Victoria chemicals PLC (A): the Merseyside Project
As a world wide major competitor in the chemical industry, Victoria
Chemicals is a leading producer of polypropylene, a polymer that is used in
a variety of products around the globe. Polypropylene is known for its
strength and malleability and was priced as a commodity. The company
operates two plants that produce polypropylene, one at Merseyside,
England and the other at Rotterdam, Holland. Both plants were identical in
scale, design, and age. However, Morris Greystock, the manager for the
Merseyside plant saw a decline in the company’s stock, and decided to
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improve the position of the company. To do that, she came up with a
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project to increase production efficiency, rationalize the Polypropylene
production line and renovate the Merseyside plant since the Merseyside
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production process was old and therefore higher in labor than competitors.
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The project Greystock wanted to propose to senior management consisted
of GBP 12 million expenditure. Grestock was faced with some issues and
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decisions related to the project that she had to address. Those issues
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includes, issues with the transport division, the ICG and marketing
department, the assistant plant manager, the treasury staff, and evaluating
the capital expenditure.
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Issues:
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Concerns of the Transport division:
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Greystock’s argument is that the purchase of tank cars shouldn’t be
included in the initial outlay because the company will use the transport
division’s excess capacity. However, The transport division thinks the
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purchase should be included, because the increased output would deplete
capacity for the tank cars currently used, which would accelerate the
purchase of new tank cars to be in 2010 instead of 2012. This change in the
timing of the purchase would change timing of cash flows as well as
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affecting incremental depreciation. My argument is in favor of Greystock to
not include the purchase, because the purchase of the tank cars will not be
incurred as of today. Plus Greystock is doing the company a favor by using
their excess capacity.
Concerns of the ICG sales and marketing department:
The sales director proposes that if the project is undertaken, they
would have to allocate capacity from Rotterdam plant to Merseyside to
make up for the increase in volume of output. This allocation of recourses
will cause Merseyside to cannibalize the sales of Rotterdam, and thus, a loss
of business for the Rotterdam plant will occur. For that reason, the sales
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director thinks the project should not be undertaken. Greystock argues that
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a charge for loss of business for the Rotterdam plant should not be included
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in his analysis because he thinks cannibalization is not a charge. However, I
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argue with Greystock against the director of sales, because both plants
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operate in different regions, which doesn’t have to mean that the
Merseyside plant will cannibalize the sales of the Rotterdam plant, but
rather cannibalize the sales of competitors in that region according to the
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vice president of marketing. And in due time the market is going to revive
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from the recession and lost business volume at Rotterdam will return at
that time. Thus, no charge is needed for loss of business at Rotterdam
because cannibalization is an externality that is not incremental to cash
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flows.
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Concerns of the assistant plant manager:
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The assistant plant manager, Griffin Tewitt, proposed unusual plan
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that would make changes to Greystock’s analysis. His plan was to modernize
an independent part of the Merseyside, that is the production line for EPC.
This plan would cost GBP 1 million and would improve cash flows by
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GBP25,000 ad infinitum and would also allow them to produce EPC at the
lowest cost in the world. The project would result in a negative NPV since
the EPC market is small. Tewitt claims this negative NPV would be offset by
Greystock’s renovation plan. The committee rejected the plan based on
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economic reasons. In my opinion, Tewitt’s plan is a waste of money to
spend in something that holds a small part of the market rather, the money
should be spent on something that have a high impact on the market. Also,
I have my suspicions about Tewitt’s plan, mainly because of his comment to
Greystock and Morris after the committee rejection. In that comment “ in a
hushed voice” he told Morris and Greystock that their anuual bonuses are
begged to the size of this operation. This makes me think that Tewitt’s plan
has a self-interest tied to it, which presents an obvious agency problem.
Therefore, I strongly reject his proposal.
Concerns of the treasury staff:
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After scanning Greystock’s analysis, Andrew Gowman, the treausury
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staff pointed out a flaw in Grestock’s analysis. The flaw in the analysis was
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not considering inflation in calculating the discount rate, which would in
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return have in affect on the cash flows. Gowman suggests a long-term
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expected inflation of 3%. Adjusting the discount rate for inflation we get a a
real discount rate of 7% instead of 10%.
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Evaluating capital expenditure proposals at Victoria Chemicals:
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To submit the project to senior management, the project had to be
identified as to which category the project belongs. They figured it belongs
in the engineering efficiency category, which was subject to four
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performance hurdles, of which 3 had to be met for the project to be
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approved. Those hurdles include: EPS, PBP, NPV, IRR.
EPS: the Earning per share method’s downfall is that, it leans more to
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evaluate short term projects because it takes current cash flows into
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account more than it does with direct cash flows. PBP: the problem with
using the pay back period method is because PBP doesn’t consider the time
value of money, it also doesn’t consider cash flows after the period is
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reached. Therefore, the EPS and PBP methods are not good enough to use
because of their limitations. NPV: the best method of all of them because it
considers all relevant costs and cash flows of the project, its only flaw is that
it doesn’t take a project size into account. IRR: is good for showing the
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return on the original money invested, but it can show conflicting answers
when compared to NPV for mutually exclusive projects. Having some
minimal flows compared to EPS and PBP, still NPV, and IRR are the best
method for valuating a project.
Two more adjustment to Grestock’s analysis needs to take place. That
is engineering costs doesn’t need to be added, because it is a sunk costs
and is already spent and cannot be recovered, weather the project is
approved or not. Overhead costs should also not be included because they
are not incremental to cash flows, and we are only concerned with
incremental cash flows. Adjustments that have been made to Greystock’s
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analysis include: adding inflation rate to the discount rate, excluding
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engineering costs and overhead costs. All of these adjustments constitute a
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change to NPV from 10.57 to 16.92 and IRR from 24.3% to 30.3%. After
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looking at the adjusted analysis, I think the company’s senior management
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should approve the project, since the project passed the performance
hurdles with a great success, by having a positive NPV, a high IRR and an
increased earning per share. All of these indicate that the project is very
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attractive.
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