Investment Case Study

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Do the circumstances surrounding the sale of the Collinsville plant play any role in your willingness to buy the assets? If so, how, if not, why not?

On the one hand, the circumstances of the sale make me less willing to buy. In particular, both Universal and the federal government think that American’s acquisition creates antitrust issues. If this is the case, American could use its market power to change the nature of the market and make Dixon’s new plant unprofitable by setting lower prices for sodium chlorate in its other plants. On the other hand, the circumstances make me more willing to buy the assets because American has to divest the plant to comply with a court order. Therefore, they have less leverage during the sale because there are only a limited number of purchasers and American must sell. I would be more willing to purchase the plant given that demand for sodium chlorate is expected to continue increasing. On the other hand, power costs which account for the majority of manufacturing costs were rising making it more expensive to produce.

1) Which firms are relevant for obtaining an asset beta for the Collinsville investment? Using the betas, determine the appropriate discount rate for the investment. Evaluate the investment.

We are interested in obtaining the asset beta for the Collinsville investment. We can estimate asset betas by 1) looking it up in Bloomberg, 2) finding “identical twins” and comparing their betas, and 3) un-levering the beta from the company itself. Here, using 2 and 3 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.[1] 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.[2] Looking at “identical twins”, we look at the financial statements of selected sodium chlorate producers listed in Exhibit 5. Using the estimated debt betas for different types of bonds from our class notes, the unlevered betas for these companies range from .59 to 1.07 with an average of .90.[3] However, 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 I used an asset beta for the Collinsville investment of .9.

Assuming a market risk premium of 8.4% and a riskfree 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%). Given that the investment project is 100% equity financed, the appropriate discount rate should be in this range.

To evaluate the investment using this range of discount rates, we must identify the after-tax cash flows from the investment.[4] I first 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 .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...
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