How do I analyse if I need to include Cannibalisation in the discounted cash flow?

Morris proposed an expenditure of GBP12 million on this program. The entire polymerization line would need to be shut down for 45 days, however, and because the Rotterdam plant was operating near capacity, Merseyside Works customers would buy from competitors. Greystock believed the loss of customers would not be permanent. The benefits would be a lower energy requirement3 as well as a 7% greater manufacturing throughput. In addition, the project was expected to improve gross margin (before depreciation and energy savings) from 11.5% to 12.5%. The engineering group at Merseyside Works was highly confident that the efficiencies would be realized.

Merseyside Works currently produced 250,000 metric tons of polypropylene pellets a year. Currently, the price of polypropylene averaged GBP675 per ton for Victoria Chemicals product mix. The tax rate required in capital-expenditure analyses was 30%. Greystock discovered that any plant facilities to be replaced had been completely depreciated. New assets could be depreciated on an accelerated basis4 over 15 years, the

expected life of the assets. The increased throughput would necessitate an increase of work-in-process inventory equal in value to 3.0% of cost of goods. Greystock included in the first year of his forecast preliminary engineering costs of GBP500,000 spent over the preceding nine months on efficiency and design studies of the renovation. Finally, the corporate manual stipulated that overhead costs be reflected in project analyses at the rate of 3.5% times the book value of assets acquired in the project per year.5

Greystock had produced the discounted-cash-flow (DCF) summary given in Exhibit 2. It suggested that the capital program would easily hurdle Victoria Chemicals required return of 10% for engineering projects.

Concerns of the ICG Sales and Marketing Department

Greystocks analysis had led to questions from the director of sales. In a recent meeting, the director had told Greystock:

Your analysis assumes that we can sell the added output and thus obtain the full efficiencies from the project, but as you know, the market for polypropylene is extremely competitive. Right now, the industry is in a downturn and it looks like an oversupply is in the works. This means that we will probably have to shift capacity away from Rotterdam toward Merseyside in order to move the added volume. Is this really a gain for Victoria Chemicals? Why spend money just so one plant can cannibalize another?

The vice president of marketing was less skeptical. He said that with lower costs at Merseyside Works, Victoria Chemicals might be able to take business from the plants of competitors such as Saone-Poulet or Vaysol. In the current severe recession, competitors would fight hard to keep customers, but sooner or later the market would revive, and it would be reasonable to assume that any lost business volume would return at that time.

Greystock had listened to both the director and the vice president and chose to reflect no charge for a loss of business at Rotterdam in his preliminary analysis of the Merseyside project. He told Morris:

Cannibalization really isnt a cash flow; there is no check written in this instance. Anyway, if the company starts burdening its cost-reduction projects with fictitious charges like this, well never maintain our cost competitiveness. A cannibalization charge is rubbish!

VRTOK CSERSPICE TUMESIST Gino DOT the Mekot und sind GBP 100% 120 15 Annual Cluput menet Clutput Changluu Mee/Ton pundering Intonated Cow Magne proc.) Margin Energy Savings Yr 1-5 Yr 8-10 673 0.0% 12.30 11.99 Decountate Tax and Investment Chalay (melt) Slepecable year WIP Inventory of Code Motherme Chaco Tel.rary to Cherad 3.0% 1.5 0.94 0.0% 1 2 10 12 9 16 SI OMIC 14 TRI 15 PER 2011 mo IR MIS US ZIR MS GIOC Year 1. semate of incremental Code New Chapter Lot Cluput-Counction 267,300 267,300 267,300 267,500 267,500 267,500 267,500 267,500 267,300 267,300 267,300 207,300 267,500 267,500 (35.5 157.90 13. 21.72 10.50 1036 10.36 106 INO 13. 24S 13 1036 13. 1056 13.3 25.92 New Charge New Chow Photo 10.36 13.3% 25.92 1056 15.396 25.92 1056 13.3 25.92 10.36 12.5% 10.36 12.5 24S 2257 230.000 TOK 19.40 250 X TO Cd Cup Cid Salica Old Incremental Chat 230.000 LOR 1941 250 X LOK 230,000 230,000 230,000 IO LOK LOR 1941 19.41 1941 5. 230,000 LOR 1941 16 250.000 LOR 1941 250.000 LOR 1941 3.16 230,000 TOK 1941 3.16 230,00 LOR 1941 3.16 230 000 TOKS 1941 3.16 250.000 LOKS 1941 3.16 2 emate of mental inventory 4.67 4.67 4.67 470 470 4.70 4.70 474 47 474 *** 0.26 -0.39 019 019 0.19 0.19 0.22 0.22 0.22 0.26 0.26 0.26 060 0.6 0.85 0.53 1. 0.6 1.20 02 1.04 0.0 0.78 0. 0.99 0. 0.55 0. 0.85 0. 0.95 0.0 0.35 00 0.55 0. 1.60 0. 0.30 -0.20 3.61 10 semate of Incremental Depreciation Overhead Thelm Er Metan & Chow Mtume Low Capital Expenditur -12.00 Add back thepreciation Les inventor 7. The -12.00 3.51 5.35 3.55 2.30 1.60 1.39 1.20 1.04 0.90 0.74 0.68 0.39 0.58 0.35 0.55 0.55 0.95 0.55 0.55 1.5 3.6 3.81 3.07 3.05 3.08 3.08 2.04 2018 2.0 2.54 NTV 10.57 VRTOK CSERSPICE TUMESIST Gino DOT the Mekot und sind GBP 100% 120 15 Annual Cluput menet Clutput Changluu Mee/Ton pundering Intonated Cow Magne proc.) Margin Energy Savings Yr 1-5 Yr 8-10 673 0.0% 12.30 11.99 Decountate Tax and Investment Chalay (melt) Slepecable year WIP Inventory of Code Motherme Chaco Tel.rary to Cherad 3.0% 1.5 0.94 0.0% 1 2 10 12 9 16 SI OMIC 14 TRI 15 PER 2011 mo IR MIS US ZIR MS GIOC Year 1. semate of incremental Code New Chapter Lot Cluput-Counction 267,300 267,300 267,300 267,500 267,500 267,500 267,500 267,500 267,300 267,300 267,300 207,300 267,500 267,500 (35.5 157.90 13. 21.72 10.50 1036 10.36 106 INO 13. 24S 13 1036 13. 1056 13.3 25.92 New Charge New Chow Photo 10.36 13.3% 25.92 1056 15.396 25.92 1056 13.3 25.92 10.36 12.5% 10.36 12.5 24S 2257 230.000 TOK 19.40 250 X TO Cd Cup Cid Salica Old Incremental Chat 230.000 LOR 1941 250 X LOK 230,000 230,000 230,000 IO LOK LOR 1941 19.41 1941 5. 230,000 LOR 1941 16 250.000 LOR 1941 250.000 LOR 1941 3.16 230,000 TOK 1941 3.16 230,00 LOR 1941 3.16 230 000 TOKS 1941 3.16 250.000 LOKS 1941 3.16 2 emate of mental inventory 4.67 4.67 4.67 470 470 4.70 4.70 474 47 474 *** 0.26 -0.39 019 019 0.19 0.19 0.22 0.22 0.22 0.26 0.26 0.26 060 0.6 0.85 0.53 1. 0.6 1.20 02 1.04 0.0 0.78 0. 0.99 0. 0.55 0. 0.85 0. 0.95 0.0 0.35 00 0.55 0. 1.60 0. 0.30 -0.20 3.61 10 semate of Incremental Depreciation Overhead Thelm Er Metan & Chow Mtume Low Capital Expenditur -12.00 Add back thepreciation Les inventor 7. The -12.00 3.51 5.35 3.55 2.30 1.60 1.39 1.20 1.04 0.90 0.74 0.68 0.39 0.58 0.35 0.55 0.55 0.95 0.55 0.55 1.5 3.6 3.81 3.07 3.05 3.08 3.08 2.04 2018 2.0 2.54 NTV 10.57