Victoria Chemicals

BACKGROUND

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 20th Century.

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 21st Century. Many new competitors have recently built newer plants with more

efficient systems and this has taken a toll on Victorias 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.

PRODUCTION

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

customers.

Due to polypropylenes 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 Victorias 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 plants gross margin would improve

to 12.5% (from 11.5%).

PROJECT CONCERNS

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

approved.

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 outlayin other words, the rate at which the NPV was zero. The IRR of engineering-efficiency projects had to be greater than 10%.

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%

Internal Competition A large part of Morris proposals 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 Victorias 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. Cannibalization 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 other? 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 economy improves. Piggyback Project 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 Tewitts recommendation based on economic merit. The EPC production line represented a small portion of the chemical industry and Victoria Chemicals 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 products. Tewitts 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 projects 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. Treasury Review 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 Victorias 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 projects 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.

PROJECT CORRECTION

Cash Flows

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 Rotterdams output and

extended depreciation of the Transport Divisions 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.

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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 Rotterdams

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

and stabilize.

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).

Tanker Cars

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 Chemicals investment, the corrected financial analysis has taken the added

depreciation of the newly acquired tanker cars as a result of the project.

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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.

Cannibalization

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 companys 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

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Original Depreciation

Revised Depreciation

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 years WIP from the previous years

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 years

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 plants

output should match an improving global economy in time as the WIP inventory moves out of

the negative output in the next decade.

Inflation

As noted by the Treasury staff, the cost of inflation is not typically counted in the companys

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.

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Original WIP

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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

Inflation

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%.

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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 members 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.