Start with the basic WACC equation:
WACC = (E/D+E) x Re + (1-t) x (D/D+E) x Rd
Break down WACC into smaller components:
Exhibit 7 provided “Profit after taxes” (Net Income), earnings per share, and closing stock price for 1979 (expected).
We used the debt structure of the project to determine the debt ratio. By taking on debt of $8M and using $4M in equity, we arrive at a 66.6% debt and 33.3% equity structure.
Cost of Equity (Re) can be determined using historical equity returns for the firm, CAPM, or APT. We chose to use the CAPM. We assumed:
– Market risk premium = 8%
– Risk-free rate of 9.5% (long-term treasury bonds at that time).
– Estimated a corporate tax rate of 48% (AVG effective tax rates from 1975-1978)
1975 1976 1977 1978 1979
Operating income $2,366.00 $ 3,925.00 $ 4,741.00 $ 6,170.00 $ 7,842.00
Taxes $1,125.00 $ 1,878.00 $ 2,285.00 $ 2,932.00 $ 3,818.00
Net income $1,241.00 $ 2,047.00 $ 2,456.00 $ 3,238.00 $ 4,024.00
Effective tax rate 47.5% 47.8% 48.2% 47.5% 48.7%
Average effective tax rate 48.0%
We need the equity beta for Dixon. Unlevering the betas for two comparable companies and re-levering with Dixon’s debt to equity structure. This resulted in a re-levered beta of 2.22%. Total cost of equity is 27.3%.
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The last component of the WACC to calculate is the cost of debt (Rd).
Multiply the interest rate of the bonds that were issued to raise capital (11.25%) by (1-t) – 48% tax rate. After tax cost of debt (Rd) is estimated at 5.85%. Plugging these into the WACC formula, we arrived at a weighted average cost of capital of 13%.
WACC = (E/D+E)Re+(D/D+E)(1-T)Rd Actual
E/D+E 33.3%
Re 27.3%
D/D+E 66.7%
T 48%
Rd = Dinterest (1-t) 11.25%
WACC 13.0%
2) What are the projected incremental cash flows associated with the acquisition of theCollinsville plant without the laminate technology? Use projections from Exhibit 8through 1984. After 1984 assume: EBIT is flat; capital expenditures are $600,000per year; and that net working capital increases 8% per year. Assume that theplant is shut down at the end of 1989 and that its salvage value is zero.
We started by calculating the free cash flow (FCF) associated with the acquisition of the Collinsville plant without the laminate technology. Free cash flow was calculated by
EBIT
less Taxes
less CapEx
plus Depreciation
plus Change in Net Working Capital
We assumed a fixed EBIT with an increase in net working capital by 8% and annual capital expenditures of $600,000. Per the information outlined in the case, the plant is anticipated to depreciate over 10 years with no salvage value at the end of its life. We depreciated the asset with the straight-line method.
3) What is the value of the Collinsville plant without the laminate technology usingthe simple WACC method?
The value of the Collinsville plant (without laminate technology) according to our financial analysis using the simple WACC method is -$2.387MM. The main contributing factors to this valuation are low earnings, a very high tax rate, and high capital expenditures relative to the cost of plant.
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4) Project the incremental cash flows associated with the 1980 investment inlaminate technology. Using the simple WACC method, what is the investment’snet present value?
The method used to project the incremental cash flows associated with the 1980 investment in the laminate technology is similar to that used in question #2 above. Similar to question #2, we used a flat EBIT, fixed CAPEX, and NWC increase of 8% after 1984. The Collinsville plant realizes a few benefits by implementing the laminate technology such as energy savings and the elimination of graphite costs. These cost savings are incorporated into the projections. Energy savings were estimated at 15% to 20% for coated graphite electrodes, so we used an average of 17.5% in energy savings. We added back these cost savings to EBIT to arrive at an adjusted EBIT. The cost for Collinsville plant to implement the laminate technology is $2.25MM in December of 1980. Because the life cycle of plant is estimated to expire at the end of 1989, we depreciated the $2.25MM capital expenditure over nine years using the straight line method. The simple WACC method resulted in a net present value of $2,338,000.
5) What is the APV of both the Collinsvile plant investment with and without the laminate technology?
Our WACC-based valuation varies from our APV-based valuation for both scenarios of the Collinsville Plant (with and without laminate).
WACC and APV valuations are negative $2.38MM and negative $4.26MM without laminate, respectively. Should the plant invest in the laminate technology, the valuation increases for both WACC and APV valuation methods to $2.338MM and $0.795MM, respectively. The difference between the two valuation methods is driven by how the tax shields are accounted. The WACC approach is a more simplified. However, it does not allow for the capital structure to change over time which is not as beneficial. APV allows for the level of debt to change over time. The debt level is changing each year because the $8M bonds are being paid off by $1M each year. APV also takes into account the tax shield. If we had ignored the tax shield valuations would have been negative, with and without laminate. The APV valuation method is superior to WACC because it takes into account the change in leverage and the benefits of the tax shield.
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6) Compare the WACC-based valuation to the APV-based valuation. Do they differand how much? If the difference is important, explain why. If the difference issmall or zero, explain why.6) As CEO of Dixon Corporation, would you approve the acquisition of theCollinsville plant at the price and on the terms proposed? Why, or why not?
It is our recommendation that Dixon should not purchase the plant. Evaluating the deal with both the WACC and APV methods, the investment is not viable with the current level of technology. Without the installation of the laminate technology, especially since the salvage value of the investment after the ten year timeline is zero. The financing constraints of $8M limit the ability of Dixon to purchase the plant and implement the necessary technology to make the plant viable.
If Dixon was able to leverage the position of Universal Paper having to sell the plant and force them to bear the cost of upgrading the technology, they may be able to purchase the plant. Given the current situation however, this deal is not viable.
