, Nova should issue $90 million of debentures and raise $252.4 million of equity to fully meet the financing needs of the next five years

Evaluation of the Sale of the Industrial Products Division (IPD)

Nova Chemicals consists of two specialty divisions and IPD, a basic chemicals division. The specialty divisions expect high growth, and therefore require investment in new product facilities. In contrast, the commodity nature of basic chemicals has led to low margins for IPD, while the cyclical nature of the industry suggests a weak outlook. From a financial perspective, the sale of IPD should be based on whether the selling price is at least equal to the value of IPD.

Our valuation of IPD suggests a value of $185 million, with a valuation range of $164 million to $208 million (see Exhibit 1). We determined this range based on (1) a range of risk premia over the market rate of return (from 5.5% to 6.5%) when determining out cost of capital, and (2) a range of long-term growth rates for IPD. The value of IPD under these different scenarios are summarized in Table 1.

Table 1: Valuation Range for IPD

Some of the key assumptions in the valuation are:

Tax rate of 40%
Risk-free rate of 7.91% based on the most recent 10-year Treasury bond rates
Price per share of $22 based on the most recent available data

Our valuation estimates accord with the market’s valuation of IPD. A discounted cash flow analysis of the Laboratory Products Division (LPD) and the Environmental Products Division (EPD) suggests a combined value of $9.69 per share for those two divisions. Based on the current stock price of $22 per share, this suggests that ...

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Table 1: Valuation Range for IPD

Some of the key assumptions in the valuation are:

Tax rate of 40%
Risk-free rate of 7.91% based on the most recent 10-year Treasury bond rates
Price per share of $22 based on the most recent available data

Five-Year Financing Plan Assuming Sale of IPD

If the Board accepts the recommendation to sell IPD, we feel the firm will be left with an improved set of options to cover the funding shortfall for supporting its growth objectives. In our five-year financial projections (see Exhibit 2), after selling the IPD division, we project the company will have sufficient resources for 1990 but will need to raise $164.1 million in 1991 and an additional $18.3 million in 1992. Although there are several factors involved, we based our recommendation on the impact to the company’s weighted average cost of capital (WACC) and interest coverage ratio (EBIT to interest expense) of each of these alternatives. We examine the following three options in detail:

$100 Million Bank Credit Agreement

We feel the first option—issuing $100 million on a 2-year bank credit agreement—is prohibitive because the company would still need to raise another $85 million, while meeting several requirements. The most prohibitive is that a maximum ratio of total debt (short-term and long-term) to net worth of 1.0. Because the company currently operates with a 1.0 total debt to net worth ratio, the company would need to raise an additional $100 million in equity. In our analysis, this gives the company a WACC of 10.99% (slightly higher than the current cost of 10.83%), but also lowers the interest coverage to 2.24 significantly below the 3.0 desired by the Board.

$200 Million in 15-Year Debentures at 11.25%

The second option to raise $200m of 15-year debentures at a coupon rate of 11.25% is handicapped again because of the same restrictions as in option 1. Because of the 1.0 total debt to net worth restriction, this again results in the need to raise $100 million in debt along with $100 million in equity. Despite the benefit of longer-term financing for the company compared to option 1, the debt raised also comes with a higher interest rate. Thus, the higher coupon on the 15-year bonds pushes the cost of debt higher and results in a WACC of 11.22% with interest coverage even of 2.21, even lower than in option 1.

Recommended Option: Issue $185 million of common stock

After reviewing the available options for the company at the current time we believe the company should proceed with Option 3 and raise $185 million of common stock. This option has significant advantages over the other two options. The new equity raised will result in a larger portion of equity financing in the company’s capital structure and less leverage in its operations. The company’s 50% debt to total value capital structure will decrease to 39% debt to total value. Since a company’s equity beta is impacted by leverage and a higher levered company will have a higher beta of equity, this would result in a reduction in Nova’s new levered beta. After adjusting the company’s capital structure and costs of debt and equity, option 3 will result in a new WACC of 11.28%.

It is noteworthy that this will leave the company with a slightly higher WACC than in option 1 or option 2, but also leaves the company with an interest coverage of 2.85, significantly higher than the other two options and much closer to the rate desired by the Board. We feel the higher interest coverage keeps the company in a better position for future growth despite the smaller incremental increase to the WACC. Further, an interest coverage ratio closer to 2, as in options 1 and 2, could have serious ramifications such as an inability to service its debt in an economic downturn or a credit rating downgrade that would increase the future cost of debt significantly in the future.

A summary of these options is presented in Table 2.

Table 2: Summary of Financing Options, Assuming Sale of IPD

Five-Year Financing Plan Assuming Retention of IPD

If the Board chooses to retain IPD, Nova will need to raise $153.4 million, $324.1 million, $342.4 million, 340.3 million and 316.5 million respectively from 1990 to 1994. As a result, none of the three options considered above can alone meet the peak funding need of $342.4 million in 1992. However, if Nova raises funds with new equity, it will have the ability to issue debt as well. To preserve an interest coverage ratio of 3.0, the maximum amount of debt that Nova can raise at a rate of 11.50% is $90 million. Thus, in this scenario, we recommend that Nova raises $252.4 million of equity capital, and simultaneously issues $90 million of 15-year debentures at the 11.25% rate. This will increase the cost of capital to 11.47%, although the debt-to-equity ratio will fall to 0.72, while interest coverage will be maintained at 3.0.

Exhibit 1: Valuation of IPD

Exhibit 2: Five-Year Estimate of Funding Needs