Victoria Chemicals plc The Merseyside Project

_________________________Capital Budgeting

College of Business Administration

Presented by:

Ibrahim Gusaer

Long-term investment decisions made by business organizations are very critical because it can affect the success or failure of a business.

It is therefore very important to carefully study and analyze capital investment projects before a proposal is submitted for evaluation by top management.

All the cost and benefits of the project must be evaluated.

Capital budgeting is the planning process used to determine whether an organization's long term investments are worth pursuing.

This report analyzes the capital investment proposal by the plant manager of Merseyside Works at Victoria Chemicals.

Introduction

To obtain an understanding on how capital expenditure proposals are evaluated.

To gain insights on how cash flows are determined

To analyze the effects of the proposal to different departments of the company.

To determine the value of the project using the different methods or techniques in assessing the attractiveness of the project.

To question the validity of some assumptions use in the capital budgeting process.

To provide improvements in the discounted cash flow analysis

To improve decision-making by providing realistic and reliable analysis.

Objectives

Victoria Chemicals is a major competitor in the chemicals industry and a leading producer of polypropylene, a polymer used in many products.

The company produces these chemicals in its two plants located in Merseyside and in Rotterdam.

Both plants are of the same scale, age and design. Managers of both plants report to the head of Intermediate Chemicals Group (ICG).

The company sells its products in Europe and the Middle East.

Victoria Chemicals faces five major competitions in the polypropylene industry in addition to numerous small producers.

Case Background

Victoria Chemicals financial performance is declining. Earnings had fallen to 180 pence per share in 2007 from 250 pence per share in 2006.

Investors are pushing the company to improve its performance because of the accumulation of the firm’s common shares by a corporate raider.

The previous manager of the Merseyside Works has been postponing maintenance over the last five years to enhance operating results.

Lucy Morris, the current plant manager has proposed a GBP 12 Million capital project to senior management to renovate and rationalize the polypropylene production line.

Case Background

Rationale  To achieve increased production efficiency To make up for the deferred maintenance at Merseyside Works The production process is old, semi-continuous and labor intensive

compare to its competitors.

Proposed Plant Improvements  Relocating and modernizing tank-car unloading areas Refurbishing the polymerization tank Renovating the compounding plant

These improvements will enable the process to be streamlined, achieve higher pressures and greater throughput, and obtain energy savings.

The Proposed Capital Program

The cost of the capital project is estimated to be GBP 12 Million which includes GBP 500,000 preliminary engineering cost for efficiency and design studies spent over the preceding nine months.

The Merseyside Works will be shut down for 45 days, thus losing sales; the other plant is operating near capacity, so it cannot accommodate more production.

Increased in work-in-process inventory equal to 3% of cost of goods sold.

Cost of the Proposed Capital Project

Increased Manufacturing Throughput ◦ a 7% increased in manufacturing throughput is

expected due to lower energy requirement.

Improved Gross Margin ◦ the project will cause the gross margin to increase

from 11.5% to 12.5% because of the expected efficiencies in the production process.

Benefits of the Proposed Capital Project

Project Categories at Victoria Chemicals:

New product or market

Product or market extension

Engineering efficiency

Safety and environment

The Merseyside project fall under engineering efficiency.

Evaluating Capital Expenditure Proposal

Impact on Earnings per share- ◦ the contribution to net income must be positive. The Merseyside project is

expected to add an average annual EPS of GBP0.022; thus it meets the first criteria.

Payback- ◦ the number of years for free cash flow to completely amortize the initial

project outlay is six years. The Merseyside project has a payback period of 3.8 years.

Discounted Cash Flow- ◦ the net present value of the project must be positive. Given the discounted

rate of 10%, Merseyside project has a positive Net present Value of GBP 10.5 Million.

Internal Rate of Return- ◦ the IRR of the proposed project must be higher than 10%, the hurdle rate.

The Merseyside project has an Internal Rate of Return of 24%.

Criteria

Issue # 1:  

Whether to include the purchase of new tank cars in the initial outlay of the capital project

  The Transport Division is a cost center that is separate from the

Intermediate Chemicals Group.

Although the Transport Division is not operating at full capacity and can accommodate the increase in production, the division manager suggests the need to purchase new rolling stock costing GBP 2 million to support the anticipated growth of the firm.

The cost of the tank cars must appropriately be included in the initial outlay of the capital project.

The Merseyside controller opposed to this suggestion and did not include the cost in the discounted cash flow analysis.

Transport Division

Include the cost of new tank cars worth GBP 2 million in the initial outlay of the capital project to be depreciated over 10-year life.

The new tank cars are necessary to accommodate the increase in throughput associated with the capital project.

The transport division and the Merseyside project belong to one company and must be treated as one.

But the benefit from the exploitation of the excess transportation capacity must also be reflected in the cash flow analysis.

Recommendation #1:

Issue #2:  

No charge for loss of business at Rotterdam  The concern of the sales and marketing department is that the

industry is in a downturn and oversupply is expected in the market.

The project will be shifting capacity away from Rotterdam towards Merseyside.

The issue is the cannibalization of Rotterdam plant due to increased efficiency and possible lower production costs in Merseyside.

No charge for a loss of business at Rotterdam is reflected in the discounted cash flow analysis.

Sales and Marketing Department

The discounted cash flow must reflect the loss of business at Rotterdam.

Merseyside as a profit center may gain from the capital project but at the expense of another plant, Rotterdam.

Both plants are under Victoria Chemicals.

To properly determine the profitability of the capital investment, both gains and losses from sales of other departments must be taken into consideration and must be included in the discounted cash flow analysis.

Recommendation #2:

Issue #3:

Inclusion of a separate and independent project

The assistant plant manager proposed the renovation of the EPC production line at a cost of GBP 1 million.

The renovation will give the company the lowest EPC cost base and would improve cash flows by GBP 25,000 annually but the Net Present Value of this modernization project is negative (GBP 750,000).

The assistant plant manager insisted on including the modernization of EPC project as part of the Polypropylene line renovation.

The positive NPV of the polypropylene project will offset the negative NPV of the EPC project.

The EPC project give will the company strategic advantage and it is important for the long-term survival of the business.

Assistant Plant Manager

The inclusion of unrelated project to the proposed capital investment project presents an ethical issue.

The two projects must be evaluated separately based on its individual merits to be able to find out the true value of each project to Victoria Chemicals.

The project with negative NPV if included with the project with positive NPV may weaken the main project and loses its attractiveness.

Also, the assistant plant manager is placing his own self-interest above all other stakeholders when he mentioned that bonuses are pegged to the size of the operation.

Besides, the risks of the two projects are different and should use different cost of capital.

Recommendation #3:

Issue #4:

Consistency in Cash Flow and Discount rate to be used

The treasury staff suggests that the cash flow and discount rate need to be consistent in their assumptions about inflation.

The real interest rate for the company is 7% and the inflation premium is 3%.

The cash flows were discounted using a 10% hurdle rate because it was the figure promoted in the latest edition of the company’s capital budgeting manual.

Treasury Staff

The discount rate must be based on the average cost of capital.

The cost of capital is the weighted average of each source of financing the project like debt, preferred stock and common stock.

There must be a clear description on how the rate is calculated.

Also, the risk-adjusted discount rate should also be considered.

Average-risk projects are discounted at the firm’s average cost of capital, higher-risk projects are discounted at a higher cost of capital and lower-risk projects are discounted at a rate below the firm’s average cost of capital.

Inflation rate of 3% can be incorporated in the cash flow provided but the discount rate used is 10%.

Recommendation #4:

SUNK COST:

◦ Preliminary engineering cost of GBP 500,000 should not be included in the first year forecast because it is a sunk cost and is irrelevant.

◦ The preliminary engineering cost is unavoidable or committed fixed cost.

ALLOCATED OVERHEAD COST

◦ The overhead cost of 3.5% of the book value of assets acquired should not be required to charge an annual pretax because the project is expected to reduce overhead cost.

◦ The project is expected to achieve improved efficiencies, thus overhead cost are minimized or reduced.

◦ Besides, the overhead is an allocation of the corporate overhead expense; it is not directly related to the proposed capital project.

Modifications on the Discounted Cash Flow Analysis

LOSS FROM CUSTOMER SALES:

◦ The discounted cash flow should include a quantitative measure of the impact of loss from customer sales during the 45 day construction period and the possibility of customers not returning when operations turn normal.

◦ It must also consider the overall state of economy and improvement in competitors’ efficiencies.

◦ Scenario analysis must be provided to give a clear definition of the project and provides option for management.

TANK CARS:

◦ Include the cost of new tank cars worth GBP 2 million in the initial outlay of the capital project to be depreciated over 10-year life.

◦ The new tank cars are necessary to accommodate the increase in throughput associated with the capital project.

Modifications on the Discounted Cash Flow Analysis

SHIFT OF CAPACITY:

◦ The discounted cash flow must reflect the loss of business at Rotterdam.

◦ Merseyside as a profit center may gain from the capital project but at the expense of their another plant, Rotterdam plant

DISCOUNT RATE, RISK AND INFLATION:

◦ The discount rate must be based on the average cost of capital. The cost of capital is the weighted average of each source of financing the project like debt, preferred stock and common stock.

◦ The risk-adjusted discount rate should also be considered. Inflation rate of 3% can be incorporated in the cash flow provided that the discount rate used is 10%.

Modifications on the Discounted Cash Flow Analysis

The proposed modernization of the Merseyside plant meets the four criteria established by Victoria Chemicals management.

◦ the contribution to net income is positive, ◦ it has a payback period lower than the 6-year cut-off, ◦ the net present value of the project is positive ◦ and the IRR of the proposed project is higher than the 10% discount rate.

But the discounted cash flow analysis prepared has several defects.

Irrelevant cash flows like sunk cost were included in the analysis and some relevant cash flows were omitted.

Cost-benefit analysis has been done but some assumptions were unrealistic.

Summary and Conclusion

The controller of the Merseyside project should reflect the suggested changes to the discounted cash flow analysis to be able to provide a meaningful, realistic and valid evaluation of the attractiveness of the project to improve decision-making by management.

Summary and Conclusion