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Victoria Chemicals is a large chemical manufacturing company and was at one time a leading
producer of polypropylene (a polymer that is used in many products ranging from medical
products to automobile components). Due to the wide range of use polypropylene has been
priced as a commodity and due to its popularity a rise in global competition and production
developed in the latter half of the 20
The company focused its sales to customers in Europe and the Middle East. Victoria Chemicals
had two production plants located in Liverpool, England (Merseyside) and another in
Rotterdam, Holland. The Merseyside plant was built in 1967 and was leading production facility
until the 21
Century. Many new competitors have recently built newer plants with more
efficient systems and this has taken a toll on Victoria’s bottom line. The Merseyside plant was
in need of drastic renovations as a result of decades of deferred maintenance. The upgrades
needed included a complete restructuring of the production flow and pressure vessels to obtain
more efficient outputs.
Additional pressure has been placed on Victoria Chemicals by its investors due to the fact that
Sir David Benjamin, a high profile corporate raider, had been accumulating shares. The gradual
decrease in revenues and dropping share price called for a proposal to redesign the older and
inefficient production facility at Merseyside.
The polypropylene production process includes receiving propylene (refined gas received in
tank cars), combining the propylene with a diluent in a pressure vessel which creates a catalytic
reaction creating polypropylene at the bottom of the vessel. The polypropylene is then
compounded with other modifiers, fillers, and pigments to create the exact product requested
by the customer. The production of polypropylene resulted in pellets that were shipped to
Due to polypropylene’s increase global use, several major production competitors developed
production plants in the same region at Victoria Chemicals. The seven plants were similar in size
and even though some were smaller, the plants were easily within a few pence of Victoria
Chemicals’ production cost per ton with newer plants resulting in much lower costs per ton.
Capital Renovation Proposal
Lucy Morris assumed the management of the Merseyside plant in approximately 2007. She
detailed a thorough review of the operations and easily discovered several areas that were
ready for efficiency improvements. Antiquated equipment and plant design were the primary
areas of identified need and her proposal for restructuring was estimated to cost £12 million.
In order to complete the renovations, the entire production line in Merseyside would have to
be shut down for a period of 45 days. This estimate was troubling to executives considering the
fact that the sister plant in Rotterdam was operating near capacity and the decrease in
production would cause Victoria’s customers to buy from competitors during the shutdown.
Plant managers believed this would be a short lapse in customer satisfaction and loyal
customers would return thus preventing permanent customer loss. Morris believes that
manufacturing throughput would increase by 7% and the plant’s gross margin would improve
to 12.5% (from 11.5%).
Project Evaluation Criteria
Frank Greystock was Lucy Morris’ controller and was directly involved in the proposal of the
capital renovation project to corporate executives. As concerns were addressed additional
requirements and changes were suggested that placed the proposal in jeopardy of not being
In order to gain approval for capital projects, Victoria Chemicals had to meet criteria in one of
four categories. The proposal was submitted through the “engineering efficiency” category and
was evaluated on the following criteria:
1. Impact on earnings per share: For engineering-efficiency projects, the contribution to
net income from contemplated projects had to be positive
2. Payback: This criterion was defined as the number of years necessary for free cash flow
of the project to amortize the initial project outlay completely. For engineering-
efficiency projects, the maximum payback period was six years.
3. Discounted cash flow: DCF was defined as the present value of future cash flows of the
project (at the hurdle rate of 10% for engineering-efficiency proposals) less the initial
investment outlay. This net present value of free cash flows had to be positive.
4. Internal rate of return: IRR was defined as being the discount rate at which the present
value of future free cash flows just equaled the initial outlay—in other words, the rate at
which the NPV was zero. The IRR of engineering-efficiency projects had to be greater
Based on Morris’ evaluation the Merseyside capital renovation project, the project met all
criteria as indicated by her analysis results below:
1. Average annual addition to EPS = GBP 0.022
2. Payback period = 3.8 years
3. Net present value = GBP10.6 million
4. Internal rate of return = 24.3%
A large part of Morris’ proposal’s success was based on the increased workload within the
Transport Division. This would be realized as a result of the improved throughput once the
renovation project was complete. Morris was able to note that the Transport Division was
operating efficiently and well below capacity and could take on the increased capacity. If this
occurred Transport would need to accelerate their purchase of new vehicles by two years.
As a result of the new workload, the controller of the Transport Division argued that the
purchase of new tank cars should be outlined in the Merseyside program and not as a part of
the Transport Division budgeting. The disagreement from Greystock stated that the Transport
Division is not running at capacity and the increased workload would ensure that Victoria’s
equipment is fully utilized.
The resulting competition between departments is the result of the fragmentation of divisions
and leadership through separate executives. Each division (Transport and Chemical Production)
reported to different executive vice presidents who each in turn reported to the chairman and
CEO. As a result, each division has equal weighting in the company and each division is
responsible for reporting their budgeting and bottom lines. To add to the complexity, each
executive vice president receives annual incentive bonuses that are tied to the performance of
their divisions. In other words, it is certainly in the best interests of the Transport Division VP to
show excess capacity to indicate an efficient fleet and work force.
In addition to the stress caused by internal competition between Transport and Chemicals, the
Sales and Marketing departments were focused on the current economic downturn and the
effects of saturation and competition of chemical production.
The VP of Sales shared concerns regarding the overall downturn of the global economy and
competitive saturation of the chemical production market. In order to maximize the new plant
efficiency and throughput, sales from competitors must be realized and even so production will
need to be taken from the Rotterdam plant to maximize the Merseyside production line. If this
is the case, is Victoria Chemicals truly gaining through the project if one plant will take over the
The VP of Marketing did believe that lost sales as a result of the economic downturn would
return as the market eventually rebounded as has been proven through past recessions. One
can always assume that sales can be taken from competitors, even though competitors will
fight tooth and nail for their customers, but overall all companies will rebound as the global
Perhaps the biggest concern that Morris’ proposal encountered was the concern of the
assistant plant manager. For several months, assistant plant manager Griffin Tewitt, was
engrossed in the attempt to modernize the production line for ethylene-propylene-copolymer
rubber (EPC). The attempts to submit a proposal have been subsequently rejected by
executives and Tewitt felt the executives were ignoring potential strategic advantages of the
improved production line.
Executives have largely ignored Tewitt’s recommendation based on economic merit. The EPC
production line represented a small portion of the chemical industry and Victoria Chemical’s
overall production and profit line. This was also a result of the growth in competition and the
development of competing materials that have led to the marginalization of EPC on common
Tewitt’s proposal suggested that cash flows would improve immediately by a minimum of
£25,000 GBP ad infinitum. Unfortunately, as a result of the proposal, the net present value of
the EPC improvement project was a negative (-) £750,000 GBP and thus viewed as a very low
priority based on economic grounds.
Viewing his proposal as critical, Tewitt proposed to Morris and Greystock that the £1 million
GBP proposal be added to the overall Merseyside project since the project’s overall positive
NPV could easily sustain the negative EPC of the EPC project.
This presented a major ethical dilemma for Morris and Greystock. Executives were already
wary the large £12 million GBP project, plant shutdown during renovation, cannibalization, and
a slow economy. Adding an additional project already viewed negatively by executives (hoping
that it goes undiscovered) will most certainly cause fury over the Merseyside project and could
fully stop the needed renovations.
A final review of the proposal from the Victoria Chemicals Treasury staff indicated that the
proposal is based on a nominal internal rate of return (IRR) as opposed to Victoria’s target rate
of return. Morris’ proposal indicates a 10% rate and is seen as a “nominal” rate. The Treasury
staff believes this takes a 3% annual expectation of long-term inflation. The real target rate of
return as indicated by the Treasury staff should remove the inflationary estimates and use 7%
as the target rate of return.
Greystock did not have a full understanding of the analysis and continued to use 10% as the
IRR. A correction to the project’s financial analysis must be made in order to figure the truer
NPV of the project. Since the targeted rate of return has been reduced, one can expect that
value of the project will be higher given that the IRR of the company has been reduced thus
giving more padding to the final proposal.
Initial project cash flows show substantial gains the first four years after due largely in part of
the new output of 267,500 tons versus the original 250,000 tons based on older plant design
and inefficiencies corrected through the capital program.
The concerns noted in the cash flow area are not related to sales and output but through the
adjustment for inflation and to a degree the cannibalization of Rotterdam’s output and
extended depreciation of the Transport Division’s new tankers. The Transport Division has
lobbied heavily to have the Merseyside project take on the acquisition of new tankers as
opposed to having the Transport Division accelerate the purchase of new tankers by two years
due to the growth in capacity from the Chemical Division.
The original cash flows indicate an immediate return of £1.27 (millions). The revised analysis
concludes that the immediate cash flow recognized is significantly less at £0.63 (millions). The
significant change can be directly correlated to lost gross profit due to the cannibalization of the
Rotterdam plant. Cannibalization will lead to an overall loss of gross profit since production is
actually shifted from one plant to another versus a true growth of production.
As indicated by the VP of Marketing, the global economic situation should begin to improve
overall as indicated gradually over the period of 14 years; however, the growth will not be as
significant as the original analysis indicates.
As show in the referenced chart, the original analysis shows a higher cash flow trend while the
revised analysis is lower as a full consideration of the loss in profit from Rotterdam’s
cannibalization is taken into consideration. The overall trend will rise (even with some drops)
and is expected to stabilize after 10 years given the expectation that global economies will rise
In order to properly calculate the revised cash flows, the new analysis takes into consideration
the loss of gross profit from the Rotterdam cannibalization. Original figures estimate total
output at 250,000 tons but estimates will drop that output overall by 17,500 tons or 7%. This
will result in a loss of £1.36 (millions) which in turn is subtracted from Old Gross Profit and New
Gross Profit difference for a new Incremental GP of £0.96 (millions) versus £2.31 (millions).
As stressed by the controller of the Transport Division, Merseyside project should include the
acquisition and depreciation of the newly required tanker vehicles. In order to calculate a true
cost of Victoria Chemical’s investment, the corrected financial analysis has taken the added
depreciation of the newly acquired tanker cars as a result of the project.
Original Incremental GP
Revised Incremental GP
Including the new depreciation will be represented in the spike which is correlated in the rise in
cash flows the same year through the new analysis as opposed to the gradual decline in
depreciation and cash flows indicated through the original calculation submitted to executives.
This is also a key factor in the overall cash flow scenario since the acceptance of the project
would actually begin the depreciation earlier. The Transport Division indicated that new
vehicles would be purchased in 2012 and acceptance of the project would accelerate the
expense and subsequent depreciation by two years.
A major point of concern voiced by the VP of Sales indicated that the increased throughput of
Merseyside would require increased sales from competitors clients and the transfer of some
production from the Rotterdam plant to Merseyside. All items combined will ensure that the
improved plant is running optimally.
The original analysis did not take the lost output and sales from Rotterdam into account. The
VP of Sales has stated that this cannibalization will initially hurt the company’s outlook while
the VP of Marketing was less skeptical of any long term damage. Given that the transfer of
production was a necessity to reach optimal efficiency, the revised analysis takes into
consideration the difference in sales and work in process inventory (WIP).
In order to effectively calculate the impact that the cannibalization will have on Victoria
Chemicals, estimates from Rotterdam will be subtracted from the Incremental Gross Profit. As
indicated in the original analysis, an estimated 7% decrease in output will occur during
construction of which will be sent to Rotterdam which in turn must be made up after the
construction. This output results in approximately 17,500 tons of the annual 250,000 tons of
production. Given the price per ton of £675.00 the lost sales results in approximately £11.81
(millions) of which the resulting loss gross profit for the Rotterdam plant is £1.36 (millions).
The WIP Inventory is calculated by subtracting the current year’s WIP from the previous year’s
WIP. The original calculations take Price/Ton, Output, Gross Margin, and WIP Inventory
Percentage of each year into account. The new analysis continues to take those items into
account and also subtracts the WIP inventory lost from Rotterdam by using the previous year’s
data and multiplying it by the lost gross profit in Rotterdam.
The improved efficiency Merseyside and cannibalization of Rotterdam will result in the
decrease of overall inventory in Rotterdam and as suspected by the VP of Marketing, the plant’s
output should match an improving global economy in time as the WIP inventory moves out of
the negative output in the next decade.
As noted by the Treasury staff, the cost of inflation is not typically counted in the company’s
rate of return and the Treasury analyst indicated that Morris’ financial proposal used a full 10%
rate of return and the company typically uses 7%. The additional 3% is accounted for through
inflation which Victoria Chemicals does not take into consideration. Morris and Greystock
continued to use the 10% figure since it was noted in the capital projects manual.
Taking the additional 3% inflation rate into consideration will have an impact on the New WIP
Inventory and the lost sales in Rotterdam. Each of these areas will begin to increase as inflation
is now taken into account.
GROUP ANALYSIS AND RECOMMENDATION
As any corporation looks to expand and invest in capital projects an analysis on a full return on
investment, net present value and the Internal Rate of Return will be calculated. Victoria
Chemicals has specifically stated that four criteria are to be evaluated for any capital project.
The renovation of the Merseyside plant was submitted with a true positive yield to all
categories. The original analysis indicated a healthy rate of return of 24.3%. Given that the
expected minimum IRR for a capital project is 10%, the renovation of Merseyside should get an
approval nod from the executives. This indicates a rate of return that is 14% higher than the
minimum expectation. The Net Present Value of the project is also valued at £10.45 (millions)
which easily indicates a successful project.
However, given that a revised financial outlook based on concerns from executives was
devised, a more careful consideration of the project will be taken. The revised financial outlook
takes the following into consideration:
Cannibalization of Rotterdam Production
Revised Work in Process Inventory
Depreciation of New Transport Vehicles
Adjusted Gross Profit and Cash Flows
As the new figures are calculated a significant difference in NPV and IRR are noted. The new
NPV for the project is now valued at £5.98 (millions) while the new IRR for the project is 18.1%.
Original WIP inventory
Revised WIP inventory
These figures are significantly lower than original estimates, however, they still represent a positive
project overall for Victoria Chemicals.
One of the interesting figures is the true result of the IRR for the project. Even as the recommended IRR
for any capital project is 10%, these new figures represent an 8.1% higher rate than minimally expected.
Even though this should suffice for approval, the Treasury staff member’s note regarding the 7%
calculation holds the project at an 11% higher rate than minimally expected for a project.
These figures holding true over time indicate that Victoria Chemicals should take on the project in order
achieve the highest return on their production lines in a highly competitive region.
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