Case 24 Analysis

Victoria Chemicals was a major producer of polypropylene, a polymer used in a wide

variety of consumer products. Their staff was thinking of investing in a capital project that
would improve the efficiency of the polypropylene production process. The Merseyside Works
plant, located in Liverpool, England, would be modernized and production costs would be
lowered. However, another production facility in Rotterdam would see its sales fall as the more
efficient Merseyside plant would be able to produce at a lower cost.
The project would cost 1.2 million pounds, and production would need to be shut down
for 45 days. Various members of the Merseyside staff had expressed concerns. The Transport
Division expressed an interest in passing on the cost of buying new rolling stock to the new
project. Taking on the project would require the division to speed up the purchase of new cars
from 2012 to 2010.
The Sales and Marketing Department was concerned whether the Merseyside plant would
take sales away from the Rotterdam entity. The concept of cannibalization would need to be
discussed and reflected in the cash flow analysis.
Griffin Tewitt, Assistant Plant Manager, wanted the project to incorporate an EPC
renovation into the Merseyside analysis. He admitted that the EPC project was not profitable,
but he believed that incorporating the EPC project would still allow the Polypropylene project to
be clear the cost of capital hurdle.
The Treasury staff was not sure how to account for inflation. They believed that inflation
would be about 3% per year. Should they reflect 0% inflation and then use a real rate for the
discount rate that would factor out inflation. Alternatively they could adjust the cash flows for
the 3% per year of inflation and then use a nominal interest rate for inflation.
A sample set of cash flows is provided in exhibit 2. These numbers are just an
approximation to get the analysis started. There are several key errors embedded in the cash
flow computations. In solving the case, you will need to analyze each item in the cash flows.
You should recall that the relevant cash flows are incremental cash flows that result from taking
on the project. You should omit sunk costs and the allocation of corporate overhead. Dont
forget to add any increase in working capital to the initial investment, but make sure that the
working capital is added back when the project closes. Make sure any cannibalization from
other plants gets included.
Finally remember to use the correct capital budgeting evaluation techniques. They use
the impact on earnings per share, payback, discounted cash flow, and internal rate of return. I can
only remember focusing on two of these techniques in previous classes. I hope that you
remember which techniques these were.