VICTORIA CHEMICALS PLC (A):

THE MERSEYSIDE PROJECT

Capital Budgeting Case Analysis

DeQuincy Adamson

Donald Harrell

Lekisha McKinley

Taylor Wolfe

Finance 5387

Spring 2012

VICTORIA CHEMICALS: CASE BACKGROUND

Victoria Chemicals was a major competitor in the chemical industry worldwide. The

company was the leading producer of polypropylene, a polymer that is used in a variety of

products including carpet fibers, packaging, and automobile parts. Polypropylene was essentially

priced as a commodity.

In order to meet demand, Victoria Chemicals produced and manufactured polypropylene

at two plants, the Merseyside Works plant in Liverpool, England, and the Rotterdam facility in

Rotterdam, Holland. The plants were built in 1967 and are identical in scale and design.

Additionally, managers of both plants reported to James Fawn, the executive vice president and

manager of the Intermediate Chemicals Group (ICG).

The production of polypropylene pellets begins at Merseyside with propylene, a refined

gas received in tank cars known as propylene. The production process consisted of two stages: In

the first stage, the gas form of polypropylene was combined with a solvent in a pressurized

vessel and then concentrated and collected in a centrifuge. Next, the polypropylene was mixed

with stabilizers, modifiers, fillers, and pigments in order to create the final product, a plastic

pellet, which is shipped to the customer. The company positioned itself as a supplier to

customers in Europe and the Middle East.

In addition to small producers, seven major competitors manufactured polypropylene in

Victoria Chemicals’ market region. Their plants operated at various cost levels. Primary

competitors CBTG A.G. and Hosche A.G. were able to produce higher annual output at lower

costs per ton. Table 1 on the following page presents a comparison of plant sizes and indexed

costs.

Table 1: Comparison on the Seven Largest Polypropylene Plants in Europe

Plant NamePlant

Location

Year

Plant

Built

Plant

Annual

Output

(in metric

tons)

Product Cost per

ton

(indexed to low-

cost producer)

CBTG A.G. Saabrun 1981 350,000 1.00

Victoria Chemicals Liverpool 1967 250,000 1.09

Victoria Chemicals Rotterdam 1967 250,000 1.09

Hosche A.G. Hamburg 1977 300,000 1.02

Montecassino SpA Genoa 1961 120,000 1.11

Saone-Poulet S.A. Marseille 1972 175,000 1.07

Vaysol S.A. Antwerp 1976 220,000 1.06

Next 10 Largest Plants 450,000 1.19

VICTORIA CHEMICALS: ISSUES/PROBLEMS

In 2007, Victoria Chemicals experienced a significant drop in its financial performance

from 2006. The company was under pressure to improve its performance as its earnings had

fallen 38% from 250 pence per share to 180 pence per share in a year. In addition, Victoria

Chemicals saw the accumulation of its common shares by a well-known corporate raider named

Sir David Benjamin. The entrance of a corporate raider may have shown that the firms’ assets

appeared to be under valued. This corporate raider could gather a large voting right, change the

management, and ultimately increase share value and get a big return on his investment.

The decline in the company’s value was due in large part to its current production process

and the condition of its facilities: The method of producing the polypropylene at the Merseyside

Works plant was obsolete compared to new technology with its competitors, and required more

labor than the process used by its competitors. As well, the previous manager of the plant had

enhanced operating results by minimizing capital expenditures to cover only necessary

maintenance over the past five years; routine maintenance had been delayed to the point that it

was now imperative for it to no longer be deferred in order to renew the production line.

Another issue that Victoria Chemicals faces is that its product is a commodity. They do

not compete with a differentiated product; as such, to remain competitive and gain market share,

they need to maintain competitive prices while increasing profits through lowering their costs.

Because both their plants are older and use a semi continuous production process, Victoria

Chemicals requires more labor than its competitors in newer, more efficient plants. Compared to

its competitors, Victoria Chemicals incurs high costs of production mainly due to higher

dependence on labor. Montecassino is the only other firm among the top 7 whose costs are

higher than that of Victoria Chemicals, but it is an older plant (built in 1961) and produces a

lower volume compared to Victoria Chemicals. Therefore, Victoria Chemicals faces issues not

only with lower revenues but with higher costs as well.

Given these factors, Merseyside Works plant manager Lucy Morris thought it an ideal

time to seek funding from corporate headquarters for a modernization program for the

Merseyside Works. Morris felt this move would help improve the company’s financial situation

and help them remain a major competitor in the worldwide chemical industry.

VICTORIA CHEMICALS: THE PROPOSED PROJECT

Morris and her controller, Frank Greystock, proposed a project to overhaul the entire

polymerization line at a cost of GBP 12 million. The proposed project would be to renovate and

rationalize the polypropylene production line at the Merseyside plant in order to make up for

deferred maintenance and to exploit opportunities to achieve increased production efficiency.

Morris revealed the areas of opportunity in which the project covered:

No longer defer maintenance on essential tools and equipment required in the production

process.

Correct the plant design on ways that would save energy and improve the process flow by:

o Relocating and modernizing the tank-car unloading areas, which would enable the

process flow to be streamlined.

o Refurbishing the polymerization tank to achieve higher pressures and thus greater

throughput.

o Renovating the compounding plant to increase extrusion throughput and obtain

energy savings.

The benefits of this project were increased efficiencies in terms of:

Reduced energy consumption, which was assumed to equal 1.25% of sales in the first

year and .75% in years 6-10.

Increased gross margin of up to 12.5%.

Increased manufacturing output. Currently, Victoria Chemicals was producing 250,000

tons of polypropylene pellets a year at a price of GBP675 per ton. The project would also

result in seven percent (7%) greater manufacturing throughput; however, the entire line

would need to be shut down for 45 days in the first year for construction. Based on the

current annual 250,000 ton production figure, Victoria Chemicals would experience

roughly a 13% decrease in production for that year upon implementing the project. The

13% figure was determined using the following equation where 1.5 (months) equals 45

days in which the plant would be shut down for construction:

Reduction∈Output=( 250,00012 )∗1.5

The tax rate required in the capital-expenditure analysis was 30%. Greystock also speculated that

any new assets acquired would depreciate in 15 years. In addition, he predicted that in the first

year the company would incur GBP500, 000 in engineering costs due to the renovation.

VICTORIA CHEMICALS: CONCERNS WITH THE PROPOSED PROJECT

Even though the project seemed to have promising returns, there were some issues or

concerns that were associated with the project. Renovating the Merseyside plant would require it

to shut down for 45 days. This was a problem because the Rotterdam plant was already operating

at near-maximum capacity, which would cause Merseyside Works’ customers to buy from

competitors until the renovation was completed. Even still, Frank Greystock, a controller at

Victoria Chemicals, assumed that this loss of customers would be temporary.

Furthermore, Victoria Chemicals owned the tank cars with which Merseyside Works

received propylene gas from four petroleum refineries in England. The Transport Division,

which oversaw the movement of all raw, intermediate, and finished materials throughout the

company and was responsible for managing the tank cars, realized that it would be required to be

increase its allocation of tank cars to Merseyside to support the growth that the renovation would

bring. Currently, the allocation could be made out of excess capacity, but doing so would

accelerate the need to purchase new rolling stock to support anticipated growth of the firm in

other areas. The purchase was estimated at GBP2 million in 2010. Rolling stock would have a

depreciable life of 10 years, but could operate much longer with proper maintenance. The rolling

stock also could not be used outside of Britain because of differences in track gauges, which

meant that the trucks could not be used to ship product to its primary customers in the Middle

East.

The Transport Division believed that the cost of the tank cars should be included in the

initial outlay of Merseyside Works’ capital program. However, Greystock disagreed, noting that

they were doing the company a favor by using the excess capacity and that company has always

operated in silos. As such Greystock did not include the charge (cost of excess rolling stock) in

the proposal on the grounds that the division should carry the allocation of rolling stock.

The Transport Division was not the only division with concerns. The ICG Sales and

Marketing department had some questions of their own. The director of sales said that the

Greystock’s analysis assumed that the company would be able to sell the increased output

brought on by the renovation. However, the entire industry was experiencing a downturn; thus,

an oversupply of polypropylene could occur. To combat the oversupply, the company would

likely shift capacity from Rotterdam to Merseyside, which could result in Merseyside

cannibalizing Rotterdam. On the other hand, the V.P. of marketing believed that lowering costs

would help Victoria Chemicals compete better with other producers of polypropylene and thus

win over customers from competitors. After hearing out both arguments, Greystock did not

include charge for loss of business in his analysis as he felt a cannibalization charge was

fictitious and including such charges would not allow them to maintain their cost

competitiveness.

Greystock’s discounted cash flow also suggested that the company would earn a 10%

return on the project, even though the Treasury staff believed the real return to be 7% due to a

3% in inflation per year. However, Greystock decided to continue to use a discount rate of 10%

because it was the figure promoted in the latest edition of the company’s capital-budgeting

manual. The high discount rate was problematic because, if the 7% figure was more accurate,

using the 10% rate would cause the company to accept projects (those that fall between seven

and 10 percent) that should be rejected.

On another note, Griffin Tewitt, assistant plant manager and Morris’s direct subordinate,

proposed that Greystock modify his proposal to include a renovation of the EPC production line

at a cost of GBP1 million. He believed that the renovation would give Victoria Chemicals the

lowest EPC cost base in the world and would improve cash flows by GBP25,000. The NPV of

this project was –GBP750,000, which Tewitt argued that the negative NPV ignored strategic

advantages from the project and increases in volume and prices when the recession ended.

VICTORIA CHEMICALS: EVALUATING THE PROPOSED PROJECT

The project was considered an engineering-efficiency and, therefore, was required to

meet certain criteria before being approved. The criteria included:

1. Impact on earnings per share: The net income had to be positive when calculated as

annual earnings per share (EPS) over its entire life, using the number of outstanding

shares at the most recent fiscal year-end as the basis for the calculation.

2. Payback: The payback period maximum was six years.

3. Discounted cash flow: The net present value of all future cash flows had to be positive.

4. Internal rate of return: The IRR had to be greater than 10%.

Morris wanted to review Greystock’s analysis in order to resolve the issue of the tank cars and

the loss of business that could occur. However, she was afraid that further analysis could lead to

rejection of the project. The Merseyside project, according to Greystock, met all four investment

criteria:

1. Average annual addition to EPS of GBP0.022

2. Payback period of 3.8 years.

3. Net present value of GBP10.6 million

4. IRR of 24.3%

In the following paper, we will analyze the four criteria based on Greystock’s findings to

determine if the analysis was conducted accurately and reflects true numbers or expectations of

return on the Merseyside project investment.

VICTORIA CHEMICALS: EARNINGS PER SHARE (EPS)

The impact on EPS is calculated as the average of annual incremental gross profit due to

the profit divided by the number of shares. In order to accept this project, the EPS needs to be

GBP0.022. [discuss how/if we met this requirement; steps we took to meet it]

VICTORIA CHEMICALS: SUNK COSTS

The plant manager has included the preliminary engineering costs of GBP 500,000 spent

over the past nine months on efficiency and design studies of the renovation. These costs are

already incurred and are independent of the project decision. Whether or not the project is going

to be approved, these costs are to be borne by the company. Therefore, these costs are not to be

considered for the DCF analysis.

VICTORIA CHEMICALS: PIGGYBACK PROJECT ETHICAL DILEMMA

The assistant plant manager, Griffin Tewitt, proposed to modernize a separate and

independent part of Merseyside Works, the production line for EPC. His argument was to

include the EPC project as part of the renovation project that is currently being analyzed. To

improve the EPC production line it would cost GBP 1 million, but it would improve cash flows

by GBP 25,000 indefinitely. The EPC project has a negative NPV of -GBP750,000, and his

contention was that the bigger renovation project with a positive NPV of GBP 10.6 million

(under the original calculation) can absorb the losses of the EPC project. The benefits of the EPC

project will come through when the recession ends and increase in volume and prices happen.

Although the EPC project has potential to become larger, the EPC market has not been

largely successful since its inception. In addition, an ethical dilemma occurs where Tewitt is

asking Greystock to add his renovation project as part of the polypropylene line renovations

stating that “in the last 20 years, no one from corporate has monitored renovation projects once

the investment decision is made.” Even if there would be benefits to the company overall, the

EPC project should not be included in the analysis because this product line would not impact

the polypropylene product line. The costs and benefits are not relevant to this analysis.

VICTORIA CHEMICALS: COMPETITION WITHIN DIVISIONS

The reporting structures and bonus programs have lead to a lack of synergies between

divisions and a violation of ethics. There is conflict between Transportation division and

polypropylene production division. Having the Transport Division and the Intermediate

Chemicals Group reporting to separate executive vice presidents is a problem. Generally, the

logistics divisions and manufacturing divisions of a company report to a single executive that

oversees the entire supply chain process. This supply chain manager facilitates the

manufacturing and movement of all materials in order to increase efficiencies and reduce costs.

Additional issues of concern is that the plant managers’ bonuses are tied to the size of the

plants they operate, which is not necessarily the proper incentive plan because operation size

does not always positively correlate with efficiency and profit margins. Other issues are that of

evaluation of projects on a periodic basis to monitor the costs incurred, progress and benefits

occurring on time. In the current system at VC, there is no post evaluation of projects at

corporate level after the investment decision is made. The company procedures for capital

expenditure approvals should incorporate a post hoc analysis to determine if the project outcome

was estimated accurately and if the project was a success or not. The procedure should also be

updated to require the analysis to include the appropriate depreciation methods and tax rates, as

these factors have a significant effect on NPV and IRR.

VICTORIA CHEMICALS: CANNIBALIZATION

The sales department is concerned that the project may lead to excess capacity and due to

excessive competition, capacity would be shifted from the Rotterdam plant to Merseyside, and

the Rotterdam plant would have to produce less. However, the Marketing department opines that

the excess production would yield benefits in a growth period, and Merseyside may be able to

cannibalize sales from competitors rather than its own sister plant at Rotterdam.

If the plants do not meet their sales volume then they would simply be running the more

productive and efficient plant (Merseyside) to capacity and have Rotterdam fulfill the overflow.

There is no question of adding a cannibalization charge to the project expense, but it is a matter

of concern for such projects.

Criteria #3: Net Present Value (NPV)

Criteria #4: Internal Rate of Return (IRR

Found this info online. May apply, may not, but just some thoughts:

Recommendation: It is recommended that the purchase of the tanks be charged to the

project cost, so you can put this expense into the cost of the project plus tanks and

have direct ownership of the plant.

It is not considered that this new project can cannibalize the plant in Rotterdam, as

the market covered by each plant is different, and the location is difficult for an end

to the other plant. Of the four methods, the two most favorable to use for evaluation would be

NPV and IRR while the EPS and PBP would be less favorable to use because of its evaluation

process. Using NPV is a good method to use to evaluate the project because it takes into account

all the costs relevant to the project and includes all the cash flows of the project.

VICTORIA CHEMICALS: CONCLUSIONS

There are various problems that keep Victoria Chemicals from achieving its financial

goals. One of the first major problems is the fact that the Merseyside plant required a lot of labor

in order to produce a similar that a competitors firm could produce for lower labor costs. In

order to continue to fall by the wayside, Victoria Chemicals has come up with a plan to turn the

firm around. By implementing these changes, they will save energy and improve productivity.

The company is proposing to upgrade the polymerization line in addition to a increasing the

production of their EPC line.

Although the plant desperately needs renovations, closing down production for 45 days

may make customers permanently switch to a competitors brand. The director of sales states that

the polypropylene market is highly competitive, therefore, any loss in customers would be

detrimental. Victoria Chemicals needs to determine how successful the upgraded plant will be in

comparison to the loss of customers. Their data does not take into consideration any customers

lost during this renovation. However, without the upgrades they will continue to operate at

much higher costs than their competitors. The analysis shows that this project is beneficial to

Victoria Chemicals, and they should implement it.

Even though Greystock’s initial analysis met all of the performance “hurdles”, he missed

some important factors that would have improved the analysis. This could have been

accomplished by changing the calculations as discussed; NPV and IRR would prove to be better

for the project’s projections.

VICTORIA CHEMICALS: RECOMMENDATIONS

Frank Greystock said that, “No one seems satisfied with the analysis so far, but the

suggested changes could kill the project.” This sort of criticism shows that the analysis

has obvious flaws and should be re-written. The company needs to agree on such a plan

because it requires a lot of time and money. It is important that the company function as

a cohesive unit. Although various departments may not always concur, it is important for

the sake of the company to come to a mutual decision. The organizational structure of the

company may need to be re-evaluated in order to create efficiency and fewer problems

when reporting to separate vice presidents.

The company should not tie managers’ bonuses with the size of the plant. Instead, they

should create incentives for efficiency, revenue, or turnover. A manager could easily

grow a plant to collect his or her bonus but this may not be best for the company and its

long term success.

In addition to the production of polypropylene, Victoria Chemicals suggested increasing

the production of EPC, ethylene-propylene-copolymer rubber. This chemical represents a

small portion in the current chemical market and has since its creation. This project will

amount to a NPV of -750,000 GBP. Due to the fact that the EPC market is so small, it

would be wasteful to spend so much money on the project. Multiple competitors produce

similar chemicals. The company should focus on something else that could potentially

hold a large part of the market, instead of such a minimal impact product.

Although Victoria Chemicals is depreciating their machines using double declining

balance method, this may be beneficial due to tax reasons, and it may not look good to

potential investors. By paying more in depreciation costs now, the company reduces its

revenues. This is potentially troublesome due to the fact the financial performance of the

firm has declined in the past few years. It may be more efficient for the firm to use

straight-line depreciation to control the loss in revenue.