St. Louis Chemical: The Investment Decision

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CASE DESCRIPTION

The primary subject matter of this case concerns the issues surrounding evaluation of capital expenditures. Case provides a systematic approach to evaluating capital expenditures including a review of alternative capital budgeting methods and the relationship between cost of capital and capital budgeting. Secondary issues include cost of capital theory and the advantages and disadvantages of financial leverage. The case requires students to have an advanced knowledge of accounting, finance and general business issues thus the case has a difficulty level of four (senior level) or higher. In particular, an understanding of capital budgeting practices and cost of capital issues are necessary to solve the case. The case is designed to be taught in one class session of approximately 1.25 hours and is expected to require 4-6 hours of preparation time from the students.

CASE SYNOPSIS

St. Louis Chemical is a regional chemical distributor, headquartered in St. Louis. Don Williams, the President and primary owner, began St. Louis Chemical five years ago after a successful career in chemical sales and marketing. The company reported small losses during it first two years of operation but has since reported increasing sales and profits. The growth has required the acquisition of equipment, expansion of storage capacity and increasing the size of the work force.

The unexpected withdrawal of one of St. Louis Chemical's competitors from the region has provided the opportunity to increase its packaged goods sales, in particular, sales of material in 55 gallon drums. However, St. Louis Chemical's 55 gallon drum filling equipment is already operating at capacity. To take advantage of this opportunity, additional equipment must be obtained, requiring a major capital investment. It is estimated that St. Louis Chemical must increase its drum filling capacity by at least 200,000 to 400,000 drums annually. The firm has no systematic capital expenditure evaluation process or an estimate of its cost of capital.

COMPANY HISTORY

St. Louis Chemical is a regional chemical distributor, headquartered in St. Louis. Don Williams, the President and primary owner, began St. Louis Chemical five years ago after a successful career in chemical sales and marketing. In his previous employment, he gained a solid understanding of the chemical industry and the distribution process, but his exposure to accounting and finance issues was limited. The company reported small losses during it first two years of operation but has since reported increasing sales and profits. The growth has required the acquisition of equipment, expansion of bulk liquid storage and warehousing for packaged goods and increasing the size of its work force.

Most initial business financing was provided by Williams, using the proceeds from liquidating his stock portfolio plus severance pay from his previous employer. Other capital was provided by an investment by his father, trade credit and a bank loan. The original bank loan was repaid last year. Williams has been reluctant to borrow funds because of the "fixed" nature of interest payments.

Despite its business success, St. Louis Chemical is still a "large" small business with Williams making all important decisions. He recognized the need to develop a professional managerial staff, particularly in the area of finance. Recently, he hired Ann Bush as the company's first finance professional and placed her in charge of the company's accounting and finance activities.

St. Louis Chemical's board of directors is composed of Williams' family members and the company's attorney. The board's existence satisfies state regulatory requirements for corporations but provides no input to business operations.

CHEMICAL DISTRIBUTION

A chemical distributor is a wholesaler. Operations may vary but a typical distributor purchases chemicals in large quantities (bulk--barge, rail or truckloads) from a number of manufacturers. …