VICTORIA CHEMICALS PLC (A):

THE MERSEYSIDE PROJECT

Capital Budgeting Case Analysis
VICTORIA CHEMICALS: CASE BACKGROUND

Victoria Chemicals was a major competitor in the chemical industry worldwide. The
company was the leading producer of polypropylene, a polymer that is used in a variety of
products including carpet fibers, packaging, and automobile parts. Polypropylene was essentially
priced as a commodity.

In order to meet demand, Victoria Chemicals produced and manufactured polypropylene

at two plants, the Merseyside Works plant in Liverpool, England, and the Rotterdam facility in
Rotterdam, Holland. The plants were built in 1967 and are identical in scale and design.
Additionally, managers of both plants reported to James Fawn, the executive vice president and
manager of the Intermediate Chemicals Group (ICG).

The production of polypropylene pellets begins at Merseyside with propylene, a refined

gas received in tank cars known as propylene. The production process consisted of two stages: In
the first stage, the gas form of polypropylene was combined with a solvent in a pressurized
vessel and then concentrated and collected in a centrifuge. Next, the polypropylene was mixed
with stabilizers, modifiers, fillers, and pigments in order to create the final product, a plastic
pellet, which is shipped to the customer. The company positioned itself as a supplier to customers
in Europe and the Middle East.

In addition to small producers, seven major competitors manufactured polypropylene in

Victoria Chemicals’ market region. Their plants operated at various cost levels. Primary
competitors CBTG A.G. and Hosche A.G. were able to produce higher annual output at lower
costs per ton. Table 1 on the following page presents a comparison of plant sizes and indexed
costs.
Table 1: Comparison on the Seven Largest Polypropylene Plants in Europe

Plant
Product Cost per
Year Annual
Plant ton
Plant Name Plant Output
Location (indexed to low-
Built (in metric
cost producer)
tons)
CBTG A.G. Saabrun 1981 350,000 1.00
Victoria Chemicals Liverpool 1967 250,000 1.09
Victoria Chemicals Rotterdam 1967 250,000 1.09
Hosche A.G. Hamburg 1977 300,000 1.02
Montecassino SpA Genoa 1961 120,000 1.11
Saone-Poulet S.A. Marseille 1972 175,000 1.07
Vaysol S.A. Antwerp 1976 220,000 1.06
Next 10 Largest Plants 450,000 1.19

VICTORIA CHEMICALS: ISSUES/PROBLEMS

In 2007, Victoria Chemicals experienced a significant drop in its financial performance

from 2006. 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. In addition, Victoria
Chemicals saw the accumulation of its common shares by a well-known corporate raider named
Sir David Benjamin. The entrance of a corporate raider may have shown that the firms’ assets
appeared to be under valued. This corporate raider could gather a large voting right, change the
management, and ultimately increase share value and get a big return on his investment.

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, and required more
labor than the process used by its competitors. As well, the previous manager of the plant had
enhanced operating results by minimizing capital expenditures to cover only necessary
maintenance over the past five years; 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.
 Another issue that Victoria Chemicals faces is that its product is a commodity. They do
not compete with a differentiated product; as such, to remain competitive and gain market share,
they need to maintain competitive prices while increasing profits through lowering their costs.
Because both their plants are older and use a semi continuous production process, Victoria
Chemicals requires more labor than its competitors in newer, more efficient plants. Compared to
its competitors, Victoria Chemicals incurs high costs of production mainly due to higher
dependence on labor. Montecassino is the only other firm among the top 7 whose costs are
higher than that of Victoria Chemicals, but it is an older plant (built in 1961) and produces a
lower volume compared to Victoria Chemicals. Therefore, Victoria Chemicals faces issues not
only with lower revenues but with higher costs as well.

Given these factors, 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. Morris felt this move would help improve the company’s financial situation
and help them remain a major competitor in the worldwide chemical industry.

VICTORIA CHEMICALS: THE PROPOSED PROJECT

Morris and her controller, Frank Greystock, proposed a project to overhaul the entire
polymerization line at a cost of GBP 12 million. 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.
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.
 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, which would enable the
process flow to be streamlined.
o Refurbishing the polymerization tank to achieve higher pressures and thus greater
throughput.
o Renovating the compounding plant to increase extrusion throughput and obtain
energy savings.

The benefits of this project were increased efficiencies in terms of:

  Reduced energy consumption, which was assumed to equal 1.25% of sales in the first
year and .75% in years 6-10.
 Increased gross margin of up to 12.5%.
 Increased manufacturing output. Currently, Victoria Chemicals was producing 250,000
tons of polypropylene pellets a year at a price of GBP675 per ton. The project would also
result in seven percent (7%) greater manufacturing throughput; however, the entire line
would need to be shut down for 45 days in the first year for construction. Based on the
current annual 250,000 ton production figure, Victoria Chemicals would experience
roughly a 13% decrease in production for that year upon implementing the project. The
13% figure was determined using the following equation where 1.5 (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%. Greystock also speculated that
any new assets acquired would depreciate in 15 years. In addition, he predicted that in the first
year the company would incur GBP500, 000 in engineering costs due to the renovation.

VICTORIA CHEMICALS: CONCERNS WITH THE PROPOSED PROJECT

Even though the project seemed to have promising returns, there were some issues or
concerns that were associated with the project. Renovating the Merseyside plant would require it
to shut down for 45 days. This was a problem because the Rotterdam plant was already operating
at near-maximum capacity, which would cause Merseyside Works’ customers to buy from
competitors until the renovation was completed. Even still, Frank Greystock, a controller at
Victoria Chemicals, assumed that this loss of customers would be temporary.

Furthermore, Victoria Chemicals owned the tank cars with which Merseyside Works
received propylene gas from four petroleum refineries in England. The Transport Division,
which oversaw the movement of all raw, intermediate, and finished materials throughout the
company and was responsible for managing the tank cars, 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. Currently, the allocation could be made out of excess capacity, but doing so would
accelerate the need to purchase new rolling stock to support anticipated growth of the firm in
other areas. The purchase was estimated at GBP2 million in 2010. Rolling stock would have a
depreciable life of 10 years, but could operate much longer with proper maintenance. The rolling
stock also could not be used outside of Britain because of differences in track gauges, which
meant that the trucks could not be used to ship product to its primary customers in the Middle
East.

The Transport Division believed that the cost of the tank cars should be included in the
initial outlay of Merseyside Works’ capital program. However, Greystock disagreed, noting that
they were doing the company a favor by using the excess capacity and that company has always
operated in silos. 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.

The Transport Division was not the only division with concerns. The ICG Sales and
Marketing department had some questions of their own. 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. However, the entire industry was experiencing a downturn; thus,
an oversupply of polypropylene could occur. To combat the oversupply, the company would
likely shift capacity from Rotterdam to Merseyside, which could result in Merseyside
cannibalizing Rotterdam. On the other hand, the V.P. of marketing believed that lowering costs
would help Victoria Chemicals compete better with other producers of polypropylene and thus
win over customers from competitors. After hearing out both arguments, 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.

Greystock’s discounted cash flow also suggested that the company would earn a 10%
return on the project, even though the Treasury staff believed the real return to be 7% due to a
3% in inflation per year. However, Greystock decided to continue to use a discount rate of 10%
because it was the figure promoted in the latest edition of the company’s capital-budgeting
manual. The high discount rate was problematic because, if the 7% figure was more accurate,
using the 10% rate would cause the company to accept projects (those that fall between seven
and 10 percent) that should be rejected.
 On another note, Griffin Tewitt, assistant plant manager and Morris’s direct subordinate,
proposed that Greystock modify his proposal to include a renovation of the EPC production line
at a cost of GBP1 million. He believed that the renovation would give Victoria Chemicals the
lowest EPC cost base in the world and would improve cash flows by GBP25,000. The NPV of
this project was –GBP750,000, which Tewitt argued that the negative NPV ignored strategic
advantages from the project and increases in volume and prices when the recession ended.

VICTORIA CHEMICALS: EVALUATING THE PROPOSED PROJECT

The project was considered an engineering-efficiency and, therefore, was required to

meet certain criteria before being approved. The criteria included:

1. Impact on earnings per share: The net income had to be positive when calculated as
annual earnings per share (EPS) over its entire life, using the number of outstanding
shares at the most recent fiscal year-end as the basis for the calculation.
2. Payback: The payback period maximum was six years.
3. Discounted cash flow: The net present value of all future cash flows had to be positive.
4. Internal rate of return: The IRR had to be greater than 10%.

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. However, she was afraid that further analysis could lead to
rejection of the project. The Merseyside project, according to Greystock, met all four investment
criteria:

1. Average annual addition to EPS of GBP0.022

2. Payback period of 3.8 years.
3. Net present value of GBP10.6 million
4. IRR of 24.3%

In the following paper, 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.
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. In order to accept this project, the EPS needs to be
GBP0.022. [discuss how/if we met this requirement; steps we took to meet it]

VICTORIA CHEMICALS: SUNK COSTS

The plant manager has included the preliminary engineering costs of GBP 500,000 spent
over the past nine months on efficiency and design studies of the renovation. These costs are
already incurred and are independent of the project decision. Whether or not the project is going
to be approved, these costs are to be borne by the company. Therefore, these costs are not to be
considered for the DCF analysis.

VICTORIA CHEMICALS: PIGGYBACK PROJECT ETHICAL DILEMMA

The assistant plant manager, Griffin Tewitt, proposed to modernize a separate and
independent part of Merseyside Works, the production line for EPC. His argument was to
include the EPC project as part of the renovation project that is currently being analyzed. To
improve the EPC production line it would cost GBP 1 million, but it would improve cash flows
by GBP 25,000 indefinitely. The EPC project has a negative NPV of -GBP750,000, and his
contention was that the bigger renovation project with a positive NPV of GBP 10.6 million
(under the original calculation) can absorb the losses of the EPC project. The benefits of the EPC
project will come through when the recession ends and increase in volume and prices happen.

Although the EPC project has potential to become larger, the EPC market has not been
largely successful since its inception. In addition, 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.” Even if there would be benefits to the company overall, the
EPC project should not be included in the analysis because this product line would not impact
the polypropylene product line. The costs and benefits are not relevant to this analysis.
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. There is conflict between Transportation division and
polypropylene production division. Having the Transport Division and the Intermediate
Chemicals Group reporting to separate executive vice presidents is a problem. Generally, the
logistics divisions and manufacturing divisions of a company report to a single executive that
oversees the entire supply chain process. This supply chain manager facilitates the manufacturing
and movement of all materials in order to increase efficiencies and reduce costs.

Additional issues of concern is that the plant managers’ bonuses are tied to the size of the
plants they operate, which is not necessarily the proper incentive plan because operation size
does not always positively correlate with efficiency and profit margins. Other issues are that of
evaluation of projects on a periodic basis to monitor the costs incurred, progress and benefits
occurring on time. In the current system at VC, 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. The procedure should also be
updated to require the analysis to include the appropriate depreciation methods and tax rates, as
these factors have a significant effect on NPV and IRR.

VICTORIA CHEMICALS: CANNIBALIZATION

The sales department is concerned that the project may lead to excess capacity and due to
excessive competition, capacity would be shifted from the Rotterdam plant to Merseyside, and
the Rotterdam plant would have to produce less. However, the Marketing department opines that
the excess production would yield benefits in a growth period, and Merseyside may be able to
cannibalize sales from competitors rather than its own sister plant at Rotterdam.

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.
There is no question of adding a cannibalization charge to the project expense, but it is a matter
of concern for such projects.
Criteria #3: Net Present Value (NPV)

Criteria #4: Internal Rate of Return (IRR

Found this info online. May apply, may not, but just some thoughts:
Recommendation: It is recommended that the purchase of the tanks be charged to the
project cost, so you can put this expense into the cost of the project plus tanks and
have direct ownership of the plant.
It is not considered that this new project can cannibalize the plant in Rotterdam, as
the market covered by each plant is different, and the location is difficult for an end
to the other plant. Of the four methods, 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. 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.

VICTORIA CHEMICALS: CONCLUSIONS

There are various problems that keep Victoria Chemicals from achieving its financial
goals. 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. In
order to continue to fall by the wayside, Victoria Chemicals has come up with a plan to turn the
firm around. By implementing these changes, they will save energy and improve productivity.
The company is proposing to upgrade the polymerization line in addition to a increasing the
production of their EPC line.

Although the plant desperately needs renovations, closing down production for 45 days
may make customers permanently switch to a competitors brand. The director of sales states that
the polypropylene market is highly competitive, therefore, any loss in customers would be
detrimental. Victoria Chemicals needs to determine how successful the upgraded plant will be in
comparison to the loss of customers. Their data does not take into consideration any customers
lost during this renovation. However, without the upgrades they will continue to operate at much
higher costs than their competitors. The analysis shows that this project is beneficial to Victoria
Chemicals, and they should implement it.

Even though Greystock’s initial analysis met all of the performance “hurdles”, he missed
some important factors that would have improved the analysis. This could have been
accomplished by changing the calculations as discussed; NPV and IRR would prove to be better
for the project’s projections.

VICTORIA CHEMICALS: RECOMMENDATIONS

 Frank Greystock said that, “No one seems satisfied with the analysis so far, but the
suggested changes could kill the project.” 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. It is important that the company function as
a cohesive unit. Although various departments may not always concur, it is important for
the sake of the company to come to a mutual decision. 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.

 The company should not tie managers’ bonuses with the size of the plant. Instead, they
should create incentives for efficiency, revenue, or turnover. 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.

 In addition to the production of polypropylene, Victoria Chemicals suggested increasing

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