Estimate of WACC for Collinsville Plant
The WACC for Collinsville, according to our estimations, came up to about 16.22% (Exhibit I). We took the average of the unlevered betas of comparable companies, 0.91, and relevered it according to Dixon’s target capital structure. Dixon’s 5-year historical debt ratio was 27.5%, but this approach would not be reliable due to its steep downturn debt ratio from 51% in 1975 to 6% in 1979. Thus, we thought that the best estimate of the target debt ratio is 15% for calculation of the WACC. The risk-free rate used was the long-term Treasury bond rate of 9.5% while the debt rate premium was calculated by subtracting the long-term Treasury bond rate from the long-term “AA” corporate bond rate. With Dixon’s ability to cover interest expense and relatively low target debt ratio, we applied “AA” rating to Dixon, which yielded the debt premium of 0.75%. Incremental Cash Flows Associated with Acquisition – Without Laminate Technology We developed pro forma financial statements with projected incremental cash flows associated with this acquisition (Exhibit II). Following 1984, the following assumptions are used: (1) EBIT stabilizes and stays constant at 1984 levels through 1989, (2) capital expenditures are 600 per year after 1984, (3) net working capital increases by 8% per year after 1984. The 8% increases in Net Working Capital were assumed to be driven by an increase of difference between current asset and current liability by subtracting accounts payable from inventory and accounts receivable. From what we calculated in 1979, the first figure is the initial outlay of $12 million from $ 10.6 million for the purchase price and $1.4 million for the initial net working capital initiating Collinsville plant. Following that, we calculated the free cash flow for each year. We calculated the free cash flow by applying tax effects to EBIT (times EBIT by 1 minus the tax rate of 45.05%), adding back depreciation expenses, and subtracting capital expenditures and increases in net working capital. The tax rate we used is from the average of historical tax rate between 1975 and 1979. The free cash flow figures started at $ 1.24 million in 1980, gradually rose to $2.36 million in 1988. The final cash flow that we calculated was the terminal value. This was made up of both the recouping of net working capital and the tax shield effect from writing off the remaining book value of assets sold. Recouping of NWC is $ 3.04 million and writing off the book value of asset is $ 1.49 million with just tax effect. After we projected all future cash flows, we discounted them using the WACC as the discount rate. The NPV of the acquisition came out to be negative $1.8 million. The IRR of the acquisition came out to be 12.9%.
Incremental Cash Flows Associated with Acquisition with Laminate Technology Investment If implemented, the December 1980 application of laminate at the Collinsville plant will provide for significant savings. The laminate has a projected installation cost of $2.25 million, which will be more than recouped over the life of the improvement. American’s scientists forecast the laminate to reduce power needs by 15% to 20%. We have forecast power expenses to start at over $6.3 million in 1980 and rise steadily to a stabilized level of near $12 million by 1984. A 15% power reduction will lead to savings of $1.16 million in 1981 and annual savings of $1.77 million from 1984 – 1989. A 20% power reduction will lead to savings of $1.55 million in 1981 and annual savings of $2.36 million from 1984 – 1989. In the calculation of incremental cash flow from these improvements, we also must factor in the initial outlay of $2.25 million and the effects of depreciation. Since the improvement is depreciated over ten years, we have an annual increase to cash flow of $225,000, which is the annual depreciation expense. We have started effects on cash flow besides initial outlay in 1981 due...