Americal Chemical Report

American Chemical Corporation

We will use the WACC approach to calculate the fair value of the investment to Dixon.

This means that the discount rate will account for the financial risks associated with the investment. This allows us to estimate unadjusted incremental cash flows and discount them directly with the calculated rate to obtain the value of the proposed acquisition.

Our time horizon is 10 years, as this is the anticipated remaining physical life of the plant.

Assumption

• Although Dixon’s current debt ratio is 0%, their long-term target ratio – with or without the project – is 35%. So, to value the investment, we will assume that we can use the same discount rate for the value of Dixon with and without the investment. As such, we will value the investment simply by discounting incremental cash flows resulting from the investment.

1. Estimate the appropriate cost of capital for the investment

The cost of capital is obtained using the WACC approach. As Dixon has no convertible debt or preferred shares, only common stock and standard debt, we use the following formula:

[pic 1]

Where  is the cost of debt,  is the corporate tax rate,  is the expected return on common stock, and  is the ratio of debt to total market capitalization.[pic 2][pic 3][pic 4][pic 5]

This is applied following these steps:

1. Estimate the unlevered beta for the industry

For this, we select a set of peer companies: These are companies in the same industry, which face similar operating risk. We take here the 6 companies provided in Exhibit 5, as they are sodium chlorate producers operating on the same market. We include Dixon in the sample as well. For each firm, we estimate the beta (in our case betas are given to us in Exhibit 5), and use the target capital structure to obtain the unlevered beta as per the formula: [pic 6][pic 7]

We obtain the following results

[pic 8]

• four of these companies are rated A or above; for them we use . For the other two, no rating is available. However, based on their interest coverage, we can assume that they have a rating of A or above as well and decide to use the same value. Dixon’s corporate bonds are BBB-rated based on the 11.25% interest rate. Therefore, we use .[pic 9][pic 10][pic 11]
• %Debt: for the 6 peer companies, we are given a 5 year history of debt ratios, and we take the average of this to de-lever the beta. For Dixon, we use Exhibit 7 to get historical debt and equity values. These are book values, so we are assuming that these numbers are reflective of market capitalization, as there is no sign of significant intangibles, trademarks, or financial distress on the balance sheet to indicate misvaluation.

As we are using a small sample, we would remove outliers and we chose to use the median rather than the mean (which is particularly sensitive to outliers with a small sample). It would be completely fair to exclude Pennwalt as an outlier. However, we have included it because it makes no difference to the median  at the end of the day.[pic 12]

This process gives us:  for the industry.[pic 13]

1. Calculate the levered beta of the company

We use the same formula as above:

[pic 14]

where D/E is Dixon’s long-term target debt to equity ratio

As the target debt ratio is given to be 35%, we use  [pic 15]

As  0.91 and , we obtain [pic 16][pic 17][pic 18]

1. Select the risk-free rate to use

Given that Dixon is investment grade, and our horizon is 10 years, we can use the yield to maturity of long-term Treasury bonds, hence 9.5%[pic 19]

1. Estimate the expected risk premium:  [pic 20]

The historical range for the market risk premium is 3%-7%. Average market risk was relatively higher in 1979 as there was less international diversification of investors. We will use 6% to be safe.

1. Deduce the expected return on common stock for Dixon using the CAPM (one-period) model:

17.60%[pic 21]

1. Estimate the corporate tax rate

Using Exhibit 7, we can compute an average corporate tax rate of 48%.

1. Deduce the cost of capital

Using the formula for WACC, we get

[pic 22]

Given that the only debt in the target structure is the newly issued one, , and the long-term target debt ratio is 35%, we obtain .[pic 23][pic 24]

1. Estimate incremental cash flows

We project incremental cash flows for the period spanning 1980 to 1989.

We calculate Incremental Free Cash Flows as:

[pic 25]

Assumptions: