RSM433 Case 6

Name: Qiyan Huang Hui Huang

Student Number: 1002092406 1002396604

1. Why Nova Chemicals is considering selling IPD? (2 points)

First of all, Nova’s president is dissatisfied with IPD’s performance in recent years. The basic chemicals
industry is in its period of weakness where the earnings are under pressure and the prices are lowering due
to excess capacity and modest expected growth in demand. Its margins affected by natural gas prices
when they were low relative to petroleum prices also put IPD in an unfavorable competitive position.
Moreover, Nova is in need of funds to finance the strong growth of the LPD and EPD, specifically, an
investment in new production facilities for the EPD.

2. Why is Nova Chemicals shocked by the offer? (2 points)

The offer from United Chemical to purchase the net assets of IPD is only half of the net book value of the
assets of IPD. Nova Chemicals is shocked by how meager this division’s value is to other companies in
the industry.

3. Derive the free cash flows for the Industrial Products Division. (4 points)

4. What are the steps to compute the cost of capital of IPD? Justify your choice of comparable firms and
estimate the cost of capital. (4 points)
Steps to compute the cost of capital of IPD:
 Find a set of comparable firms.
 Compute asset beta for each comparable firm and take the average.
 Use the average asset beta and the target capital structure for the IPD to calculate the equity beta
(Relever the beta). The average of comparable firms’ market leverage is used as an estimate of IPD’s
target capital structure.
 Using CAPM to calculate the cost of equity for the IPD.
 Calculate the cost of debt (given in the Excel file).
 Calculate WACC using the target capital structure for the IPD.
Justification: IPD is the basic chemical division of Nova Chemical Corporation so we choose Dupont,
Dow Chemical and United Chemical, who operate in the same basic chemicals industry, as our
comparable firms.
Estimation of cost of capital: 15.103% (See Excel file for detailed calculation).

5. Would you sell IPD to United Chemicals for $160 million? Why? (5 points)
We would sell IPD for $160 million. Firstly, the pretax loss of $190.6 million due to the sale of IPD
would create a tax gain of $76.24 million, which leads to a total benefit of $236.24 million. This is larger
than the NPV of IPD ($185 million). The sale of this slow-growing division can also provide funds for
more promising divisions and release the financial pressure of the firm. What’s more, since the specialty
chemical divisions with strong growth potential need significant amount of R&D to prosper, it’s vital for
Nova to free the resources and concentrate on the development of these divisions. Last but not least, the
downward pressure on basic chemicals prices suggests a not-so-bright future for the IPD division and it
may be wise to get rid of it now.

6. What financing strategy would you adopt if IPD is kept? What are costs and benefits? (3 points)
We would recommend Nova to finance the investment by issuing common stocks. This way Nova will
not have to bear even heavier debt on top of its already high leverage compared to other firms in the basic
chemical industry. It will be under less cash demand pressure as well. However, equity issuance generally
arouses negative market reaction toward the company and the share price will possibly drop.