Academic journal article Journal of the International Academy for Case Studies

ST. Louis Chemical: The Investment decision.(Instructor's Note)

Academic journal article Journal of the International Academy for Case Studies

ST. Louis Chemical: The Investment decision.(Instructor's Note)

Article excerpt

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.

INSTRUCTORS' NOTES CASE OVERVIEW

As the case opened Don Williams, the President of the St. Louis Chemical, a regional chemical distributor, headquartered in St. Louis is considering the opportunity to increase its packaged goods sales, in particular, sales of material in 55 gallon drums. The company's 55 gallon drum filling equipment is operating at capacity, thus 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.

Williams is considering two alternatives proposed by the company's engineer. The first is the acquisition and installation of used equipment that will provide the capacity to fill an additional 200,000 fifty-five gallon drums annually. The used equipment will cost $860,000 to acquire and install. The equipment is projected to have an estimated life of three years. The second option is the acquisition and installation of new equipment with the capacity to fill 400,000 drums annually. The new equipment would cost $2,480,000 to acquire and install and have an economic life of seven years. The new equipment is more efficient thus the cost to fill a drum is less than the per drum filling cost of the used equipment. Williams asked Bush to lead the evaluation process. The company does not have a formal evaluation process for capital projects.

Bush thinks the used equipment could be obtained without new bank debt. The acquisition of the new equipment would require new bank borrowing. 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. The evaluation of each alternative requires an estimate of the financial benefits associated with each.

The learning objectives of the case include: 1) Introducing students to a systematic approach to capital budgeting decisions 2) Examining how firm's cost of capital is calculated and financial theory regarding a firm's optimum capital structure 3) Examining the relationship between a firm's cost of capital, capital budgeting and long-term financial performance 4) Examining capital expenditure evaluation techniques (NPV, IRR and Cash Payback and 5) Exploring non-financial issues that need to be considered when evaluating capital expenditures. …

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