Case 24 Assignment
1. Explain the proposed investment at Merseyside Works. What are the expected advantages that
the investment would bring to the company?
2. Discuss the concept of cannibalization as it relates to Merseyside and Rotterdam. Should
cannibalization affect the cash flows for the Merseyside Project? Explain.
3. Go to lines 4 and 5 in exhibit 2. Should (1) overhead and (2) preliminary engineering costs be
included in the calculation of the cash flows for the Merseyside Project? Why o
r why not?
Explain.
4. The Treasury Staff believes the long
-
term inflation rate will be 3% per year. However, the
assumption in exhibit 2 is that inflation is 0%. Explain how inflation should be reflected in the
sales figures used in the cash flow calc
ulations.
5. Examine the 4 criteria used on page 354 to evaluate the capital expenditure proposals. Offer a
critique of each of the 4 techniques. Which criteria should be used and which are not helpful?
Explain your reason
s r 20 Victoria Chemicals plc (A): The Merseyside Project Late one aftern satisfied with the analysis so far, but the suggested changes could kill the project. l solid projects like this can't swim past the corporate modernize. oon in January 2008, Frank Greystock told Lucy Morris, "No one seems If piranhas, the company will never Morris was plant manager of Victoria Chemicals' Merseyside Works in Liverpool. England. Her controller, Frank Greystock, was discussing a capital project that Morris wanted to propose to senior management. The project consisted of a GBP12 million expenditure to renovate and rationalize the polypropylene production line at the Mer- seyside plant in order to make up for deferred maintenance and to exploit opportunities to achieve increased production efficiency Victoria Chemicals was under pressure from investors to improve its financial per- formance because of the accumulation of the firm's common shares by a well-known corporate raider, Sir David Benjamin. Earnings had fallen to 180 pence per share at the end of 2007 from around 250 pence per share at the end of 2006. Morris thus believed that the time was ripe to obtain funding from corporate headquarters for a moderniza- tion program for the Merseyside Works-at least she had believed this until Greystock presented her with several questions that had only recently surfaced. Victoria Chemicals and Polypropylene Victoria Chemicals, a major competitor in the worldwide chemicals industry, was a leading producer of polypropylene, a polymer used in an extremely wide variety of products (ranging from medical products to packaging film, carpet fibers, and The author wishes to acknowledge the helpful comments of Dr:. Frank H. Me Tigue, the literary color of Anthony Trollope, and the financial support of the Citicorp Global Scholars Program. GBP-British pounds. fictional case was prepared by Robert F. Bruner as a basis for class discussion rather than to rate effective or ineffective handling of an administrative situation. Victoria Chemicals is a company reflecting the issues facing actual firms. Copyright 0 2008 by the University of Vin Darden School Foundation, Charlottesville, VA. All rights reserved. To onder copies, send an e-mail to sales @ dardenbusinesspublishing.com. No part of this publication may be repruduced stored in a retrieval system, used in a spreadsheet, or transmited in any form or by any means-electronic, mechanica photocopying, recording, or otherwise-without the permission of the Darden School Foundation illus 257 Capital Budgeting and Resource automobile components) and known for its strength and malleability p. was essentially priced as a commodity 258 Part Four side Works beg out refineris rom an with of plyr ene, a refined gas received in tank cars. Propylene was purchased in England that produced it in the course of refining crude oil into as rour ref stage of the production process, polymerization, the propylene gas a diluent (or solvent) in a large pressure vessel. In a catalytic reaction, the precipitated to the bottom of the tank and was then c was combined with The second stage of the production process compounded the basice. pment the bottom of the tank and was then concentrated in a centrpop with stabilizers, modifiers, fillers, and pigments to achieve the desired atri p to particular customer. The finished plastic was extruded into pellets for shi customer therefore, higher in labor content than its competitors' newer plants. The M Works plant was constructed in 1967 The Merseyside Works production process was old, semicontinuous at Victoria Chemicals produced polypropylene at Merseyside Works and in Rotterthn Holland. The two plants were of identical scale, age, and design. The managers plants reported to James Fawn, executive vice president and manager of the Intermedi ate Chemicals Group (ICG) of Victoria Chemicals. The company positioned itself as a supplier to customers in Europe and the Middle East. The strategic-analysis staff est mated that, in addition to numerous small producers, seven major competitors manu- factured polypropylene in Victoria Chemicals' market region. Their plants operated a various cost levels. Exhibit 20.1 presents a comparison of plant sizes and indexd costs. The Proposed Capital Program Morris had assumed responsibility for the Merseyside Works only 12 months previ following a rapid rise from the entry position of shift engineer nine years be fore. When she assumed responsibility, she undertook a detailed review of the operations and discovered significant ene production. Some of those opportunities stemmed from the deferral of mate nance over the preceding five years. In an effort to enhance the operating Merseyside Works, the previous manager had limited capital expenditures t most essential. Now what previously had been routine and deferrable was becomii essential. Other opportunities stemmed from correcting the antiquated plant desig u ways that would save energy and improve the process flow: (1) relocating anu ernizing tank-car unloading areas, which would enable the process flow to resu the greater throughput; and (3) renovating the compounding plant to increase e throughput and obtain energy savings d: (2) refurbishing the polymerization tank to achieve higher pressures a be stream- Morris proposed an expenditure of GBP12 million on this program. lymerization line would need to be shut down for 45 days, however, an otterdam plant was operating near capacity, Merseyside Works' custom from competitors. Greystock believed the loss of customers would not be The entire po would buy the company and was responsible for managing the tank cars. Because increased throughput, the Transport Division would have to inc tank cars to Menseyside Works. Currently, the Transport Division s aller location out of excess capacity, although doing so would accel the need to purchase new rolling stock to support the anticipa other areas. The purchase was would have a depreciable life of 10 years, but with proper maintenancetst operate much longer. The rolling stock could not be used outside Britain ouls ferences in track gauge 260 Part Four Capital Budgeting and Resource Allocation of the its allocation pr oje could make this a se was estimated to be GBP2 million in 2010. The roll cars because of dif. cost of the tank cars should be included in the initial outlay of Merseyside w tal program. But Greystock disagreed. He told Morris: suggested that the initial outlay of Merseyside Works' capi-. A memorandum from the controller of the Transport Division su The Transport Division isn't paying one pence of actual cash because of w at Merseyside. In fact, we're doing the company a favor in using its excess if an allocation has to be made somewhere, it should go on the Transport Division's h The way we've always evaluated projects in this company has been with the philosd every tub on its own bottom" every division has to fend for itself. The Transpon Dvisien isn 't part of our own Intermediate Chemicals Group, so they should carry the allocation of rolling stock Accordingly, Greystock had not reflected any charge for the use of excess rolling stock in his preliminary DCF analysis, given in Exhibit 20.2. The Transport Division and Intermediate Chemicals Group reported to separate executive vice presidents, who reported to the chairman and chief executive officer of the company. The executive vice presidents received an annual incentive bonus peggod to the performance of their divisions. Concerns of the ICG Sales and Marketing Department Greystock's analysis had led to questions from the director of sales. In a recent mecin the director had told Greystock Your analysis assumes that we can sell the added output and thus obtain the full effiins from the project, but as you know, the market for polypropy lene is extremely competit Right now, the industry is in a downturn and it looks like an oversupply is in the works lha means that we will probably have to shift capacity away from Rotterdamtow end in order to move the added volume. Is this really a gain for Victoria Chen money just so one plant can cannibalize another? The vice president of marketing was less skeptical. He said that with at Merseyside Works, Victoria Chemicals might be able to takebusiesessioe plants of competitors such as Sane-Poulet or Vaysol. In the current severe ower costs Currentslness from the ransport division depreciated rolling stock using DDB depreciation for the first eight yea The transport division straight-line depreciation for the last two years and Case 20 Victoria Chemicals PLC GA: The Merseyside Project2 261 mpetitors would fight hard to keep customers, but sooner or later the market revive, and it would be reasonable to assume that any lost business volume wou return at that time. Greystock had listened to both the director and the vice president and chose to re flect no charge for a loss of business at Rotterdam in his preliminary analysis of Merseyside project. He told Morris: Cannibalization really isn't a cash flow; there is no check written in this instance. Anyway if the company starts burdening its cost-reduction projects with fictitious charges we'll never maintain our cost competitiveness. A cannibalization charge is rubbish! like this Concerns of the Assistant Plant Manager Griffin Tewitt, the assistant plant manager and Morris's direct subordinate, proposed an unusual modification to Greystock's analysis during a late-afternoon meeting with Greystock and Morris. Over the past few months, Tewitt had been absorbed with the development of a proposal to modernize a separate and independent part of the Merseyside Works, the production line for ethylene-propylene-copolymer rub (EPC). This product, a variety of synthetic rubber, had been pioneered by Victoria Chemicals in the early 1960s and was sold in bulk to European tire manufacturers. Despite hopes that this oxidation-resistant rubber would dominate the market in syn thetics, EPC remained a relatively small product in the European chemical industry Victoria Chemicals, the largest supplier of EPC. produced the entire volume at Mer seyside Works. EPC had been only marginally profitable to Victoria Chemicals be cause of the entry by competitors and the development of competing synthetic-rubber compounds over the past five years ber Tewitt had proposed a renovation of the EPC production line at a cost of GBPI million. The renovation would give Victoria Chemicals the lowest EPC cost base in the world and would improve cash flows by GBP25,000 ad infinitum. Even so, at cur- rent prices and volumes, the net present value (NPV) of this project was-GBP750,000. Tewitt and the EPC product manager had argued strenuously to the company's execu- tive committee that the negative NPV ignored strategic advantages from the project and increases in volume and prices when the recession ended. Nevertheless, the executive committee had rejected the project, basing its rejection mainly on eco- nomic grounds In a hushed voice, Tewitt said to Morris and Greystock: Why don't you include the EPC project as part of the polypropylene line renovations? The positive NPV of the poly renovations can easily sustain the negative NPV of the EPC ect. This is an extremely important project to the company, a point that senior management doesn't seem to get. If we invest now, we'll be ready to exploit the market when the rec proj es on ends. If we don't invest now, you can expect that we will have to exit the business all together in three years. Do you look forward to more layoffs? Do you want to manage a shrinking plant? Recall that our annual bonuses are pegged to the size of this operation. Also remember that, in the last 20 years, no one from corporate has monitored renovation rojects once the investment decision was made. 262 Part Four Capital Budgeting and Rescurce Al tafm Concerns of the Treasury S Gowan scanned After a meeting on a different matter, Greystock described his dil lyst on Victoria Chemicals' treasury staff. Gowan After a mecting on a di Gowan, who worked as an ana about infation. The Greystock's analysis and pointed out: Cash flows and discount rate need to be consistent in their assumptions 10% hurdle rate you're using is a nominal target rate of return. The Treas his impounds a long-term inflation expectation of 3% per year. Thus Victoy staff thinks The conversation was interrupted before Greystock could gain full unc Gowan's comment. For the time being. Greystock decided to continue to use rate of 10% because it was the figure promoted in the latest edition of Victoria real (that is, zero inflation) target rate of return is 7%. a discoun Evaluating Capital-Expenditure Proposals at Victoria Chemicals In submiting a project for senior management's approval, the project's inititors adto identify it as belonging to one of four possible categories: (1) new product or duct or market extension, (3) engineering efficiency, or (4) safety or environmen The first three categories of proposals were subject to a system of four performance "hurdles," of which at least three had to be met for the proposal to be considered. The Merseyside project would be in the engineering-efficiency category 1. Impact on earnings per share: For engineering-efficiency projects, the contribu- tion to net income from contemplated projects had to be positive. This criterion was calculated as the average annual earnings per share (EPS) contribution of the project over its entire economic life, using the number of outstanding shares at the most recent fiscal year-end (FYE) as the basis for the calculation.(At FYE200 Victoria Chemicals had 92,891,240 shares outstanding.) 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 the project (at the hurdle rate of 10% for engineering-efficiency proposals) less initial investment outlay. This net present value of free cash flows had to be posiv 4. Internal rate of retumn: IRR was defined as being the discount rate at which ole present value of future free cash flows just equaled the initial outlayc words, the rate at which the NPV was zero. The IRR of engineering-e projects had to be greater than 10%. efficiency Conclusion Morris wanted to review Greystock's analysis in detail and settle the queerda. As rounding the tank cars and the potential loss of business volume at R questions sur 3 888 264 s r 20 Victoria Chemicals plc (A): The Merseyside Project Late one aftern satisfied with the analysis so far, but the suggested changes could kill the project. l solid projects like this can't swim past the corporate modernize. oon in January 2008, Frank Greystock told Lucy Morris, "No one seems If piranhas, the company will never Morris was plant manager of Victoria Chemicals' Merseyside Works in Liverpool. England. Her controller, Frank Greystock, was discussing a capital project that Morris wanted to propose to senior management. The project consisted of a GBP12 million expenditure to renovate and rationalize the polypropylene production line at the Mer- seyside plant in order to make up for deferred maintenance and to exploit opportunities to achieve increased production efficiency Victoria Chemicals was under pressure from investors to improve its financial per- formance because of the accumulation of the firm's common shares by a well-known corporate raider, Sir David Benjamin. Earnings had fallen to 180 pence per share at the end of 2007 from around 250 pence per share at the end of 2006. Morris thus believed that the time was ripe to obtain funding from corporate headquarters for a moderniza- tion program for the Merseyside Works-at least she had believed this until Greystock presented her with several questions that had only recently surfaced. Victoria Chemicals and Polypropylene Victoria Chemicals, a major competitor in the worldwide chemicals industry, was a leading producer of polypropylene, a polymer used in an extremely wide variety of products (ranging from medical products to packaging film, carpet fibers, and The author wishes to acknowledge the helpful comments of Dr:. Frank H. Me Tigue, the literary color of Anthony Trollope, and the financial support of the Citicorp Global Scholars Program. GBP-British pounds. fictional case was prepared by Robert F. Bruner as a basis for class discussion rather than to rate effective or ineffective handling of an administrative situation. Victoria Chemicals is a company reflecting the issues facing actual firms. Copyright 0 2008 by the University of Vin Darden School Foundation, Charlottesville, VA. All rights reserved. To onder copies, send an e-mail to sales @ dardenbusinesspublishing.com. No part of this publication may be repruduced stored in a retrieval system, used in a spreadsheet, or transmited in any form or by any means-electronic, mechanica photocopying, recording, or otherwise-without the permission of the Darden School Foundation illus 257 Capital Budgeting and Resource automobile components) and known for its strength and malleability p. was essentially priced as a commodity 258 Part Four side Works beg out refineris rom an with of plyr ene, a refined gas received in tank cars. Propylene was purchased in England that produced it in the course of refining crude oil into as rour ref stage of the production process, polymerization, the propylene gas a diluent (or solvent) in a large pressure vessel. In a catalytic reaction, the precipitated to the bottom of the tank and was then c was combined with The second stage of the production process compounded the basice. pment the bottom of the tank and was then concentrated in a centrpop with stabilizers, modifiers, fillers, and pigments to achieve the desired atri p to particular customer. The finished plastic was extruded into pellets for shi customer therefore, higher in labor content than its competitors' newer plants. The M Works plant was constructed in 1967 The Merseyside Works production process was old, semicontinuous at Victoria Chemicals produced polypropylene at Merseyside Works and in Rotterthn Holland. The two plants were of identical scale, age, and design. The managers plants reported to James Fawn, executive vice president and manager of the Intermedi ate Chemicals Group (ICG) of Victoria Chemicals. The company positioned itself as a supplier to customers in Europe and the Middle East. The strategic-analysis staff est mated that, in addition to numerous small producers, seven major competitors manu- factured polypropylene in Victoria Chemicals' market region. Their plants operated a various cost levels. Exhibit 20.1 presents a comparison of plant sizes and indexd costs. The Proposed Capital Program Morris had assumed responsibility for the Merseyside Works only 12 months previ following a rapid rise from the entry position of shift engineer nine years be fore. When she assumed responsibility, she undertook a detailed review of the operations and discovered significant ene production. Some of those opportunities stemmed from the deferral of mate nance over the preceding five years. In an effort to enhance the operating Merseyside Works, the previous manager had limited capital expenditures t most essential. Now what previously had been routine and deferrable was becomii essential. Other opportunities stemmed from correcting the antiquated plant desig u ways that would save energy and improve the process flow: (1) relocating anu ernizing tank-car unloading areas, which would enable the process flow to resu the greater throughput; and (3) renovating the compounding plant to increase e throughput and obtain energy savings d: (2) refurbishing the polymerization tank to achieve higher pressures a be stream- Morris proposed an expenditure of GBP12 million on this program. lymerization line would need to be shut down for 45 days, however, an otterdam plant was operating near capacity, Merseyside Works' custom from competitors. Greystock believed the loss of customers would not be The entire po would buy the company and was responsible for managing the tank cars. Because increased throughput, the Transport Division would have to inc tank cars to Menseyside Works. Currently, the Transport Division s aller location out of excess capacity, although doing so would accel the need to purchase new rolling stock to support the anticipa other areas. The purchase was would have a depreciable life of 10 years, but with proper maintenancetst operate much longer. The rolling stock could not be used outside Britain ouls ferences in track gauge 260 Part Four Capital Budgeting and Resource Allocation of the its allocation pr oje could make this a se was estimated to be GBP2 million in 2010. The roll cars because of dif. cost of the tank cars should be included in the initial outlay of Merseyside w tal program. But Greystock disagreed. He told Morris: suggested that the initial outlay of Merseyside Works' capi-. A memorandum from the controller of the Transport Division su The Transport Division isn't paying one pence of actual cash because of w at Merseyside. In fact, we're doing the company a favor in using its excess if an allocation has to be made somewhere, it should go on the Transport Division's h The way we've always evaluated projects in this company has been with the philosd every tub on its own bottom" every division has to fend for itself. The Transpon Dvisien isn 't part of our own Intermediate Chemicals Group, so they should carry the allocation of rolling stock Accordingly, Greystock had not reflected any charge for the use of excess rolling stock in his preliminary DCF analysis, given in Exhibit 20.2. The Transport Division and Intermediate Chemicals Group reported to separate executive vice presidents, who reported to the chairman and chief executive officer of the company. The executive vice presidents received an annual incentive bonus peggod to the performance of their divisions. Concerns of the ICG Sales and Marketing Department Greystock's analysis had led to questions from the director of sales. In a recent mecin the director had told Greystock Your analysis assumes that we can sell the added output and thus obtain the full effiins from the project, but as you know, the market for polypropy lene is extremely competit Right now, the industry is in a downturn and it looks like an oversupply is in the works lha means that we will probably have to shift capacity away from Rotterdamtow end in order to move the added volume. Is this really a gain for Victoria Chen money just so one plant can cannibalize another? The vice president of marketing was less skeptical. He said that with at Merseyside Works, Victoria Chemicals might be able to takebusiesessioe plants of competitors such as Sane-Poulet or Vaysol. In the current severe ower costs Currentslness from the ransport division depreciated rolling stock using DDB depreciation for the first eight yea The transport division straight-line depreciation for the last two years and Case 20 Victoria Chemicals PLC GA: The Merseyside Project2 261 mpetitors would fight hard to keep customers, but sooner or later the market revive, and it would be reasonable to assume that any lost business volume wou return at that time. Greystock had listened to both the director and the vice president and chose to re flect no charge for a loss of business at Rotterdam in his preliminary analysis of Merseyside project. He told Morris: Cannibalization really isn't a cash flow; there is no check written in this instance. Anyway if the company starts burdening its cost-reduction projects with fictitious charges we'll never maintain our cost competitiveness. A cannibalization charge is rubbish! like this Concerns of the Assistant Plant Manager Griffin Tewitt, the assistant plant manager and Morris's direct subordinate, proposed an unusual modification to Greystock's analysis during a late-afternoon meeting with Greystock and Morris. Over the past few months, Tewitt had been absorbed with the development of a proposal to modernize a separate and independent part of the Merseyside Works, the production line for ethylene-propylene-copolymer rub (EPC). This product, a variety of synthetic rubber, had been pioneered by Victoria Chemicals in the early 1960s and was sold in bulk to European tire manufacturers. Despite hopes that this oxidation-resistant rubber would dominate the market in syn thetics, EPC remained a relatively small product in the European chemical industry Victoria Chemicals, the largest supplier of EPC. produced the entire volume at Mer seyside Works. EPC had been only marginally profitable to Victoria Chemicals be cause of the entry by competitors and the development of competing synthetic-rubber compounds over the past five years ber Tewitt had proposed a renovation of the EPC production line at a cost of GBPI million. The renovation would give Victoria Chemicals the lowest EPC cost base in the world and would improve cash flows by GBP25,000 ad infinitum. Even so, at cur- rent prices and volumes, the net present value (NPV) of this project was-GBP750,000. Tewitt and the EPC product manager had argued strenuously to the company's execu- tive committee that the negative NPV ignored strategic advantages from the project and increases in volume and prices when the recession ended. Nevertheless, the executive committee had rejected the project, basing its rejection mainly on eco- nomic grounds In a hushed voice, Tewitt said to Morris and Greystock: Why don't you include the EPC project as part of the polypropylene line renovations? The positive NPV of the poly renovations can easily sustain the negative NPV of the EPC ect. This is an extremely important project to the company, a point that senior management doesn't seem to get. If we invest now, we'll be ready to exploit the market when the rec proj es on ends. If we don't invest now, you can expect that we will have to exit the business all together in three years. Do you look forward to more layoffs? Do you want to manage a shrinking plant? Recall that our annual bonuses are pegged to the size of this operation. Also remember that, in the last 20 years, no one from corporate has monitored renovation rojects once the investment decision was made. 262 Part Four Capital Budgeting and Rescurce Al tafm Concerns of the Treasury S Gowan scanned After a meeting on a different matter, Greystock described his dil lyst on Victoria Chemicals' treasury staff. Gowan After a mecting on a di Gowan, who worked as an ana about infation. The Greystock's analysis and pointed out: Cash flows and discount rate need to be consistent in their assumptions 10% hurdle rate you're using is a nominal target rate of return. The Treas his impounds a long-term inflation expectation of 3% per year. Thus Victoy staff thinks The conversation was interrupted before Greystock could gain full unc Gowan's comment. For the time being. Greystock decided to continue to use rate of 10% because it was the figure promoted in the latest edition of Victoria real (that is, zero inflation) target rate of return is 7%. a discoun Evaluating Capital-Expenditure Proposals at Victoria Chemicals In submiting a project for senior management's approval, the project's inititors adto identify it as belonging to one of four possible categories: (1) new product or duct or market extension, (3) engineering efficiency, or (4) safety or environmen The first three categories of proposals were subject to a system of four performance "hurdles," of which at least three had to be met for the proposal to be considered. The Merseyside project would be in the engineering-efficiency category 1. Impact on earnings per share: For engineering-efficiency projects, the contribu- tion to net income from contemplated projects had to be positive. This criterion was calculated as the average annual earnings per share (EPS) contribution of the project over its entire economic life, using the number of outstanding shares at the most recent fiscal year-end (FYE) as the basis for the calculation.(At FYE200 Victoria Chemicals had 92,891,240 shares outstanding.) 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 the project (at the hurdle rate of 10% for engineering-efficiency proposals) less initial investment outlay. This net present value of free cash flows had to be posiv 4. Internal rate of retumn: IRR was defined as being the discount rate at which ole present value of future free cash flows just equaled the initial outlayc words, the rate at which the NPV was zero. The IRR of engineering-e projects had to be greater than 10%. efficiency Conclusion Morris wanted to review Greystock's analysis in detail and settle the queerda. As rounding the tank cars and the potential loss of business volume at R questions sur 3 888 264
