ST. LOUIS CHEMICAL: THE INVESTMENT DECISION

A. Abstract
§ St. Louis Chemical is a regional chemical distributor
§ The company reported small losses during it first two years → reported increasing sales and profits
§ The growth has required:
i. acquisition of equipment
ii. expansion of storage capacity
iii. increasing the size of the work force

B. Case Overview
§ headquartered in St. Louis → considering the opportunity to increase its packaged goods sales, sales of material in 55 gallon drums
§ to take advantage of this opportunity → additional equipment must be obtained → requiring a major capital investment
§ Williams is considering two alternatives
i. The acquisition and installation of used equipment that will provide the capacity to fill an additional 200,000 fifty-five gallon drums annually → economic life 3 years
ii. The acquisition and installation of new equipment with the capacity to fill 400,000 drums annually → economic life 7 years
a. New equipment is more efficient thus the cost to fill a drum is less than the per drum filling cost of the used equipment
§ Bush feels that Williams may be willing to consider using debt if she can convince him of the advantages of using debt in the firm's capital structure

C. Content
1. Prepare a presentation for Williams regarding the concept of WACC
§ the weighted average cost of capital (WACC) is the cost the company is paying to finance its assets and reflects the riskiness of the firm or the firm's assets
§ it is a weighted average of the costs of the various sources of capital (debt and equity) used in the firm's capital structure
§ WACC is an after-tax cost → calculated using the after-tax cost of each source of capital
§ determine WACC:
i. calculate the cost it must pay for each source of capital
ii. determine the target mix of debt and equity to be used by the firm

2. Calculate St. Louis Chemical's WACC (round to the nearest whole number). arguments should be made to convince Williams of the advantage of using long-term debt in the firm's capital structure
§ WACC = W^sub d^(k^sub d^)(l-t) + W^sub 8^(k^sub 8^)
§ The best argument that can be made to convince Williams to use debt capital in its capital structure is to calculate the firm's WACC with and without debt
§ Without debt, the firm's cost of capital is 16% → with 30% debt, its cost of capital is 13%
§ The use of debt lowers St. Louis Chemical's cost of capital because low cost debt capital is substituted for high cost equity capital
§ Debt has a lower cost than equity because to the holder of debt there is less risk
§ Debt has less risk → the certainty of payments associated with debt (interest and principal) is greater than the payments associated with equity (dividends and stock appreciation)

3. Since the used equipment will be financed with internal capital and the new equipment with a bank loan, the same discount rate should be used to evaluate each alternative
§ The discount rate used to evaluate the project reflects the risk level of the project, not the cost of the financing
§ The cost of capital represents the risk level of the firm's assets

4. An accurate WACC is important to a firm's long-term success.
§ A firm's WACC is used to assess investment decisions
§ An asset's return is less than the WACC → shareholders will not receive their required return
§ If the WACC is underestimated → the firm risks losing equity capital as unsatisfied investors take their funds elsewhere or will have difficulty raising capital in the future
§ If the WACC is overestimated → the firm risks missing profitable growth opportunities
§ Making investment decisions based on informal analysis is an unacceptable process and will not result in an effective allocation of the firm's scarce resources

5. Evaluate the strengths and weaknesses of the NPV, IRR and Cash Payback Period capital expenditure budgeting methods. Prepare a recommendation for Williams regarding the capital budgeting method or methods to use in evaluating the expansion alternatives
§ Cash Payback Period is the number of years it takes a firm to recover the original investment
i. The advantages of the Payback Period
a. easy to calculate and explain
b. focuses on future cash flows
c. places a premium on liquidity
ii. The disadvantages of the payback period
a. ignores time value of money
b. ignores cash flows beyond the payback period
c. does not include an accept/reject feature

§ Net Present Value (NPV) method is determined by:
i. calculating the present value of the future cash flows
ii. deducting the project's cost from the present value of the future cash flows
© If the project's value (the present value of its future cash flows) exceeds its cost → the project is a good investment and should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. includes an accept/reject feature
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. requires knowledge of a firm's WACC

§ Internal Rate of Return (IRR) method is calculated by determining the discount rate that will cause the present value of the future cash flows to equal the project's cost
© If the IRR exceeds the firm's WACC, the project should be accepted
i. Advantages of this method
a. focuses on future cash flows
b. takes into account time value of money
c. considers all cash flows associated with the project
d. does not require knowledge of a firm's WACC
ii. Disadvantages of this method
a. relatively difficult to explain and calculate
b. if the project's future cash flows include some years with cash outflows rather than cash inflows, multiple IRRs may result
§ Recommendation should include the use of all evaluation methods because each provides valuable information regarding a potential project
§ Priority should be given to the results of the NPV method because it compares the projects value to the projects cost

6. The projected cash flow benefits of both projects did not include the effects of inflation. Future cash flows were determined using a constant selling price and operating costs (real cash flows). The cash flows were then discounted using a WACC that included the impact of inflation (nominal WACC). Discuss the problem with using real cash flows and a nominal WACC when calculating a project's NPV or IRR.
§ If inflation is neutral, impacting revenues and costs equally, the NPV and IRR will be underestimated → Because revenues are usually greater than costs, revenues will increase by a greater dollar amount than costs