Nova Chemical Corporation

Preliminaries

1. How can we tell that IPD is underperforming?

2. Is there a solid economic motivation for selling IPD?
3. How do we calculate whether to accept the United Chemical offer?

Valuing IPD
Could use APV approach or WACC approach
Both approaches must incorporate some assumptions about how IPD is financed
The method of financing could depend on who the owner is
Using a Basic Chemicals industry average
(D/D+E) ratio of .209
(D/E) ratio of .276
Calculating the cost of capital
Use pure plays in the basic chemical industry (assume constant ratios)
Unlever each firms beta unlevered = [D/V x debt ] + [E/V x equity ]
Average these unlevered betas
(1) APV approach use this unlevered beta to calculate all equity cost of capital
(2) WACC approach relever the beta to the target capital structure

Cost of Capital at IPD

Calculations
Assume TC = .40
Average industry unlevered beta of 1.02
Assume IPD division BBB rated and financed like basic chemicals industry average
Using target D/E ratio of .276 equity = 1.02 + .276 x [1.02 - .23] = 1.24
Assume rf = .0791, risk-premium = 7.6%
CAPM requity = .0791 + (1.24 x .076) = .1732
Cost of debt (BBB rating) = 9.96%
WACC = (.209 x (1-.4) x 9.96%) + (.791 x 17.32%) = 14.95%

Cash Flows and Value of IPD

Use Figures in Exhibit 10 to calculate cash flows of IPD
Adjust for the fact that R&D spending does not go with IPD sale
( Add $15 million back to EBIT)
1990
36.7
15

1991
35.6
15

1992
34.9
15

1993
35.8
15

1994
36.2
15

1995 and on
36.2
15

(EBIT+R&D)x(1-Tc) 31.0
+Deprec
22.5
-Capex
41.6
-NWC
-6.9
FCF
18.8

30.4
26.1
31.1
-2.3
27.7

30
29
30
.9
28.1

30.5
31.9
30.8
3.2
28.4

30.7
34.8
34.6
4.3
26.6

30.7
34.8
34.6
.0
30.9

EBIT
R&D

Discounting the FCF at 14.95% stand alone value of 188.34

Selling the division

Worth 188.34 million to Nova if kept
Worth 188.34 million to external party if sold (subtle tax issues though)
Tax gain on the realized loss in sale of IPD is: (350.6 160) x .40 = $76.24
Agree to sale if:
(Offer + 76.24 mil.) to 188.34 mil.
More generally sell if:

Offer + [.4 x (350.6 Offer)] > 188.34

Offer > 80.17

Issues
1. Can they get a better price?
2. Part of the value gain here is realizing the tax loss early
3. Benefits of raising $$ from the sale should push them towards a sale
4. Strategic bidders take this all into account in their bids

Financing Issues
1. Clearly Nova needs to raise some cash (numbers in a minute)
2. Asset sale can be an efficient way to raise $$ particularly for a tangible asset
Asset sale raises some funds today, results in smaller cash flow tomorrow
3. What are Novas cash needs and where will they stand after the asset sale?

Novas cash needs

Break-down cash flows by each part of the business
Keep R&D and interest tax savings separate
Calculate Free cash flow of each division as:
Divisional FCF = [EBIT x (1-TC)] + Deprec. Capex. NWC + [R&D x (1-Tc)]
Corporate FCFE = (Sum of division FCFs) [total R&D x (1-TC)] - [interest x (1-TC)]
[equiv. Corporate FCFE= net income + depreciation capex NWC ]
Predicted Nova
Corporate FCFE
Less Dividends
Less Maturing debt
Total cash generated

1990
-139.54
-13.97
-10
-163.51

1991
-134.42
-16.32
-20
-170.74

1992
23.26
-20.57
-20
-17.31

1993
48.64
-26.54
-20
2.11

1994
77.66
-33.92
-20
23.75

Novas cash needs (continued)

Clearly Nova needs a lot of cash in the next 2 years
An asset sale to United will result in a ($160 + $76.24) = $236.24 inflow
This will help in the short-run
However, cash flows from IPD will then not accrue to Nova in future
From our earlier valuation
of IPD predict cash flows of: 1990
18.8

1991

1992

1993

1994

27.7

28.1

28.4

26.6

So by selling IPD, Nova:

(a) Gets 236.24 immediately
(b) Cash in subsequent years changes by above amount

Financial aspects to asset sale

Asset sale does not eliminate the need to raise new funds, does postpone the
need for a year this flexibility can have value
The more costly it is to access the external capital markets, the more an
asset sale makes sense
Since firm is relatively highly levered and it is clear that it has insufficient
internal cash to fund major new investment, market reaction to equity issue
may not be that negative (case suggests 10% cost of equity issuance)
Firm could finance with a mix of debt and equity to keep leverage at safe
(but aggressive) levels. Information impact likely to be small.
Firm could cut dividend short term negative news

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