Case 27 258 Empirical Chemicals, Ltd. (8): Merseyside and Rotterdam Projects Trevor Livesey, executive vice president of the Intermediate Chemicals Group (ICG) of Empirical Chemicals (EC), met with his financial analyst, Karen Cooper, to review two mutually exclusive capital-expenditure proposals. The firm’s capital budget would be submitted for approval to the board of directors early in February 1992, and any projects proposed by Livesey for the ICG had to be forwarded soon to the chief executive officer of EC for his review. Plant managers in Liverpool and Rotterdam independently had submitted expenditure proposals, each of which would expand the polypropylene output of their respective plants by 7 percent.' EC’s strategic-analysis staff argued strenuously that a companywide increase in polypropylene output of 7 percent made no sense, but half that amount did. Thus, Livesey decided he could not accept both projects; he could sponsor only one for approval by the board Corporate policy was to evaluate projects based on four criteria: (1) net present value (NPV), computed at the appropriate cost of capital, (2) internal rate of return (IRR), (3) payback, and (4) growth in carnings per share. In addition, the board of directors was receptive to “strategic factors” —considerations that might be difficult to quantify. The "Background information on Empirical Chemicals and the polypropylene business is given in “Empirical Chemicals (A): The Merseyside Project” (UVA-F-1020). ‘This case was written by Professor Robert F. Bruner as the basis for classroom discussion, rather than to illustrate effective or ineffective handling of an administrative situation, Facts and figures have been disguised. ‘The author wishes to acknowledge the helpful comments of Dr. Frank H. McTigue and the financial support of the Citicorp Global Scholars Program. Copyright © 1992 by the Darden Graduate Business School Foundation, Charlottesville, VA.Case 21 Empirical Chemicals, Lid. (B): Merseyside and Rotterdam Projects 259 manager of the Rotterdam plant, Johan Silver, argued vociferously that his project easily hurdled all the relevant quantitative standards, and that it had important strategic benefits. Indeed, Silver had interjected these points in two recent meetings with senior management and at a cocktail reception for the board of directors. Livesey expected to review the proposal from Frances Trelawney, manager of the Liverpool plant, at this meeting with Cooper, but he suspected that neither proposal dominated the other on all four criteria, Livesey's choice would apparently not be straightforward. THE PROPOSAL FROM MERSEYSIDE, LIVERPOOL The project for the Merseyside plant entailed the enhancement of existing facilities and production process. Based on the type of project and the engineering studies, the potential benefits of the project were fairly certain [see “Empirical Chemicals (A)” for a detailed discussion of this project]. To date, Trelawney, manager of the Merseyside Works, had limited her discussions about the project to conversations with Livesey and Cooper. Cooper had raised various exploratory questions about the project and had presented preliminary analyses of it to managers in marketing and transportation for their comments. Separately, she had approached EC’s environmental adviser about the likelihood of further environ- mental investment at Merseyside.’ The revised analysis emerging from these discussions would be the focus of discussion with Cooper in the forthcoming meeting. Cooper had indicated that Trelawney’s final memo on the project was short, only three pages and one exhibit. Trevor wondered whether this memo would satisfy his remaining questions. THE ROTTERDAM PROJECT Johan Silver’s proposal consisted of a 90-page document replete with detailed schematics, engineering comments, strategic analyses, and financial projections. The basic discounted- cash-flow (DCF) analysis is presented in Exhibit 1 and shows that the project had an NPV of £9.12 million and an IRR of 17.87 percent; accounting for a “worst-case” scenario, in which erosion of Merseyside’s volume by undertaking the Rotterdam project, the NPV was £8.03 million and the IRR about 17.3 percent. In essence, Silver's proposal called for the expenditure of £8 million spread over three years (and having a present value of about £7 million) to convert the plant’s polymerization line from batch to continuous-flow technology and to install sophisticated state-of-the-art process controls throughout the polymerization and compounding operations. The heart of the new system would be an analog computer driven by advanced software written by *The environmental adviser indicated that the trend in the United Kingdom and European Community made the likelihood of further environmental investment at Merseyside a virtual certainty. For this reason, Livesey had advised Trelawney to include energy savings over the entire life of the Merseyside project.260 Part IV. Capital Budgeting and Resource Allocation a team of engincering professors at an institute in Japan. The three-year-old process- control technology had been used on a smaller polypropylene production facility in Japan and had produced significant improvements in cost and output. Other major producers were known to be evaluating this system for use in their plants. Silver explained that installing the sophisticated new system would not be feasible without also obtaining a continuous source of supply of propylene gas. He proposed to obtain this gas by pipeline from one refinery five kilometers away (rather than by railroad tank cars sourced from three refineries). EC had an option to purchase a pipeline and its right-of-way for £3 million; then, for relatively little cost, the pipeline could be extended to the Rotterdam plant and the refinery at the other end. The option had been purchased several years earlier. A consultant had informed Silver that to purchase a right-of-way at today’s prices and to lay a comparable pipeline would cost approximately £6 million. The consultant also forecasted that in 15 years the value of the right-of-way would be £35 million.’ This option was to expire in six months. ‘Some senior EC executives believed firmly that, if the Rotterdam project were not undertaken, the option on the right-of-way should be allowed to expire unexercised. The reasoning was summarized by Henry Digbee, chairman of the executive committee: ‘Our business is chemicals, not land speculation. Simply buying the right-of-way with an intention of reselling it for a profit takes us beyond our expertise. Who knows when we could sell it, and for how much? How distracting would this little side venture be for Johan Silver? Younger members of senior management were more willing to consider a potential in- vestment arbitrage on the right-of-way. Silver expected to realize benefits (such as increased output and gross margin) of t investment gradually over time as the new technology was installed and shaken down and as Iearning-curve effects were realized. He advocated a phased investment program (as opposed to all at once) to minimize disruption to plant operations and to allow the new technology to be calibrated and fine-tuned: Given the complexity of the technology and the extent to which it would permeate the plant, the system would be very expensive to dismantle. Practically, there would be no ‘going back once the decision had been made to install the new controls. Silver's project Would represent an irrevocable commitment to the analog technology at the Rotterdam plant. Livesey recalled that the “strategic factors” to which Silver referred had to do with the obvious cost and output improvements expected from the new system, as well as from an advantage from being the first major European producer to implement the new tech- nology. Being the first to implement the technology probably meant a head start in moving >The rightof-way had several altemate cSmmercial uses. Most prominently, the Dutch government had expressed an interest in using the right-of-way for a new high-speed railroad line. However, the planning for this line had barely begun, which suggested that and-acquisition efforts were years away. Moreover, government budget deficits threatened the timely implementation of the rail project. Another potential user was Medusa Communications, an international telecommunications company that was looking for pathways along which to bury its new optical-iber cables. Power companies and other chemical companies or refiners might also be interested in acquiring the right-of-way.Case 21 Empirical Chemicals, Ltd. (B): Merseyside and Rotterdam Projects 261 down the learning curve toward reducing costs as the organization became familiar with the technology. Silver argued, ‘The Japanese, and now the Americans, exploit the learning-curve phenomenon aggressively. Fortunately, they aren’t major players in European polypropylene, at least for now. ‘This is a ‘once-in-a-generation opportunity for EC to leapfrog its competition through the exploitation of new technology. In an oblique reference to the Merseyside proposal, Silver went on to say, There are two alternatives to implementation of the analog process-control technology. One is a series of myopic enhancements to existing facilities; but this is nothing more than sticking one’s head in the sand, for it leaves us at the mercy of our competitors who are making choices for the long term. The other alternative is to exit the polypropylene business; but this amounts to walking away from the considerable know-how we've accumulated in this business and from what is basically a valuable activity. Our commitment to analog controls makes the right choice at the right time. The analog process-control system seemed to be the most advanced on the market. There were rumors, however, that an engineering design team at GliiBingen University in Germany was testing a radically different process-control technology —based on lasers, spectral chromatography, and digital computing—and that it was outperforming the Jap- anese system on cost reduction and output improvement by a factor of 1.1:1. If these rumors were true, such a system might become commercially available within five years. Livesey wondered how to take the potential new technology into account in making his decision. Even if he recommended the Merseyside project and no better technology emerged, the new controls could be installed later at Merseyside. Cooper had suggested that the flexibility to change technologies under the Merseyside project represented es- sentially two mutually exclusive call options (one each on the German and Japanese systems).* CONCLUSION Trevor Livesey wanted to give this choice careful thought, because the plant managers at Merseyside and Rotterdam seemed to have so much invested in their own proposals. He wished that the capital-budgeting criteria would give a straightforward indication about the relative attractiveness of the two mutually exclusive projects. He wondered by what rational analytical process he could extricate himself from the ambiguities of the present measures of investment attractiveness. Moreover, he wished he had a way to evaluate the primary technological difference between the two proposals: the Rotterdam project firmly committed EC to the new process technology; the Merseyside project did not, but it retained the flexibility to allow the technology in the future. ‘Using Monte Carlo simulation, she had estimated that the cash returns from both the German and Japanese technologies had standard deviations of 8 percent and that the correlation of the two returns was predictably hhigh: 80 percent. The risk-free rate of return was about 7.5 percent. The German digital-based process-control system would emerge in the next five years or not emerge at all,EXHIBIT 1 _Johan Silver's DCF Analysis Assumptions Used in the DCF Analysis Annual output (metric tons) 135,000 ‘Output gain per year/prior year . 0.8% Maximum possible output... 144,450 Price/ton (pounds sterling) 611 Rate of growth in gross margin per year . 0.40% Maximum possible gross margin . .. 16.0% (Old gross margin 11.5% Tax rate eras 35.0% ‘Setup and labor savings/sales (year 1) 0.0% 1 2 3 4 5 6 192 1993 194 1995 1996 197 1. Estimate of incremental gross profit: New output 136,080 137,169 138,266 139,372 140,487 141,611 Lost output, constru (45,360) (34,292) (11,522) 0 0 [New sales (millions) . 55.43 83.81 84.48 85.16 85.84 86.52 New gross margin 11.5% 11.6% 11.8% 12.0% 12.2% 12.5% New gross profit ..... 6.40 9.75 9.95 10.19 10.48 10.82 Old output... fs 135,000 135,000 135,000 135,000 135,000 135,000 Od sates 82.49 82.49 82.49 82.49 82.49 82.49 Od gross profit 9.49 9.49 9.49 9.49 9.49 9.49 Incremental gross profit 3.09 027 0.46 on 0.99 1.33 2, Estimate of incremental depreciation: ‘Year | outlays ; 027 0.23 0.20 0.7 ous 0.13 Year 2 outlays 0.21 0.18 0.16 0.13 0.12 Year 3 outlays ........ 0.15 0.13 our 0.09 ‘Total, new depreciation... 0.27 0.45 0.54 0.46 0.40 0.34 3. Overhead ..... 3 0 0 0 ° 0 0 4, Pretax incremental profit 3.35 0.18 =0.07 0.24 0.60 1.00 5. Tax eNpense ees... =1.17 0.06 =0.03 0.09 0.21 0.35 6. Aftertax profit -2.18 =0.11 =0.05 0.16 0.39 0.65 7. Cash-flow adjustments: ‘Add back depreciation. 0.27 0.45 0.54 0.46 0.40 0.34 Less added WIP inventory ...... —0.81 0.22 0.44 0.23 0.02 0.02 Capital spending ............3 2 1s 1 ‘Terminal value, land . = = - = . = 8. Free cash flow ..... 3 3.10 -1.39 =0.95 0.39 0.76 0.97 DCF of Rotterdam project = £9.12 million IRR of Rotterdam project = 17.87% Adjustment for possible erosion in Merseyside volume: Lost Merseyside output 0 0 0 5,487 6,611 Lost Merseyside revenue ..... 0 0 0 34 40 Lost Merseyside gross profits. 0 0 ° 0.4 05s Lost gross profits after taxes 0 0 0 03 03 Change in Merseyside inventory 0 0 0 on OL Total effect on free cash flow 0 0 0 0.15 0.18 DCF of erosion at Merseyside = —£1.09 million DCF of Rotterdam project, adjusted for possible ‘erosion at Merseyside = £8.03 millionAssumptions Used in the DCF Analysis Discount rate 10.0% Depreciable life (years) 15s ‘Overhead /investment 3.5% Salvage VaIUC 6... sess essesesee ees 0 \Worksin-process (WIP) inventory/sales. 3.0% Terminal value of rightof-way £35 million dal 1992 1993 1994 1 1 Investment outlay (millions) ....2...++.5 3 2 15 Months downtime, construction 4 3 7 8 9 10 ul 22 1B 4 15 1998 1999 2000 2001 2002 2003 2004 2005 2006 142,744 143,886 144,450 144,450 144,050 144,450 144,450 144,450 144,450 87.22 87.91 88.26 88.26 88.26 88.26 88.26 88.26 88.26 12.9% 13.3% 13.8% 14.3% 15.0% 15.1% 16.0% 16.0% 16.0% 11.22 11.67 12.15 12.64 13.21 13.86 14.12 14.12 14,12 135,000 135,000 135,000 135,000 135,000 135,000 135,000 135,000 ‘135,000 82.49 82.49 82.49 82.49 82.49 82.49 82.49 82.49 82.49 9.49 9.49 9.49 9.49 9.49 9.49 9.49 9.49 9.49 Ls 219 2.66 3.16 3.72 437 4.64 4.64 4.64 ot 0.10 0.08 0.07 0.06 0.06 0.05 0.04 0.04 0.10 0.08 0.07 0.06 0.05 0.05 0.04 0.03 0.03 0.08 0.07 0.06 0.05 0.04 0.03 0.03 0.02 0.02 0.29 0.25 0.21 0.18 0.16 0.14 0.12 0.10 0.09 0 0 0 0 0 0 0 0 0 144 1.94 2.45 2.97 3.57 424 4.52 454 4.55 0.50 0.68 0.86 1.04 1.25 1.48 1.58 1.59 1.59 0.94 1.26 1.59 1.93 2.32 2.95 2.94 2.95 2.96 0.29 0.25 0.21 0.18 0.16 O14 0.12 0.10 0.09 0.02 0.02 0.01 0.00 0.00 0.00 0.00 0.00 0.17 eS = = S =, = = 35 121 1.49 1.79 242 2.48 2.89 3.05 3.05 38.22 1,744 8,886 9,450 9,450 9,450 9,450 9,450 9,450 9,450 47 54 58 58 58 5.8 58 58 58 0s 06 07 07 0.7 07 07 0.7 07 04 04 04 04 0.4 0.4 0.4 0.4 04 ol 0.2 0.2 0.2 02 0.2 02 0.2 0.2 021-026 «= 028 = 0.26 = 026 = 026 «0.28 = 0.25 0.26