# Case: American Chemical Corporation

**Topics:**Weighted average cost of capital, Costs, Variable cost

**Pages:**7 (1841 words)

**Published:**December 9, 2011

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

2.1 ASSUMPTIONS FOR CALCULATIONS IN THE CASE:

l Plant life is 10 years (p.4)

l Salvage value of plant is 0 (p.4)

l Book value of plant at end of 1979 is 10.6 million (=12 million purchase price - 1.4 million working capital)

l Tax rate is 48% (calculated from Exhibit 7)

l For the period from 1980 to 1984: all data of sales, depreciation and manufacturing and other costs are given in the case (Exhibit 8)

l For the period from 1984 to 1989 we use the below assumption:

- Price growth rate is 8% (p.4)

- Power cost growth rate is 12% (p.4)

- Net working capital is always 9% of sales (Exhibit 8, current asset and liability items remain historical to sales)

- PPE and depreciation are based on historical data in 1980-1984 period (Exhibit 8)

- Capital investment are based on historical data in 1980-1984 period (Exhibit 8)

- Variable and fixed costs: we use 4-year average growth rates calculated based on Exhibit 8. So non-power variable cost growth rate is 11%, fixed cost growth rate is 6%, selling expenses growth rate is 7% and R&D expenses growth rate is at 5%

- To use this 4-year average growth rates, we assume that the scale of operations of this plant is constant so we need to adjust such cost growths to account for inflation. If the scale increases we should consider growths in costs on percentage of sale basis.

2.2 COST OF CAPITAL:

a. Calculate beta β of sodium chlorate:

The β of Dixon is 1.06 (Exhibit 7). This beta may be irrelevant to the project to buy Collinsville plant because Dixon produces specialty chemical products but never produce sodium chlorate. The systematic risk of the project could be the risk of the production of sodium chlorate in the industry. Therefore, we calculate beta of the project based on the beta of the sodium chlorate industry.

We do not simply use the beta of Brunswick and Southern, 2 firms purely produce sodium chlorate, because they are small in the industry and their stocks might not be traded largely on the market. Hence, we decide to calculate the beta of all firms that produce sodium chlorate to see the trend of beta of all firms in the market since we believe that such trend can be a benchmark for calculating the beta of sodium chlorate for Dixon’s project.

The average beta is calculated from the formula: βasset = βequity / [1+ (1-t)*D/E], where D is debt, E is equity and t is tax rate. To simplify the calculation, we assume that all these firms have tax rate at 48% and βdebt is zero. The detailed calculation is provided in the Appendix 1. From the table, we notice that the betas of 3 diversified chemical producers American Chemical, Kerr-McGee and Int. Minerals and Chemicals (Ga is a paper company and Pennwalt is a large diversified chemical producer) is less than the market beta (1.00). We also observe that the two pure play firms (last 2 rows) have higher beta than the market beta. Thus, sodium chlorate may have higher beta than other chemical products. Because sodium chlorate is totally new to Dixon, we assume that Dixon plays the role of a pure sodium chlorate producer and...

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