MFIN 820 Advanced Corporate Finance - 2013 - Oguzhan Ozbas 1

Dixon Corporation: The Collinsville Plant

(Session 2)

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FCF w/o Laminate: Forecast Assumptions

• 1980-84: Use numbers from Exhibit 8.

• 1984-89:– EBIT assumed flat.– CAPX assumed to be $600,000 per year.– NWC (=9% of Sales) increases with Sales at 8%.

• 1989: Terminal value (more on this in “Company Valuation”):– Superior metal electrode technology Liquidate plant (say) PPE is completely written off Get tax credit:

t * (PPE-Salvage Value)– Also, recover the NWC

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1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989EBIT 833 2,218 3,035 3,134 3,026 3,026 3,026 3,026 3,026 3,026Taxes at 48% 400 1,065 1,457 1,504 1,452 1,452 1,452 1,452 1,452 1,452EBIT (1-t) 433 1,153 1,578 1,630 1,574 1,574 1,574 1,574 1,574 1,574Depreciation 1,060 1,110 1,160 1,210 1,270 1,330 1,390 1,450 1,510 1,570PPE 10,600 10,025 9,440 8,840 8,230 7,560 6,830 6,040 5,190 4,280 3,310PPE -575 -585 -600 -610 -670 -730 -790 -850 -910 -970CAPX 485 525 560 600 600 600 600 600 600 600A/R 1,622 1,328 1,680 1,976 2,136 2,303Inventory 651 598 756 889 961 1,036A/P 873 730 924 1,087 1,175 1,267NWC=A/R+Inv.-A/P 1,400 1,196 1,512 1,778 1,922 2,072 2,238 2,417 2,610 2,819 3,044NWC -204 316 266 144 150 166 179 193 209 226

Free Cash Flow 1,212 1,422 1,912 2,096 2,094 2,138 2,184 2,230 2,275 2,318

Terminal value (end 1989) PPE 1989 * t 1,589 NWC 1989 3,044

Discount rate 15.0% PV 10,465 NPV -1,535Discount rate 16.0% PV 9,986 NPV -2,014Discount rate 17.0% PV 9,538 NPV -2,462Discount rate 18.0% PV 9,121 NPV -2,879

Valuation of Collinsville Plant without Laminate Technology

Remarks:• 1979-84: Could use directly (ex.8): FCF=EBIT(1-t) – Net Assets• CAPX obtained from PPE = CAPX - Depreciation

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Remarks About Terminal Value

Assumption 1: The plant is liquidated.• We could explore alternative assumptions (e.g., perpetuity).

Assumption 2: We recoup the full WC of 3,044.• Not sure we do, e.g., actual value of Inventory might be more or

less than the reported book value.

Assumption 3: Plant’s liquidation value is zero.• Could be positive but also negative (e.g. need to clean up).

Assumption 4: Dixon’s Taxable income exceeds 3,310• Otherwise, cannot use the full tax credit PPE*t

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Bottom Line: Overall NPV = NPV(w/o laminate) + NPV (laminate) looks positive for reasonable discount rates (about $3 million).

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989Power Savings 1,354 1,643 1,842 2,061 2,309 2,586 2,896 3,244 3,633Graphite Savings 791 875 940 992 1,042 1,094 1,148 1,206 1,266Incremental CF 2,145 2,518 2,782 3,053 3,351 3,680 4,044 4,450 4,899Taxes at 48% 1,030 1,209 1,335 1,465 1,608 1,766 1,941 2,136 2,352After-tax 1,115 1,309 1,447 1,588 1,743 1,914 2,103 2,314 2,547CAPX 2,250Depreciation 225 225 225 225 225 225 225 225 225PPE 2,250 2,025 1,800 1,575 1,350 1,125 900 675 450 225Depreciation * t 108 108 108 108 108 108 108 108 108

Incremental FCF -2,250 1,223 1,417 1,555 1,696 1,851 2,022 2,211 2,422 2,655

Terminal value PPE 1989 * t 108

Discount rate 14% NPV 5,642 Discount rate 15% NPV 5,287 Discount rate 16% NPV 4,956 Discount rate 17% NPV 4,648 Discount rate 18% NPV 4,360

Valuation of Laminate Technology

Cost Savings assumptions:• Power costs (17.5%) grow at 12% past 1984.• Graphite costs (100%) grow at 5% past 1984.

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Remark: Cost of Capital for Laminate?

• May make sense to use a lower discount rate for the cost savings brought about by the Laminate technology than for the FCF of Collinsville.

• This innovation is cutting variable costs.

• Variable costs are less volatile than profits.

• This would raise the NPV of laminate and thus the overall NPV.

Note: Firms with high beta tend to have high fixed costs.

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average -10% 10%Demand (in millions of units) 10 9 11

Revenue (in $ million) 100 90 110Variable costs 70 63 77Fixed costs 15 15 15Profit 15 12 18

Example

• XYZ has the following technology:– Revenue of $10 per unit produced,– Variable costs of $7 per unit,– Fixed costs are $15 million

• 10% deviations from average demand of 10 million units:– 10% deviations for variable costs– 20% deviations for profit

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Risk of Technological Failure

• Suppose there is a 30% chance that the laminate technology doesn’t work. How do we account for this?

• Adjust expected cash flows, not discount rate.

• Indeed, the risk of failure is (most likely) purely idiosyncratic.

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Valuation

• Do you learn about failure before spending $2.3 M or after?• If after (Scenario A), cost $2.3M is sunk and only the PV of

revenues (7.3) are weighted by the probability of success:$7.3M * 70% - $2.3M = $2.8 M.

• If before (Scenario B): Weigh NPV by probability of success: $5.0 M * 70% = $3.5 M.

Probability of failure 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Scenario APV of laminate 7.3 6.6 5.8 5.1 4.4 3.7 2.9 2.2 1.5 0.7 0.0Cost of laminate 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3NPV (laminate) 5.0 4.3 3.5 2.8 2.1 1.4 0.6 -0.1 -0.8 -1.6 -2.3Overall NPV 3.0 2.3 1.5 0.8 0.1 -0.7 -1.4 -2.1 -2.8 -3.6 -4.3

Scenario BPV of laminate 7.3 6.6 5.8 5.1 4.4 3.7 2.9 2.2 1.5 0.7 0.0Cost of laminate 2.3 2.1 1.8 1.6 1.4 1.2 0.9 0.7 0.5 0.2 0.0NPV (laminate) 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0Overall NPV 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0

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Sensitivity Analysis

• Big concern: new plants use metal, have lower costs. Even with laminate, our variable costs are about 10% higher.

• In a commodity market, prices tend to be driven by variable cost of low-cost producers.

• What happens to NPV if prices are 10% lower than forecast in each year?

• NPV falls by about $5M!

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Key Points for Dixon Corporation

• Discounted cash flow approach, applied mechanically, does not give “the answer”.

• Rather, DCF is a useful tool for translating information about project economics into a statement about value creation.

• DCF plus sensitivity analysis: a good way to identify key “value drivers” - those factors that merit most careful thought.

• Comparables are a good way to check DCF, but should always be used in conjunction with DCF.

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Appendix

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Using Comparables

• In practice, valuation exercises very often include a direct comparisons to other firms or assets.

• We will have much to say about the use of comparables when we value companies.

• For now, the Dixon case illustrates how one could use comparables and some of the issues with this method.

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Comparables

Idea: Firms in the same business should have similar Market to Book Ratio, i.e., ratio of Market Value of Firm to Book Value of Assets.

• STEP 1: Identify companies in same basic business as the Collinsville plant: Brunswick and Southern.

• STEP 2: Calculate Market to Book Ratio for comps.

• STEP 3: Multiply average Market to Book Ratio by the Book Value of Assets of the Collinsville plant to get valuation of Collinsville plant.

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Comparables Calculation

Brunswick SouthernMarket Value of Equity $5.75M $4.39M Book Value of Debt $0.48M $0.63MMarket Value of Firm $6.23M $5.02MBook Value of Assets $3.20M $3.00MMarket to Book Ratio 1.95 1.67Average Market to Book Ratio 1.81

Collinsville’s Value = 1.81 * Collinsville Assets at end of 1979= 1.81 * 6,287 = $11.4M

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Problems with Comparables

• We should also use other multiples such as multiples of cash flow (but we don’t have data).

• Other multiples calculations give very different answers. For example, with average P/E of Brunswick and Southern of 6.85 applied to pro-forma earnings in 1979 of $3.6 get unrealistic valuation of $24.6M. Applied to 1980 earnings of $0.8, get unrealistically low valuation of $5.5M.

• Multiples valuations have a hard time incorporating firm specific information, particularly if there are operating changes --- such as the laminate technology --- that are going to be implemented.

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APV Calculation

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The APV Procedure

• Calculate the present value of future CF using the discount rate that corresponds to zero leverage (i.e. all-equity financing).– This is the discount rate we obtained in Session 1 using the

CAPM and the (unlevered) asset beta for Collinsville.

• Find out the contribution of the PV of tax shield (and possibly other components) separately.

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FCF of Collinsville, as Before1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

EBIT 833 2,218 3,035 3,134 3,026 3,026 3,026 3,026 3,026 3,026Taxes at 48% 400 1,065 1,457 1,504 1,452 1,452 1,452 1,452 1,452 1,452EBIT (1-t) 433 1,153 1,578 1,630 1,574 1,574 1,574 1,574 1,574 1,574Depreciation 1,060 1,110 1,160 1,210 1,270 1,330 1,390 1,450 1,510 1,570PPE 10,600 10,025 9,440 8,840 8,230 7,560 6,830 6,040 5,190 4,280 3,310PPE -575 -585 -600 -610 -670 -730 -790 -850 -910 -970CAPX 485 525 560 600 600 600 600 600 600 600A/R 1,622 1,328 1,680 1,976 2,136 2,303Inventory 651 598 756 889 961 1,036A/P 873 730 924 1,087 1,175 1,267NWC 1,400 1,196 1,512 1,778 1,922 2,072 2,238 2,417 2,610 2,819 3,044NWC -204 316 266 144 150 166 179 193 209 226

Free Cash Flow 1,212 1,422 1,912 2,096 2,094 2,138 2,184 2,230 2,275 2,318

Terminal value (end 1989) PPE 1989 * t 1,589 NWC 1989 3,044

All-equity (APV) discount rate 16.8% PV 9,625 NPV -2,375Discount rate 14.0% PV 10,980 NPV -1,020Discount rate 15.0% PV 10,465 NPV -1,535Discount rate 16.0% PV 9,986 NPV -2,014Discount rate 17.0% PV 9,538 NPV -2,462Discount rate 18.0% PV 9,121 NPV -2,879

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Assumptions for Debt and Interest

• What leverage ratio should we use in our calculations?– The acquisition of Collinsville was financed by 100% debt.

But this debt is also a claim on Dixon’s existing assets, so we cannot use 100% leverage.

– Should we use the leverage ratio of Dixon + Collinsville? Only if Dixon is a good comp for Collinsville.

• Use the optimum leverage ratio.– 22% D/(D+E) from Session 1 translates into 25% of PPE.– This is the best balance between tax shield benefits and

costs of financial distress. If leverage is any higher, the expected costs of FD exceed the tax shield benefits!

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Projections of Debt, Interest, and Tax Shield

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

PPE 10,600 10,025 9,440 8,840 8,230 7,560 6,830 6,040 5,190 4,280 3,310Debt (25% of PPE) 2,650 2,506 2,360 2,210 2,058 1,890 1,708 1,510 1,298 1,070 828Interest expense (10.50%) 278 263 248 232 216 198 179 159 136 112

Interest tax shield (48%) 134 126 119 111 104 95 86 76 65 54

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Discount Rate for the Interest Tax Shield

• How risky is the CF due to the interest tax shield?– First cut, let’s assume that it is about as risky as the interest

payments on the debt, kD = 10.50% from Session 1.

• In reality, a firm may not be able to use interest tax shields even if it manages to service its debt.– The “right” discount rate would be a little higher.

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PV of Tax Shield

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

PPE 10,600 10,025 9,440 8,840 8,230 7,560 6,830 6,040 5,190 4,280 3,310Debt (25% of PPE) 2,650 2,506 2,360 2,210 2,058 1,890 1,708 1,510 1,298 1,070 828Interest expense (10.50%) 278 263 248 232 216 198 179 159 136 112

Interest tax shield (48%) 134 126 119 111 104 95 86 76 65 54PV of interest tax shield 121 103 88 75 63 52 43 34 27 20

Discount rate 10.50%PVTS 626

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The Value of Laminate Technology1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

Power Savings 1,354 1,643 1,842 2,061 2,309 2,586 2,896 3,244 3,633Graphite Savings 791 875 940 992 1,042 1,094 1,148 1,206 1,266Incremental CF 2,145 2,518 2,782 3,053 3,351 3,680 4,044 4,450 4,899Taxes at 48% 1,030 1,209 1,335 1,465 1,608 1,766 1,941 2,136 2,352After-tax 1,115 1,309 1,447 1,588 1,743 1,914 2,103 2,314 2,547CAPX 2,250Depreciation 225 225 225 225 225 225 225 225 225PPE 2,250 2,025 1,800 1,575 1,350 1,125 900 675 450 225Depreciation * t 108 108 108 108 108 108 108 108 108

Incremental FCF -2,250 1,223 1,417 1,555 1,696 1,851 2,022 2,211 2,422 2,655

Terminal value PPE 1989 * t 108

All-equity (APV) discount rate 16.80% NPV 4,598Discount rate 14% NPV 5,579Discount rate 15% NPV 5,207Discount rate 16% NPV 4,859Discount rate 17% NPV 4,535Discount rate 18% NPV 4,230

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Tax Shield for Laminate Technology

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989

PPE 2,250 2,025 1,800 1,575 1,350 1,125 900 675 450 225Debt (25% of PPE) 563 506 450 394 338 281 225 169 113 56Interest expense (10.50%) 59 53 47 41 35 30 24 18 12 6

Interest tax shield (48%) 28 26 23 20 17 14 11 9 6 3PV of interest tax shield 26 21 17 13 10 8 6 4 2 1

Discount rate 10.50%PVTS 108

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Adding Up Components of APV

PV(FCF) + PVTS = APV

APV of Collinsville -2,375 + 626 = -1,749APV of Laminate, 100% success 4,598 + 108 = 4,706

APV of C+L, 100% success = 2,957APV of C+L, 50% success = 604

For comparison:NPV of C+L, 100% success, with WACC=16% = 2,942

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APV and WACC

• Meticulously applied, both APV and WACC should produce the same NPV.

• Here they produce more or less the same result, NPV=$3M.

• Generally APV is preferable:– More straightforward; needs fewer assumptions– Distinguishes between different components of NPV