VICTORIA CHEMICALS PLC (A): THE MERSEYSIDE PROJECT

Capital Budgeting Case Analysis

DeQuincy Adamson Donald Harrell Lekisha McKinley Taylor Wolfe

Finance 5387 Spring 2012

England. the Merseyside Works plant in Liverpool. Next. and automobile parts. and Hosche A. Table 1 on the following page presents a comparison of plant sizes and indexed costs. The company was the leading producer of polypropylene. Primary competitors CBTG A. a polymer that is used in a variety of products including carpet fibers. Polypropylene was essentially priced as a commodity. Additionally. the polypropylene was mixed with stabilizers. packaging. Their plants operated at various cost levels. In addition to small producers. Victoria Chemicals produced and manufactured polypropylene at two plants. The production process consisted of two stages: In the first stage. The company positioned itself as a supplier to customers in Europe and the Middle East. and the Rotterdam facility in Rotterdam. the executive vice president and manager of the Intermediate Chemicals Group (ICG). a plastic pellet.VICTORIA CHEMICALS: CASE BACKGROUND Victoria Chemicals was a major competitor in the chemical industry worldwide. a refined gas received in tank cars known as propylene. The plants were built in 1967 and are identical in scale and design. seven major competitors manufactured polypropylene in Victoria Chemicals’ market region.G. were able to produce higher annual output at lower costs per ton. which is shipped to the customer.G. . In order to meet demand. the gas form of polypropylene was combined with a solvent in a pressurized vessel and then concentrated and collected in a centrifuge. managers of both plants reported to James Fawn. Holland. The production of polypropylene pellets begins at Merseyside with propylene. modifiers. fillers. and pigments in order to create the final product.

The entrance of a corporate raider may have shown that the firms’ assets appeared to be under valued. the previous manager of the plant had enhanced operating results by minimizing capital expenditures to cover only necessary . The company was under pressure to improve its performance as its earnings had fallen 38% from 250 pence per share to 180 pence per share in a year.19 Plant Name VICTORIA CHEMICALS: ISSUES/PROBLEMS In 2007. The decline in the company’s value was due in large part to its current production process and the condition of its facilities: The method of producing the polypropylene at the Merseyside Works plant was obsolete compared to new technology with its competitors. Victoria Chemicals experienced a significant drop in its financial performance from 2006. Next 10 Largest Plants Saabrun Liverpool Rotterdam Hamburg Genoa Marseille Antwerp 1981 1967 1967 1977 1961 1972 1976 350.000 450. change the management. In addition.000 120. Victoria Chemicals Victoria Chemicals Hosche A.A. Montecassino SpA Saone-Poulet S.000 250.Table 1: Comparison on the Seven Largest Polypropylene Plants in Europe Plant Plant Location Year Plant Built Annual Output (in metric tons) CBTG A.02 1.000 175.07 1.G.00 1. Victoria Chemicals saw the accumulation of its common shares by a well-known corporate raider named Sir David Benjamin.09 1. and ultimately increase share value and get a big return on his investment. Vaysol S. As well.06 1.09 1. This corporate raider could gather a large voting right.000 220.A.G. and required more labor than the process used by its competitors.000 300.11 1.000 250.000 Product Cost per ton (indexed to lowcost producer) 1.

routine maintenance had been delayed to the point that it was now imperative for it to no longer be deferred in order to renew the production line. Victoria Chemicals requires more labor than its competitors in newer. as such. Merseyside Works plant manager Lucy Morris thought it an ideal time to seek funding from corporate headquarters for a modernization program for the Merseyside Works. Montecassino is the only other firm among the top 7 whose costs are higher than that of Victoria Chemicals. The proposed project would be to renovate and rationalize the polypropylene production line at the Merseyside plant in order to make up for deferred maintenance and to exploit opportunities to achieve increased production efficiency. o Refurbishing the polymerization tank to achieve higher pressures and thus greater throughput. . Another issue that Victoria Chemicals faces is that its product is a commodity.maintenance over the past five years. they need to maintain competitive prices while increasing profits through lowering their costs. VICTORIA CHEMICALS: THE PROPOSED PROJECT Morris and her controller. Victoria Chemicals faces issues not only with lower revenues but with higher costs as well. Therefore. proposed a project to overhaul the entire polymerization line at a cost of GBP 12 million. Victoria Chemicals incurs high costs of production mainly due to higher dependence on labor. They do not compete with a differentiated product. Compared to its competitors. Because both their plants are older and use a semi continuous production process. Given these factors. more efficient plants. Frank Greystock. Morris felt this move would help improve the company’s financial situation and help them remain a major competitor in the worldwide chemical industry. which would enable the process flow to be streamlined. to remain competitive and gain market share. Correct the plant design on ways that would save energy and improve the process flow by: o Relocating and modernizing the tank-car unloading areas. but it is an older plant (built in 1961) and produces a lower volume compared to Victoria Chemicals. Morris revealed the areas of opportunity in which the project covered:   No longer defer maintenance on essential tools and equipment required in the production process.

000 in engineering costs due to the renovation. Greystock also speculated that any new assets acquired would depreciate in 15 years. the entire line would need to be shut down for 45 days in the first year for construction. The project would also result in seven percent (7%) greater manufacturing throughput. Based on the current annual 250. In addition. there were some issues or concerns that were associated with the project. which would cause Merseyside Works’ customers to buy from competitors until the renovation was completed. Frank Greystock. Currently. This was a problem because the Rotterdam plant was already operating at near-maximum capacity. Victoria Chemicals owned the tank cars with which Merseyside Works received propylene gas from four petroleum refineries in England. The benefits of this project were increased efficiencies in terms of:    Reduced energy consumption. The 13% figure was determined using the following equation where 1. Even still. assumed that this loss of customers would be temporary.5%. Increased gross margin of up to 12. Furthermore.5 (months) equals 45 days in which the plant would be shut down for construction: ( ) The tax rate required in the capital-expenditure analysis was 30%. The Transport Division. a controller at Victoria Chemicals. Increased manufacturing output. which was assumed to equal 1.75% in years 6-10. Victoria Chemicals would experience roughly a 13% decrease in production for that year upon implementing the project.25% of sales in the first year and . however.o Renovating the compounding plant to increase extrusion throughput and obtain energy savings. he predicted that in the first year the company would incur GBP500.000 tons of polypropylene pellets a year at a price of GBP675 per ton.000 ton production figure. Renovating the Merseyside plant would require it to shut down for 45 days. . Victoria Chemicals was producing 250. VICTORIA CHEMICALS: CONCERNS WITH THE PROPOSED PROJECT Even though the project seemed to have promising returns.

thus.which oversaw the movement of all raw. The Transport Division was not the only division with concerns. which could result in Merseyside cannibalizing Rotterdam. the company would likely shift capacity from Rotterdam to Merseyside. Currently. which meant that the trucks could not be used to ship product to its primary customers in the Middle East. of marketing believed that lowering costs would help Victoria Chemicals compete better with other producers of polypropylene and thus win over customers from competitors.P. The Transport Division believed that the cost of the tank cars should be included in the initial outlay of Merseyside Works’ capital program. The rolling stock also could not be used outside of Britain because of differences in track gauges. but doing so would accelerate the need to purchase new rolling stock to support anticipated growth of the firm in other areas. Greystock disagreed. the V. However. After hearing out both arguments. noting that they were doing the company a favor by using the excess capacity and that company has always operated in silos. Greystock decided to continue to use a discount rate of 10% . Greystock did not include charge for loss of business in his analysis as he felt a cannibalization charge was fictitious and including such charges would not allow them to maintain their cost competitiveness. and finished materials throughout the company and was responsible for managing the tank cars. The director of sales said that the Greystock’s analysis assumed that the company would be able to sell the increased output brought on by the renovation. but could operate much longer with proper maintenance. The ICG Sales and Marketing department had some questions of their own. The purchase was estimated at GBP2 million in 2010. To combat the oversupply. Rolling stock would have a depreciable life of 10 years. However. However. On the other hand. the entire industry was experiencing a downturn. an oversupply of polypropylene could occur. Greystock’s discounted cash flow also suggested that the company would earn a 10% return on the project. the allocation could be made out of excess capacity. even though the Treasury staff believed the real return to be 7% due to a 3% in inflation per year. intermediate. As such Greystock did not include the charge (cost of excess rolling stock) in the proposal on the grounds that the division should carry the allocation of rolling stock. realized that it would be required to be increase its allocation of tank cars to Merseyside to support the growth that the renovation would bring.

Payback period of 3. Net present value of GBP10. using the 10% rate would cause the company to accept projects (those that fall between seven and 10 percent) that should be rejected.022 2. Internal rate of return: The IRR had to be greater than 10%. VICTORIA CHEMICALS: EVALUATING THE PROPOSED PROJECT The project was considered an engineering-efficiency and. assistant plant manager and Morris’s direct subordinate. 3. which Tewitt argued that the negative NPV ignored strategic advantages from the project and increases in volume and prices when the recession ended. The NPV of this project was –GBP750. The Merseyside project. proposed that Greystock modify his proposal to include a renovation of the EPC production line at a cost of GBP1 million. On another note. He believed that the renovation would give Victoria Chemicals the lowest EPC cost base in the world and would improve cash flows by GBP25.8 years. The high discount rate was problematic because. according to Greystock. IRR of 24. Payback: The payback period maximum was six years. 3. Morris wanted to review Greystock’s analysis in order to resolve the issue of the tank cars and the loss of business that could occur. was required to meet certain criteria before being approved. Discounted cash flow: The net present value of all future cash flows had to be positive. 2. Average annual addition to EPS of GBP0. met all four investment criteria: 1. Griffin Tewitt. However. therefore. she was afraid that further analysis could lead to rejection of the project.3% .6 million 4.000. The criteria included: 1. 4. if the 7% figure was more accurate. Impact on earnings per share: The net income had to be positive when calculated as annual earnings per share (EPS) over its entire life.because it was the figure promoted in the latest edition of the company’s capital-budgeting manual. using the number of outstanding shares at the most recent fiscal year-end as the basis for the calculation.000.

The EPC project has a negative NPV of -GBP750. To improve the EPC production line it would cost GBP 1 million. Griffin Tewitt. the EPS needs to be GBP0.000 indefinitely. These costs are already incurred and are independent of the project decision. Therefore. the production line for EPC. VICTORIA CHEMICALS: EARNINGS PER SHARE (EPS) The impact on EPS is calculated as the average of annual incremental gross profit due to the profit divided by the number of shares.000. steps we took to meet it] VICTORIA CHEMICALS: SUNK COSTS The plant manager has included the preliminary engineering costs of GBP 500.In the following paper.6 million (under the original calculation) can absorb the losses of the EPC project.022. but it would improve cash flows by GBP 25. and his contention was that the bigger renovation project with a positive NPV of GBP 10. . we will analyze the four criteria based on Greystock’s findings to determine if the analysis was conducted accurately and reflects true numbers or expectations of return on the Merseyside project investment. His argument was to include the EPC project as part of the renovation project that is currently being analyzed. these costs are not to be considered for the DCF analysis. VICTORIA CHEMICALS: PIGGYBACK PROJECT ETHICAL DILEMMA The assistant plant manager. [discuss how/if we met this requirement. The benefits of the EPC project will come through when the recession ends and increase in volume and prices happen. In order to accept this project. Whether or not the project is going to be approved. these costs are to be borne by the company.000 spent over the past nine months on efficiency and design studies of the renovation. proposed to modernize a separate and independent part of Merseyside Works.

Additional issues of concern is that the plant managers’ bonuses are tied to the size of the plants they operate. progress and benefits occurring on time.Although the EPC project has potential to become larger. In the current system at VC. VICTORIA CHEMICALS: COMPETITION WITHIN DIVISIONS The reporting structures and bonus programs have lead to a lack of synergies between divisions and a violation of ethics. Other issues are that of evaluation of projects on a periodic basis to monitor the costs incurred. In addition. There is conflict between Transportation division and polypropylene production division. This supply chain manager facilitates the manufacturing and movement of all materials in order to increase efficiencies and reduce costs. as these factors have a significant effect on NPV and IRR. an ethical dilemma occurs where Tewitt is asking Greystock to add his renovation project as part of the polypropylene line renovations stating that “in the last 20 years. no one from corporate has monitored renovation projects once the investment decision is made. VICTORIA CHEMICALS: CANNIBALIZATION . Having the Transport Division and the Intermediate Chemicals Group reporting to separate executive vice presidents is a problem. the EPC market has not been largely successful since its inception. The costs and benefits are not relevant to this analysis.” Even if there would be benefits to the company overall. which is not necessarily the proper incentive plan because operation size does not always positively correlate with efficiency and profit margins. The procedure should also be updated to require the analysis to include the appropriate depreciation methods and tax rates. the logistics divisions and manufacturing divisions of a company report to a single executive that oversees the entire supply chain process. the EPC project should not be included in the analysis because this product line would not impact the polypropylene product line. there is no post evaluation of projects at corporate level after the investment decision is made. The company procedures for capital expenditure approvals should incorporate a post hoc analysis to determine if the project outcome was estimated accurately and if the project was a success or not. Generally.

Of the four methods. they will save energy and improve productivity. Using NPV is a good method to use to evaluate the project because it takes into account all the costs relevant to the project and includes all the cash flows of the project. . and the location is difficult for an end to the other plant. If the plants do not meet their sales volume then they would simply be running the more productive and efficient plant (Merseyside) to capacity and have Rotterdam fulfill the overflow. and the Rotterdam plant would have to produce less. May apply. In order to continue to fall by the wayside. and Merseyside may be able to cannibalize sales from competitors rather than its own sister plant at Rotterdam. capacity would be shifted from the Rotterdam plant to Merseyside. Victoria Chemicals has come up with a plan to turn the firm around. By implementing these changes. Criteria #3: Net Present Value (NPV) Criteria #4: Internal Rate of Return (IRR Found this info online. However. may not. the two most favorable to use for evaluation would be NPV and IRR while the EPS and PBP would be less favorable to use because of its evaluation process. but just some thoughts: Recommendation: It is recommended that the purchase of the tanks be charged to the project cost. but it is a matter of concern for such projects. There is no question of adding a cannibalization charge to the project expense. as the market covered by each plant is different. so you can put this expense into the cost of the project plus tanks and have direct ownership of the plant. the Marketing department opines that the excess production would yield benefits in a growth period. VICTORIA CHEMICALS: CONCLUSIONS There are various problems that keep Victoria Chemicals from achieving its financial goals. It is not considered that this new project can cannibalize the plant in Rotterdam. One of the first major problems is the fact that the Merseyside plant required a lot of labor in order to produce a similar that a competitors firm could produce for lower labor costs.The sales department is concerned that the project may lead to excess capacity and due to excessive competition.

“No one seems satisfied with the analysis so far. NPV and IRR would prove to be better for the project’s projections. Even though Greystock’s initial analysis met all of the performance “hurdles”. without the upgrades they will continue to operate at much higher costs than their competitors. Victoria Chemicals needs to determine how successful the upgraded plant will be in comparison to the loss of customers. The director of sales states that the polypropylene market is highly competitive. and they should implement it. he missed some important factors that would have improved the analysis. The organizational structure of the company may need to be re-evaluated in order to create efficiency and fewer problems when reporting to separate vice presidents. A manager could easily grow a plant to collect his or her bonus but this may not be best for the company and its long term success. The analysis shows that this project is beneficial to Victoria Chemicals. but the suggested changes could kill the project. Although the plant desperately needs renovations. However. it is important for the sake of the company to come to a mutual decision.  The company should not tie managers’ bonuses with the size of the plant.The company is proposing to upgrade the polymerization line in addition to a increasing the production of their EPC line. Although various departments may not always concur. . VICTORIA CHEMICALS: RECOMMENDATIONS  Frank Greystock said that. or turnover. Instead. they should create incentives for efficiency. This could have been accomplished by changing the calculations as discussed. therefore. It is important that the company function as a cohesive unit. Their data does not take into consideration any customers lost during this renovation. revenue. closing down production for 45 days may make customers permanently switch to a competitors brand. any loss in customers would be detrimental.” This sort of criticism shows that the analysis has obvious flaws and should be re-written. The company needs to agree on such a plan because it requires a lot of time and money.

this may be beneficial due to tax reasons. Due to the fact that the EPC market is so small. the company reduces its revenues.  Although Victoria Chemicals is depreciating their machines using double declining balance method. and it may not look good to potential investors. It may be more efficient for the firm to use straight-line depreciation to control the loss in revenue.000 GBP. it would be wasteful to spend so much money on the project. Multiple competitors produce similar chemicals. Victoria Chemicals suggested increasing the production of EPC. By paying more in depreciation costs now. The company should focus on something else that could potentially hold a large part of the market. ethylene-propylene-copolymer rubber. In addition to the production of polypropylene. This is potentially troublesome due to the fact the financial performance of the firm has declined in the past few years. instead of such a minimal impact product. . This project will amount to a NPV of -750. This chemical represents a small portion in the current chemical market and has since its creation.

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