Chris Ragan EDHEC MBA, Microeconomics Case Studies page -9-

EDHEC MBA Microeconomics: Christopher Ragan

Case Study #4

Price Discrimination and Simple Corporate Valuation

A. The Setting: After years of expensive R&D effort ($50 million), in January of 2007 Nouveau Chem Inc. opened its innovative and highly specialized chloralkalye plant that had cost $35 million to build. Here, using the firm's newly patented process, electricity is passed through a mixture of brine and a special catalyst to produce caustic soda and an innovative chlorine substitute called Repli-Chlor. Caustic soda is a chemical commodity produced by many companies and produced, distributed and sold by them and by a host of brokers in well organized spot markets all over the world. Repli-Chlor is a new chemical that can replace chlorine in most applications with the joint benefits that there is less corrosion and it is better for the environment. Moreover, Repli-Chlor enables the production, in standard plastics factories, of new plastics that have properties uniquely well suited for the fabrication of weapons components subject to high stress at extreme temperatures. Despite the absence of start-up problems at the plant and a ready market for Repli-Chlor, the financial results of its new operations are disappointing to Nouveau Chem. You are called in to help the firm evaluate the business, to review the decision-making process, to make suggestions about the management of marketing and distribution, and to think about a $60 million offer that Nouveau Chem has received for the plant and the patent together. The owners know that the plant itself, being specifically designed to produce a unique product, has no market value without the patent -- it would simply be too expensive to re-tool the plant to manufacture other products.

B. The Market Details: In 2007 the plant produced and sold 200,000 tonnes each of caustic soda and Repli- Chlor. (The chemistry of the production process dictates that caustic soda and Repli-Chlor are always produced in equal weights.) The firm had plenty of excess capacity at this level of output.

In 2007, the market price of caustic soda was $120 per tonne, and Nouveau Chem sold all its entire output of Repli-Chlor for $130 per tonne.

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The 2007 sales of 200,000 tonnes of Repli-Chlor were sold to the four market segments as follows: - New Plastics Manufacturers: 35,000 tonnes - Municipalities: 30,000 tonnes - PVC Manufacturers: 75,000 tonnes - Pulp & Paper Manufacturers: 60,000 tonnes

Gross revenues in 2007 were $50 million (200,000 x $120 = $24 million from the caustic soda, and 200,000 x $130 = $26 million from the Repli-Chlor). Variable costs in 2007 totalled $30 million: $18 million for power, $3 million for labour, $2 million for brine and catalyst, $2 million for sales and marketing, $1 million for plant maintenance, $3 million for distribution, and $1 million for management. In the next year (2008), the market price of caustic soda rose to $130 per tonne. At the same time, the decline in construction activity in the economy depressed by 20 percent the demand for PVC. As a result of this demand reduction, plus Nouveau Chem's decision to raise the price of Repli-Chlor to $143 per tonne "in accordance with full costs", purchases of Repli-Chlor by the PVC industry dropped by 40%. Also, during 2008 not much appeared to be going on in the other three market segments. Sales to the New Plastics industry and to the Municipalities were unchanged by Nouveau-Chem's price increase. Sales to the Pulp & Paper firms fell to 50,000 tonnes, and this appeared to be a response solely to the price increase.

Gross revenues in 2008 were $43.7 million (160,000 x $130 = $20.8 million from the caustic soda, and 160,000 x $143 = $22.9 million from the Repli- Chlor). Variable costs totalled $24 million in 2008 (80% of the corresponding figures for 2007).

C. The Problem: These financial results disappointed the management at Nouveau Chem Inc. because the 2007 and 2008 surpluses of revenues over variable cost, $20 million and $19.7 million respectively, fell short of their target rate of return on their invested capital. Their analysis projected that the industry would engineer around their patent in 5 years (3 years from now), so they sought to depreciate their investments in R&D and the factory over that period of time. In total, using a reasonable expected risk-adjusted rate of return for the owners' initial investment (of $85 million), the financial management of

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Nouveau Chem sought a surplus of revenues over variable costs of at least $24.5 million annually from the operation of the new plant, and the results achieved were significantly short of this target. If $20 million is all that can be earned each year from this plant, perhaps the $60 million offer should be accepted!

D. The Extra Information: After your initial meeting at which you received this overview, you wisely sought out the VP of marketing, who has responsibility for pricing. He told you that Nouveau Chem has no ability to influence the market price of caustic soda, and that the firm can sell any amount it wishes without altering the existing market price. The same VP confessed to a bit of nervousness about market acceptance of Repli-Chlor in 2007, so he was delighted to find a reasonable price that would permit the plant's full output to be sold that year. In 2008, since the financial people were on his back, he talked to the cost analysts over in the accounting department and set the price for Repli-Chlor to cover "full costs". He then told you that he had recently read a best-selling business book by Edgar Bronfman called Insights on Pricing, and this book had confirmed his common-sense pricing strategy. He even showed you an autographed copy of the book he was quite excited. You felt a little uneasy as you left his office, but you were unsure exactly why. You then interviewed the cost analysts and discovered how costs were calculated for pricing in 2008: The production process is quite straightforward, and variable costs per two- tonne combined unit of caustic soda and Repli-Chlor are $150. The industrial engineers therefore split this value down the middle -- and, when asked, informed the accounting department that the marginal cost for Repli-Chlor was $75 per tonne.

As the finance people have already told you, $24.5 million per year is needed to deliver a reasonable return on the owners' initial investment of plant and R&D. Based on the plant's 2007 output of 400,000 tonnes (200,000 tonnes of each product), this comes to $61.25 per tonne. The total cost per tonne is therefore $136.25, $75 to cover the variable costs and $61.25 to cover the required return on the fixed costs.

Since caustic soda brings in $130 per tonne, Repli-Chlor must be priced at $142.50 per tonne in order for revenue per tonne to average $136.25, as required to cover costs. This figure was rounded to $143 per tonne as the recommended price of Repli-Chlor for 2008.

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To complete your round of interviews, you talked to the sales manager, and asked how Nouveau Chem's customers reacted to the recent 10-percent price increase in Repli-Chlor. She explained that the PVC manufacturers are always quite cost conscious and that, despite the considerable appeal of Repli-Chlor, many of them switched back to plain chlorine in response to the price increase because either chlorine or Repli-Chlor constitutes a major cost item for them. In fact, she added, many PVC manufacturers didn't initially switch to Repli-Chlor in 2007 due to its relatively high price. On the other hand, the manufacturers of the new plastics built with Repli-Chlor didn't complain at all about the price increase because they just pass it on to the Defence Department which is excited about the material's excellent properties for weapons components. Municipalities are also good customers for Repli-Chlor, and they didn't complain about the price increase because Repli-Chlor is a winner in terms of environmental cleanliness. The sales manager notes that Nouveau Chem doesn't talk to the municipalities very often because Nouveau Chem sells to an intermediary who distributes Repli-Chlor in the kind of canisters that fit well into municipal water systems. The sales manager also noted that the customers in the pulp and paper industry reduced their purchases of Repli-Chlor by some 17 percent in 2008, even though their business didn't weaken that year. They use a lot of chlorine for bleaching, and the special properties of Repli-Chlor are not all that useful to them.

E. The Tasks: The central question on the table is whether Nouveau Chem should accept the $60 million offer to purchase the plant and patent. If there is no way to improve the profits for the three remaining years of the patent, then the offer looks very good. But can these profits be increased?

1. What do you recommend about how Nouveau Chem should price the Repli-Chlor in each of the market segments? 2. Under these prices, can you estimate the value of annual operating profits? 3. How can Nouveau Chem change its marketing and distribution practices to sustain any price discrimination that you recommend? 4. What should Nouveau Chem do about the $60 million offer it has received?

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