Evaluate the opinions expressed in the following discussion. Point ...

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Evaluate the opinions expressed in the following discussion. Point out the ones that you think are incorrect, explain why, and indicate briefly how you would correct them.
Ebbers and Kozlowski, CEO and Executive vice-president, respectively, of HP (Hurd
Packed-off), joined Lay, the CFO, for a Management Committee meeting.
1. Ebbers: Have we decided what to do with the plant in Flint, now that we have stopped production there?
2. Kozlowski: Both Specialty Products and Biomedical Products divisions have submitted proposals for using it (see attached dashboard).
3. Lay: Specialty Products’ proposal has an IRR of 12% whereas Biomedical’s proposal has an IRR of 15%. So, I recommend we allow Biomedical to use the Flint facility.
4. Ebbers: Do these IRRs beat our WACC?
5. Lay: They sure do. Our company WACC is 9%.
6. Kozlowski: No surprise the project IRRs are handily beating the WACC. Neither project is spending anything to build a plant.
7. Ebbers: What about the new product proposal from our Basic Chemicals group?
8. Lay: Their IRR is only 8%. I recommend we reject it.
9. Kozlowski: That doesn’t make sense. The entire capital for this project is being borrowed at
5.5%. Last time I checked, 8 was greater than 5.5.
10. Lay: Where did you get the borrowing rate of 5.5% from?
11. Kozlowski: Easy. I just divided our interest payment in the income statement you prepared by the amount of total debt that we carried on our balance sheet.
12. Ebbers: By the way, I don’t see any interest deductions in your free cash flow to all capital analysis of the Basic Chemicals group project. Interest payments are cash flows.
13. Kozlowski: I would like us to work on reducing our WACC. We need to use more debt which is cheaper.
14. Ebbers: Have you identified any acquisition candidates as part of our growth strategy?
15. Lay: We are in preliminary discussions with Cysco Oil which is privately held. We have their income statement. They are doing great with gross operating margins upwards of 25%, making them an attractive acquisition candidate.
16. Kozlowski: How much will it cost us to buy them?
17. Lay: Slightly under $90 million should do it to buy all their shares. Here is the ballpark analysis (attached). I should have a detailed analysis by next week.
18. Ebbers: Good. Let us move on to our performance this year. How do the numbers look?
19. Lay: We are doing great! Profits are up from last year.
20. Ebbers: I am glad that our gross margins are beating the WACC by three percentage points.
21. Kozlowski: How about ROCE?
22. Lay: We are doing fine. This year’s ROCE will again be positive.
Problem intent: As general managers, ability to critically evaluate financial information presented by others and integrate it in decision making. You may consult any course resource.

Dashboard of capital requests
(Dollar values in millions)
DIVISION             CAP-EX         WC       NPV @ 9%       IRR
Basic Chemicals       $20          $3.2          $6.7                8.0%
Biomedical Products None*       $6.3          $16.7             15.0%
Specialty Products    None*       $5.4          $11.4             12.0%
*Because of use of Flint Plant.

Ballpark analysis of Cysco Oil acquisition
Cysco Income Statement (thousands)
Revenue from operations      $88,519
Cost of goods sold                $58,254
Gross Profit                            $30,265
Selling General and Administrative $16,801
Depreciation & Amortization   $1,690
Operating Income                   $11,774
Interest Income                      $1,166
Earnings Before Interest And Taxes $12,940
Interest Expense                     $919
Income Before Tax                  $12,021
Income Tax Expense               $4,012
Net Income                              $8,009

Earnings Before Interest & Taxes (EBIT) = $12,940
EBITDA = EBIT + Depreciation and Amortization = 12,940 + 1,690 = $14,630
Enterprise value/EBITDA multiple at which firms similar to Cysco are trading (from
Yahoo! Finance) = 6.14
Value of Cysco Oil = 14,630 × 6.14 = $89,828

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