Dixon Corporation, a U.S.-based chemical company, is mulling on buying a plant from American Chemical Corp. American Chemical’s Collinsville plant makes sodium chlorate for the paper and pulp industry. Dixon will have to pay $12 million as purchase price for the plant. It may also pay $2.25 million to complete the laminate technology developed by the plant’s research and development staff, which is expected to improve the plant’s efficiency.
Dixon already has transacted business with some of American Chemical’s major customers. Dixon, however, believes that the acquisition will enable it to widen product lines and penetrate the paper and pulp industry.
26%. We presuppose that the Dixon’s debt will solely be used for the Collinsville acquisition. Assuming debt at 11.25%, we can compute for the after-tax cost of debt as (1-0.48)*11.25% equaling 5.85%.
We can now compute for the weighted average of the costs of debt and equity funds, noting that target debt-to-equity ratio is 35%. The WACC, using the formula WACC = D/V*After-tax cost of debt + E/V*Cost of equity = 0.35*5.85%+0.65*21.26% = 16%.
We use the historical cash flow for 1980 to 1984, and projected cash flow for 1985 to 1989, using this information:
-- Historical data will be used for property plant and equipment and depreciation costs.
-- Prices increase 8% annually
-- Power expenditures increase 12% each year
-- Net working capital is 9% of revenues
-- we use the average figures for 1980 to 1984 to project other costs – non-power variable costs rate is 11% per year, selling expenses increase 7%, fixed cost increase 6%, R&D expenses at 5%.
Given figures and other assumptions are:
-- plant’s life is 10 years and its salvage value is zero.
-- book value of the plant is $10.6 mill, assuming a $1.4 mill. Working capital
-- company’s tax rate is 48%
We can now determine whether the investment, i.e., the Collinsville acquisition, increases value of the business or shareholders’ wealth. We do that by computing its NPV. We actually have two options if we pursue the acquisition, include or exclude the laminate technology. Net present value = Present value of the expected cash flows - Cost of the project = -Initial Investment + CF1/(1+r)1+ CF2/(1+r)2+ CF3/(1+r)3+ CF4/(1+r)4.
Using our projected cash flows, and the WACC (cost of capital), we will yield an NPV of ($3,700) or negative $3,700.
Given that the laminate technology is expected to give cost savings, including elimination in graphite costs and a 15% to 20% reduction in power costs, and tax benefits, we assume that NPV with the new technology is equal to NPV (without laminate) + NPV (cost savings). The NPV from additional savings is $6,600. So NPV with laminate technologies is -$3,700 + $6,600 = $2,900.
Under the NPV rule, an investment is viable if its NPV is positive, but is not should be rejected if negative.
If Dixon pursues the acquisition of the Collinsville plant absent the new technology, it will have negative NPV. This means that the company will actually reap more returns by investing in government bonds. Investing in...