Victoria Chemicals plc.

(A)
The Merseyside Project

3/12/15
Introduction

Victoria Chemicals is one of the leading competitors in the chemical industry

that mainly produces polypropylene, a polymer that is used in a wide range of

products such as medical products, packaging film, automobile fibers, and more.

Victoria Chemicals consisted of two plants, one in Merseyside, England and the

other plant in Rotterdam, Holland. Both of the plants were of identical scale with the

same age and design. Victoria Chemicals supplied to customers in Europe and the

Middle East. It was estimated that there were seven major competitors that also

manufactured polypropylene in the same market region as Victoria Chemicals.

The controller of Merseyside, Morris Greystock, noticed that there was a

decline in stock price. It went from 250 pence per share in 2006 to 180 pence per

share in 2007. With pressure from investors and the need to increase production

efficiency, Greystock decided to renovate Merseyside so the company would be able

to continue to be one of the major competitors in the industry. Greystock analyzed

the problem and came up with four different components, which soon became

criticized and questioned by other people.

Capital Expenditures

The company included four types of methods in order to determine its

capital budgeting for proposed projections: Earning per Share, Pay Back Period, Net

Present Value, and Internal Rate of Return. In this specific case, it does not make

much sense to use Earnings per Share and Pay Back Period to evaluate the project.

Earnings per Share is more acceptable for shorter term projects because it focuses
more on current cash flows rather the direct. Pay Back Period is not a good

determining factor as well because it does not take into consideration the time value

of money when accepting a project and it also ignores cash flows that happen after

the pay back period. Using NPV and the IRR makes more sense in this case because

NPV accounts for all costs relevant to the project at hand and includes the cash flow.

IRR is also useful because of the positive picture it creates and that it factors risk

into the calculation.

Possible Internal Cannibalization

The director of sales made note that if the company were to accept the

project, then it would most likely have to shift capacity away from Rotterdam and

focus on Merseyside in order to adjust for cannibalization. The director of sales

believes it is not a good idea to accept the project because of the risk for internal

cannibalization. Looking at the current NPV of the company, it is obvious that

internal cannibalization is possible, but not strong enough to bring the NPV to a

concerning level. The NPV of the company is at a strong point where it can take a hit

and the company would still be in good shape.

Concerns of The Assistant Plant Manager

The assistant plant manager, Griffin Tewitt, proposed an idea to modernize

the separate and independent part of the Merseyside Works, which was the

production line for ethylene-propylene-copolymer rubber (EPC). Tewitt claimed the

renovation would cost the company GBP1 million and would give Victoria Chemicals
the lowest cost base for EPC in the world and also improve cash flows by GBP25,000

ad infinitum. Even with this cash flow advantage, it would leave the company’s NPV

at a negative GBP750,000. It was argued that the positive NPV of the poly

renovations would be able to sustain the repercussions of the EPC project producing

a negative NPV. It is clear to see that Dewitt may not have the best intentions with

the proposal and to reject his plans.

Concerns of the Treasury Staff

Andrew Gowen, treasury staff, had a few suggestions regarding Greystock’s

analysis. Greystock did not take into consideration that in regards to inflation, cash

flows and discount rates needed to be consistent. In Greystock’s analysis, he did not

account for inflation. In my analysis in exhibit 3 in excel, I used an inflation rate of

2% since inflation is a constant.

Changes From the Assistant Plant Manager

After reviewing Greystock’s analysis and looking at different opinions, it was

obvious that there needed to be changes to the manager’s assumptions. First, I

added in the inflation rate of 2% starting with the first year. Next, I had to account

for depreciation for the tank cars. In the original analysis, this was not taken into

consideration, which needs to be since they are accelerating the date of when you

need more tanks from 2012 to 2010. Since we are adding in the tank cars into

depreciation, capital expenditure of GBP2 million was needed for 2011. Then to

calculate the depreciation, the DDB method was used for the first eight years and
then the last two years were calculated using the straight-line method. I also

disregarded overhead costs and engineering costs. I did this because overhead has

to do with allocation and engineering costs is a sunk cost, which does not get used

for determining the NPV.

Clear Benefits

Benefits from accepting this project include a 7% throughput as well as the

gross margin improving from 11.5% to 12.5%. Another added benefit is the energy

savings that will increase sale by 1.25% in year 5 and .75% of sales for years 6-10.

These benefits will be reflected as income revenue.

Scenario Analysis

When Lucy Morris took over as plant manager, there were many opportunities to

improve the production. By making improvements, would in the long run save

energy and improve the entire process. With all of the possible improvements they

could achieve, it would require an expenditure of GBP12 million for this program.

a) Temporary Closing of the Plant

A disadvantage of this proposal would mean that the plant would need to be

shut down for at least 45 days. This would cause customers to buy from

competitors, though it is to be believed it would not be permanent. It is only

assumed that it would be closed for a 45 days. In my analysis, I test out what would

happen if the plant stays closed for longer than that in Table 1.
Table 1

# of Days Closed 45 60 90

NPV 15.42 14.76 13.44

IRR 29.1% 27.7% 25.2%

Even with the company closed down for up to three months, this still does not have

that big of an effect on the NPV or the IRR. With loyal customers, closing down

should not be an issue to the project.

b) Change in Price per Ton

Price per ton is pretty sensitive to the project NPV and IRR. Table 2 shows the

differences within an optimistic price versus and pessimistic price deflation.

Table 2

Price/Ton Base Optimistic Optimistic Pessimistic Pessimistic

0% 3% 5% -3% -5%

NPV 15.42 16.92 17.45 15.36 14.82

IRR 29.1% 30.60% 31.10% 28.90% 28.40%

Break Even 330

This scenario can be used when dealing with the scenario of the plant closing for 45

days or longer. It is possible to lose some customers, and in this scenario, the

pessimistic approach calculates a decline in the base price being sold for. Even with

a selling for 5% less, it did not make a big difference in the overall NPV or IRR for

the company. This approach could be useful when pricing against competitors in

order to regain customers.

c.) Decline in Energy Saving

There is a possibility that Victoria Chemicals may not obtain the energy savings that

is predicted. In table 3, I created a scenario the obtains the NPV and IRR at the

original proclaimed energy saving, half of that, and then 0% energy saving as an

extreme pessimistic view.

Table 3

Energy Saving Base 50% decrease 100% decrease

Yr 1-5 1.25% .63% 0%

Yr 6-10 .75% .38% 0%

NPV 15.42 11.11 6.8

IRR 29.1% 23.30% 17.90%

This proves that if the company experiences a lower energy level than expected, the

NPV is affected but not to a negative level, even with a 100% decrease.
 Data Analysis

With the original data from Greystock, the expected Net Present value of this

project was GBP10.45 million. In the adjusted analysis in exhibit 3, all of the changes

made as mentioned create an NPV of GBP15.42 million. If the NPV of a project is

greater than zero, a company can assume that this would be an acceptable project to

take on. In this case, the NPV is at a solid level and can expect to have high returns

for stockholders.

The Internal Rate of Return of the original Greystock analysis was placed at

24% and with the adjusted changes it was able to reach 29.1%. The IRR is important

in this project because it includes risk in its measure. The IRR is necessary because

of the economic state the market is in. The IRR must be greater than the hurdle rate

of 10% and this project achieves that in both analyses.

Decision Criteria

There were concerns with the sales and marketing departments that internal

cannibalism could be a problem with this project, especially with the sales of

Rotterdam. As discussed previously, the NPV of the company is at a level so great,

that even with 100% cannibalism, the NPV would still be at a positive level, making

this factor not necessary for the decision on acceptance.

Recommendation

After careful analysis of the project, it is concluded that Victoria Chemicals

should go ahead with the proposal. With the high NPV and IRR, the capital program
shows that it will be a success. After the market becomes more stable, the company

is expected to be in a dominant position in the competitive market and is expected

to take more market share than it previously did.