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We will discuss issues here as time permits. Good case to discuss real asset options.
Questions to discuss prior to class 1. What are Du Pont's competitive advantages in the TiO2 market as of 1972? How permanent or defensible are they? What must Du Pont do to retain its competitive advantages in the future? Given the forecasts provided in the case, what are the relevant cash flows associated with the following three strategies for managing DuPont's TiO2 business? Strategy I: Status Quo. Hold production capacity at 325,000 tons per year. Strategy II: Maintain Strategy. Build capacity to 482,000 tons by 1985. Strategy III: Growth Strategy. Build capacity to 685,000 tons per year by 1985. Notice, the status quo is not directly discussed in the case, it just gives a benchmark of comparison between the two strategies being considered (maintain vs. growth). 3. How much risk and uncertainty surround these future cash flows? What are particular sources of risk facing Du Pont? How might competitors respond to Du Pont's choice of either strategy in the TiO2 market? What other factors should Du Pont consider in making this decision? Which strategy, maintain or growth, looks more attractive for Du Pont? What are the key factors leading to your conclusion? FYI, in 1972, bond yields and recent inflation data were approximately as follows: Long-term Treasuries = 6.2% Aaa Corporate bonds = 7.2% Baa corporate bonds = 7.8% Inflation rate (CPI) = 3.2% p 4, column one: "Ongoing capital expenditure for maintenance and replacement were expected to approximate depreciation allowances over time. Thus, should TiO2 production terminate at any point in the future, it was believed that DuPont's investment in working capital and book value of other assets could be completely recovered." What do these two sentences telling you?
. a method of calculating the annual free cash flow of a project. so do it.. These investments are risky investments..tax + (Depreciation . You know how to do terminal values (Project cash flows note). The second sentence is giving you a shortcut to calculate the terminal value of the investment alternatives at the end of the forecast interval.Maintenance CAPEX) . .Growth CAPEX . which is not) will cancel with the depreciation addback. but maintenance capex. The authors of the case assume you don¶t know how to calculate continuing values of investments. More explicitly. etc. which are estimable from case numbers. FCF is as follows: FCF = Operating profit before tax (after depreciation) . these plants will not be nearly as valuable in their next best use. a shortcut that allows you avoid estimating depreciation. if someone should find a better substitute for TiO2. so they are saying you should use the remaining book value of assets plus any working capital invested to assess the project¶s terminal value.´ This is not what the sentence means. This second sentence is particularly troubling if misinterpreted to mean that investments in either the growth strategy or the maintain strategy are not really risky.The first sentence is telling you that maintenance capital expenditures (not growth capital expenditures.Change in working capital requirements They are telling you that the italicized row may be left out of the equation. because the company can always get their incremental investments out ³at any point in the future.
it¶ll improve Du Pont¶s competitive position in the industry. they run the risk of losing market share in the near future. If Du Pont is able to expanding capacity. Continue with its existing strategy and maintain its current revenue st ream. sharp increases in the cost of rutile ore required for the sulfite based process and the heightened environmental regulations enacted against domestic sulfur based plants made the ilmelite . On the other hand. First. multi-million dollar investment decisions such as these are not easily made and require a tremendous amount of due diligence to include financial forecasting. competitors may also try to gain market share by investing in a new innovative. and extensive research. a key component of the ilmenite chloride technology. The growth strategy has a higher NPV compared to the maintain strategy for discount rates under 23%. Recent events have dramatically altered and created excess demand in the titanium dioxide industry. Du Pont will benefit from this because most of its production uses the ilmenite chloride process. Du Pont has a dominant position in many markets. We assumed sales of $100 million in 1972 based off of Exhibit 2¶s dollar value of shipments. Their competitors may add capacity and flood the market. restrict the licensing of the ilmenite chloride process. Du Pont found itself in a fortunate position as it was faced with the following two options: 1. and maintains a competitive advantage over other firms in the industry. Sulfate process plants were forced to make major capital expenditures to comply with new environmental legislation and the price of rutile ore increased dramatically. Two recent developments in the industry. There are also the usual risks of technical failure. Du Pont¶s growth strategy will have an $886 million NPV and their maintain strategy will have a NPV of $715 million at a 5% (NPV at other discount rates available on spreadsheet). Du Pont should also consider other factors such as the possibility of price increases or limited access to ilmenite ore. Since US firms currently dominate the domestic market for TiO2. or 2. (b) Statement of Facts and Assumptions. Du Pont was a leader in the Titanium Dioxide industry possessing the highest capacity for use of the ilmelite chloride process. Du Pont also has a competitive advantage in the chloride process because of the recent enacted environmental protection legislation. as noted on page 76 footnotes. labor ramifications. competitors may invest in R&D and develop a cost effective process or imitate Du Pont¶s current ilmenite chloride technology. since it offers the highest NPV. if Du Pont chooses a growth strategy. Overview In 1972. there is the possibility tariffs on TiO2 imports will be lowered and foreign markets will gain more market share. The growth strategy looks the most attractive since the net present value is higher for all discount rates between 5%-23%. which has made TiO2 production costs much higher. Due to the size of the firm and its technological superiority. cost effective process or develop a process comparable to Du Pont¶s ilmenite chloride technology. delayed startups. Market Position Du Pont's position in the market was fortunate for several reasons. Du Pont has a few competitive advantages over its competitors as of 1972. As one can imagine. The terminal value was calculated as the sum of all capital expenditures and the change in working capital. The tax rate was assumed to be 48%. The Inter nal rate of return could not be calculated because there is no initial outlay for either strategy.(a) Statement of Problem. If Du Pont chooses a maintain strategy. and diminished cash flow from TiO2 operations. Using a 5% discount rate. (c) Analysis. and achieve forecasted sales of TiO2. Therefore. In addition. Du Pont had developed its ilmenite chlorine process. Management currently reevaluated their capacity expansion strategy to see whether or not to expand or maintain their current market share. we¶d recommend Du Pont to pursue a growth strategy with a discount rate of 5%. declining prices. Modify its strategy and invest additional capital to increase its revenue stream in the future. a technology that processes at lower grade ores. which is much cheaper than the processes used by competitors.
Du Pont has much to gain if they were to choose this course of action. and there appears to be no shortage of the necessary raw material given that it was just discovered a few years pri or. it already had the funding and expertise to build these facilities and could do so more effectively than any present competitor. Du Pont has the most cost effective and environmentally clean process. Therefore. it would likely encounter fewer problems than any other company seeking to enter the industry or expand in it. it should determine whether or not there is a better use for the capital inside the company. was highly leveraged and the other producers in the market were relatively much smaller. responsible for the production of titanium dioxide. the risks to choosing such a path are minimal. we believe. Conclusion Our conclusion in this case. The company should leverage these circumstances and use them as opportunity to take a small part of their company and turn it into a future growth engine.chloride process more attractive. cost overruns. Through our analysis. With the contacts Du Pont had established throughout the political and labor world. we believe the decision is fairly simple: pursue the "Growth" strategy. worst case. it is difficult to get a gauge where it should apply its excess capital. it was still the second smallest of Du Pont's ten departments. As stated. as indicated above and verified again through our sensitivity analysis. Granted. While the pigments department. Du Pont had a competitive advantage in the ilmelite chloride process accounting for approximately 60% of the total market production in 1970. while the "growth" provides over $130M. For example. most likely). it would be difficult to exceed the NPV gain of $80M(+) in choosing the "growth" strategy over the "maintain" strategy. Du Pont should move forward with the investment and increase production. the "maintain" strategy of non-expansion leads to positive future cash flows of $50M+. Du Pont was a large diversified company that spanned a number of different industries. is to pursue a "Growth" strategy. Some of the factors can be attributed to their own decision making (to diversify production using the ilmenite process) and others can not be (environmental crackdowns on sulfur plants. and the development of huge economies of scale were risks that were obviously present for Du Pont. Therefore. they have the industr y knowledge and presence to be able to expand in the right way without attracting the ire of legislators and environmentalists. NL Industries. high cost of rutile ore). This competitive advantage translated to an average pre-tax profit margin of 40% doubling that of its competitors in the industry. the risks surrounding these future cash flows appear to be minimal. One of their smaller industries could grow to become a more significant contributor to the company and could fund future growth. the growth strategy appears to be the more attractive option. Sensitivity Analysis The company should also conduct some "sensitivity analysis" to verify all external factors that could possibly affect the raising or lowering of projected future cash flows (insert our analysis of such sensitivities here best case. Du Pont should examine other factors as well. it is uncertain whether or not such an investment would generate the desired returns. Using the numbers in Appendices A and B. With no knowledge of other opportunities. The company also had the name and established corporate presence necessary to facilitate such development. For example. Finally. Other Considerations There are always inherent risks involved in pursuing a particular course of action. However. regulation. however. Consequently. especially with the recent decline of many of its competitors. Du Pont has been handed a very fortuitous set of circumstances. Through our analysis. was an important part of Du Pont's holdings. Finally. . As our analysis shows. the added production would provide higher cash flows in the future. The Issue The issue facing Du Pont is whether or not to invest additional money into this capital intensive process and expand production. the risk associated with the pigment department was fairly mitigated. the company could afford to cut prices as needed to keep future competitors out of the industry and maintain market share. As a result. This advantage was strengthened by the fact that the number two producer.
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