Caso Essay

702 WordsApr 7, 20153 Pages
SOLVAY BUSINESS SCHOOL MBA André Farber Finance CHEM-CAL CORPORATION The main issue raised in the case is to find a cutoff rate to be used for the analysis of investment projects. Mr Cochran is willing to apply what he learned recently in a management program. Unfortunately, there is room for improvement in his grasp of finance. Moreover, since 1979, academic have gained a better understanding of the issues raised in the case: they now more cautious about using the textbook weighted average of capital. The current capital structure of Chem-Cal is the following (to simplify the analysis, preferred stocks are included in debt): Exhibit 1: Current capital structure (USD millions) |Book value|Market value|% | Equity|80|50|63%| Debt|35|30|37%| Total|115|80|| Notice that the company is not in excellent shape: market value of equity is less then book value. The first step is to calculate the cost of equity. A starting point (in the absence of data about the beta of the stocks) is the current stock price ($25) relative to EPS ($4.25). Assuming that the present value of growth opportunity is zero: There is another way to obtain the same result based on the simplest version of the Dividend Discount Model: If the NPV of new investment is zero (PVGO = 0), then ROE = r and: The second step is to find the unlevered cost of capital We know that the cost of equity of a levered firm is higher than the cost of equity of an unlevered firm (r0) because of financial risk. The relation between rS and r0 is (MM Proposition II with corporate taxes): With rS = 17%, rB = 10.5%, TC = 50% and B/S= 0.6, we get r0 = 15.5%. This is the discount rate to use to calculate the value of the projects for an unlevered firm. The third step is to calculate the NPV of the unlevered projects To do this we need to know the expected unlevered cash flows

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