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Transcript
College of Business Administration
Capital Budgeting
CASE 22:
Victoria Chemicals plc
The Merseyside Project
A CASE STUDY
Submitted by:
Ibrahim Gusaer
SUMMER 2012
Introduction
Long-term investment decisions made by business organizations are very critical. It can
affect the success or failure of a business. It is therefore very important to carefully study and
analyze capital investment projects before accepting the project proposal. Since large amount
of capital is involved, the decision-making process is long. All the possible advantages and
disadvantages of the project is analyzed and carefully studied before a proposal is submitted for
evaluation by top management.
Capital budgeting is the planning process used to determine whether an organization's
long term investments are worth pursuing. It is making long-run planning decisions for
investments in projects (Horngren p. 71).
This report analyzes the capital investment proposal by the plant manager of
Merseyside Works at Victoria Chemicals. The objectives of this report are;
1. To obtain an understanding on how capital expenditure proposals are evaluated.
2. To gain insights on how cash flows are determined
3. To analyze the effects of the proposal to different departments of the company.
4. To determine the value of the project using the different methods or techniques in
assessing the attractiveness of the project.
5. To question the validity of some assumptions use in the capital budgeting process.
6. To provide improvements in the discounted cash flow analysis
7. To improve decision-making by providing realistic and reliable analysis.
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Case Background
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.
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, with
the help of Frank Greystock, the controller, has proposed a GBP 12 Million capital project to
senior management to renovate and rationalize the polypropylene production line.
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The Proposed Capital Program
Rationale:
1. To achieve increased production efficiency
2. 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
1. Relocating and modernizing tank-car unloading areas
2. Refurbishing the polymerization tank
3. Renovating the compounding plant
These improvements will enable the process to be streamlined, achieve higher
pressures and greater throughput, and obtain energy savings.
Cost of the Proposed Capital Project
1. 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.
2. 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.
3. Increased in work-in-process inventory equal to 3% of cost of goods sold.
4|Page
Benefits of the Proposed Capital Project
1. Increased Manufacturing Throughput- a 7% increased in manufacturing throughput is
expected due to lower energy requirement.
2. 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.
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Evaluating Capital Expenditure Proposal at Victoria Chemicals
Project Categories
Victoria Chemicals has four project proposal categories;
1. New product or market
2. Product or market extension
3. Engineering efficiency
4. Safety and environment
Criteria
The Merseyside project is included in the engineering efficiency category and must meet
the following test to be considered;
1. 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.
2. 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.
3. 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.
4. 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%.
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The Merseyside project has met all the four investment criteria. Victoria Chemicals has
a complicated scheme in evaluating the project proposals because it involves large amount of
investment capital. Failure to carefully scrutinize the proposed project may lead to faulty
decisions and may negatively affect the company as a whole.
Besides it is difficult to
turnaround the decision once the project has started that’s why there are no room for errors or
mistakes in the decision-making process that involves capital investment projects.
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Transport Division
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.
Recommendation #1:
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. The concern of the transport division has merit.
8|Page
Sales and Marketing Department
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. The concern of the sales
and marketing department has a merit.
Recommendation #2:
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.
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Assistant Plant Manager
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 proposal was rejected by the executive
committee base on economic grounds. 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.
Recommendation #3:
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.
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Treasury Staff
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.
Recommendation #4:
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 riskadjusted discount rate should also be considered. Normally, 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%.
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Modifications on the Discounted Cash Flow Analysis
1. 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.
2. 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.
3. 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.
4. 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.
5. 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
12 | P a g e
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.
6. 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%.
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Summary and Conclusion
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 of 3.8 years lower than the 6-year cut-off, the net present value of the project is positive
and the IRR of the proposed project is 24%, 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. Costbenefit analysis has been done but some assumptions were unrealistic.
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.
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References
Brigham, E., Ehrhardt, M. “Financial Management: Theory and Practice” Thomson SouthWestern 2005
Horngren, C.,et al. “ Cost Accounting: A Managerial Emphasis”, 11th Edition, Pearson Education
Inc., New Jersey
Keown, A., Martin, J.,William Petty, J., et al. “Financial Management: Principles and
Applications” 10th Edition, Pearson Education International Prentice Hall 2005
Moyer, C., McGuigan, J., Kretlow, W. “Contemporary Financial Management” 8th Edition, SouthWestern College Publishing 2001
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