CASE ANALYSIS I

American Chemical Corporation

Determining the appropriate discount rate for the investment and evaluate the investment
We are interested in obtaining the asset beta for the Collinsville investment. We can estimate
asset betas by finding “identical twins” and comparing their betas, or un-levering the beta from the
company itself. Here, 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. 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. Looking at “identical twins”, we look at the financial statements of selected
sodium chlorate producers listed in Exhibit 5. 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 Dixon’s beta of .81 we used an asset beta
for the Collinsville investment of 0.9.
Assuming a market risk premium of 8.4% and a risk free 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 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%).
To evaluate the investment using this range of discount rates, we must identify the after-tax cash
flows from the investment. We 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 0.7% 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 values the plant at $7.9M. 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. 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.

Effective value addition by 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

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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. Assuming power costs reduce by 17.5%, the deal would be valued at $9.6M. 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.
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.

Purchase Decision and the consideration

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 on time 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.

Important assumptions
 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 1 st, 1981 and that it will have the desired effect of
eliminating graphite costs and cutting power costs is critical to the deal.
 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.

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Calculations
Un-levered Beta for Dixon (Assuming Firm’s Debt is Risk free)
Dixon Corporation Financial Data
1975 1976 1977 1978 1979 Avg ('75-'79)
Debt 7314 6836 6402 6138 6113 6560.60
1202
Total Liability 9 13268 14849 17382 20831 15671.80
D/(D+E) 0.61 0.52 0.43 0.35 0.29 0.44
E/(D+E) 0.39 0.48 0.57 0.65 0.71 0.56
Βd 0.3 0.3 0.3 0.3 0.3 0.30
Βe 1.06 1.06 1.06 1.06 1.06 1.06
βU = βD*D/(D+E)βE * E/(D+E) 0.60 0.67 0.73 0.79 0.84 0.73

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
1738
Total Liability 2 20831 19106.50
D/(D+E) 0.35 0.29 0.32
E/(D+E) 0.65 0.71 0.68
Βd 0.3 0.3 0.30
βE 1.06 1.06 1.06
βU = βD*D/(D+E)βE *
E/(D+E) 0.79 0.84 0.81

Un-levered Beta for Other Selected Large Sodium Chlorate Producers

Pennwalt
1974 1975 1976 1977 1978 Avg ('75-'79)
D/(D+E) 0.28 0.34 0.33 0.34 0.33
E/(D+E) 0.72 0.66 0.67 0.66 0.67 0.68
βD 0.21 0.21 0.21 0.21 0.21 0.21
βE 1.33 1.33 1.33 1.33 1.33 1.33
βU = βE * E/(D+E) + βD * D/(D+E) 1.02 0.95 0.96 0.95 0.96 0.97

Kerr McGee
1974 1975 1976 1977 1978 Avg ('75-'79)
D/(D+E) 0.19 0.20 0.24 0.21 0.17
E/(D+E) 0.81 0.80 0.76 0.79 0.83 0.80
βD 0.2 0.2 0.2 0.2 0.2 0.20
βE 1.06 1.06 1.06 1.06 1.06 1.06
βU = βE * E/(D+E) + βD * D/(D+E) 0.90 0.89 0.85 0.88 0.91 0.89

International Minerals
1974 1975 1976 1977 1978 Avg ('75-'79)
D/(D+E) 0.42 0.38 0.37 0.36 0.32 0.37
E/(D+E) 0.58 0.62 0.63 0.64 0.68 0.63
βD 0.21 0.21 0.21 0.21 0.21 0.21

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βE 0.81 0.81 0.81 0.81 0.81 0.81
βU = βE * E/(D+E) + βD * D/(D+E) 0.56 0.58 0.59 0.59 0.62 0.59

Georgia-Pacific
1974 1975 1976 1977 1978 Avg ('75-'79)
D/(D+E) 0.45 0.42 0.22 0.29 0.29 0.33
E/(D+E) 0.55 0.58 0.78 0.71 0.71 0.67
βD 0.2 0.2 0.2 0.2 0.2 0.20
βE 1.5 1.5 1.5 1.5 1.5 1.50
βU = βE * E/(D+E) + βD * D/(D+E) 0.92 0.95 1.21 1.12 1.12 1.07

Brunswick Chemical
1974 1975 1976 1977 1978 Avg ('75-'79)
D/(D+E) 0.19 0.15 0.17
E/(D+E) 0.81 0.85 0.83
βD 0.2 0.2 0.20
βE 1.1 1.1 1.10
βU = βE * E/(D+E) + βD * D/(D+E) 0.93 0.97 0.95

Southern Chemicals
197
4 1975 1976 1977 1978 Avg ('75-'79)
D/(D+E) 0.28 0.21 0.25
E/(D+E) 0.72 0.79 0.76
βD 0.2 0.2 0.20
βE 1.2 1.2 1.20
βU = βE * E/(D+E) + βD * D/(D+E) 0.92 0.99 0.96

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5
“Best Case” DCF Analysis of Investment without Laminate Technology

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“Expected” DCF Analysis Including Laminate Technology

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8
“Best Case” DCF Analysis with Laminate Technology

hirlpool

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 Whirlpool Europe
WHIRLPOOL EUROPE Project Atlantic          

Incremental Cash Flows and

Valuation (US$000s            

Discount Rate 9.00%                

Profiles Tax Rate 40.00%                

Description 1999 2000 2001 2002 2003 2004 2005 2006 2007

Capital Expenditure -4,900 -8,900 -6,900 -4,100          

42,07
Revenue   7,848 23,964 4 51,346 56,551 58,041 58,041 58,041

-
- 33,93 - - - - -
Cost of Goods sold   -6,590 19,358 6 40,989 45,050 46,377 46,377 46,377

Operation Expenditures -6,361 -4,892 -1,395 -3,745 -700 -243 103 134 166

Depreciation Expense   -980 -2,760 -4,140 -4,960 -4,960 -3,980 -2,200 -820

Taxable Earnings -6,361 -4,614 -2,549 253 4,697 6,298 7,787 9,598 11,010

Taxes -2,544 -1,846 -1,020 101 1,879 2,519 3,115 3,839 4,404

Earnings after Taxes -3,817 -2,768 -1,529 152 2,818 3,779 4,672 5,759 6,606

add back Depreciation   980 2,760 4,140 4,960 4,960 3,980 2,200 820

Cash Flow from Operation -3,817 -1,788 1,231 4,292 7,778 8,739 8,652 7,959 7,426

Reduction in need for

Inventory   2,685 6,967 8,429 6,218 3,765 1,529    

Cash Flow -8,717 -8,003 1,298 9,621 13,996 12,504 10,181 7,959 7,426

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 CASE ANALYSIS III

LEX SERVICES PLC

Objective:

Lex service Plc sold its various subsidiaries and other assets in between 1991 and 1993 which provides
more than £340 million of funds. To reinvest this huge amount of funds it evaluates many investment
options and acquisitions. To evaluate the worth of new investments, Lex uses discounted cash flow
analysis. In order to employ DCF analysis method, discount rate or cost of capital required. Now the
question is arises ‘what should be real cost of capital’.

Case Analysis:

After a long series of acquisition and divestment, Lex service Plc’s businesses remains to consist only
two fundamental halves:

 Automotive distribution
 Contract hire (vehicle leasing and finance)

In addition to these operating halves, Lex was also a substantial holder of property which was further
reclassified as investment properties.

Method of calculating cost of capital:

Most prominent method of calculating cost of capital is CAPM (capital asset pricing model).

One important point here is that as company was utilizing both debt and equity as its source of funds
then we calculate WACC (weighted average cost of capital) instead of simple cost of capital.

Since long-term bonds chosen as a risk-free rate, we will choose 7.14%, which mostly close to
7.2%, during period of 1946 to 1993, as a new risk-free rate. Accordingly, R_M will be 16.63% during the
same period of 1946 to 1993. Therefore, we could compute equity risk premium 〖 (R 〗_M - R_F) =
9.49% based on the same time frames. By applying CAPM formula of R_F + β(R_M – R_F) on the
time point of 1993, we can easily get the company’s cost of equity of 18.9%. (β is estimated to be 1.23).

As we know un-levered beta can be defined as a production of levered equity beta and market
value of equity over total market value (E/V). From exhibit 4, we get the(more detail,E=,V=,) equity-to-
total capital ratio of 0.408 on market value. Then, by applying the function of un-levered asset beta (β^u
= E/Vβ, the company’s un-levered asset beta could derived, which is 0.502.

If there is no debt in its capital structure, the WACC function

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WACC = D/(D+E)*(1-t)*K_D + E/(D+E)*K_E

could be reduced to WACC = K_E = 18.9% .

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