VICTORIA CHEMICALS PLC (A): THE MERSEYSIDE PROJECT

Capital Budgeting Ca e Anal! i

VICTORIA CHEMICALS: CASE BAC"#RO$%D 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 erseyside !orks plant in "iverpool, #ngland, and the $otterdam facility in $otterdam, %olland. The plants were built in &'() and are identical in scale and design. *dditionally, managers of both plants reported to +ames ,awn, the e-ecutive vice president and manager of the Intermediate Chemicals .roup /IC.0. The production of polypropylene pellets begins at erseyside with propylene, a refined

gas received in tank cars known as propylene. The production process consisted of two stages1 In the first stage, the gas form of polypropylene was combined with a solvent in a pressuri2ed vessel and then concentrated and collected in a centrifuge. 3e-t, the polypropylene was mi-ed with stabili2ers, 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 #urope and the iddle #ast.

In addition to small producers, seven major competitors manufactured polypropylene in Victoria Chemicals4 market region. Their plants operated at various cost levels. Primary competitors C5T. *... and %osche *... were able to produce higher annual output at lower costs per ton. Table & on the following page presents a comparison of plant si2es and inde-ed costs.

Ta&le ': C()pa*i (n (n t+e Se,en La*ge t P(l!p*(p!lene Plant in Eu*(pe

Plant Plant Plant Name Locatio n
CBTG A.G. Victoria Chemicals Victoria Chemicals 'osche A.G. )ontecassino S!A Saone*+oulet S.A. Va,sol S.A. .e/t 10 Lar(est +lants Saabrun Li er!ool %otter&a m 'ambur( Genoa )arseille Ant-er!

Product Cost per ton (indexed to low-cost producer)

1.00 1.09 1.09 1.0$ 1.11 1.0# 1.0" 1.19

Year Plant Built

1981 19"# 19"# 19## 19"1 19#$ 19#"

Annual Output (in metric tons)

350,000 $50,000 $50,000 300,000 1$0,000 1#5,000 $$0,000 050,000

VICTORIA CHEMICALS: ISS$ES-PROBLEMS In 677), Victoria Chemicals e-perienced a significant drop in its financial performance from 677(. The company was under pressure to improve its performance as its earnings had fallen 89: from 6;7 pence per share to &97 pence per share in a year. In addition, Victoria Chemicals saw the accumulation of its common shares by a well<known corporate raider named =ir >avid 5enjamin. The entrance of a corporate raider may have shown that the firms4 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 company4s value was due in large part to its current production process and the condition of its facilities1 The method of producing the polypropylene at the erseyside !orks plant was obsolete compared to new technology with its competitors, and re?uired more labor than the process used by its competitors. *s well, the previous manager of the plant had enhanced operating results by minimi2ing capital e-penditures 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.

*nother 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. 5ecause both their plants are older and use a semi continuous production process, Victoria Chemicals re?uires 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. ontecassino is the only other firm among the top ) whose costs are higher than that of Victoria Chemicals, but it is an older plant /built in &'(&0 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. .iven these factors, erseyside !orks. erseyside !orks plant manager "ucy orris thought it an ideal

time to seek funding from corporate head?uarters for a moderni2ation program for the orris felt this move would help improve the company4s financial situation and help them remain a major competitor in the worldwide chemical industry. VICTORIA CHEMICALS: THE PROPOSED PROJECT orris and her controller, ,rank .reystock, proposed a project to overhaul the entire polymeri2ation line at a cost of .5P &6 million. The proposed project would be to renovate and rationali2e the polypropylene production line at the erseyside plant in order to make up for deferred maintenance and to e-ploit opportunities to achieve increased production efficiency. orris revealed the areas of opportunity in which the project covered1 3o longer defer maintenance on essential tools and e?uipment re?uired in the production process. Correct the plant design on ways that would save energy and improve the process flow by1 o $elocating and moderni2ing the tank<car unloading areas, which would enable the process flow to be streamlined. o $efurbishing the polymeri2ation tank to achieve higher pressures and thus greater throughput.

o $enovating the compounding plant to increase e-trusion throughput and obtain energy savings. The benefits of this project were increased efficiencies in terms of1

$educed energy consumption, which was assumed to e?ual &.6;: of sales in the first year and .);: in years (<&7.

Increased gross margin of up to &6.;:. Increased manufacturing output. Currently, Victoria Chemicals was producing 6;7,777 tons of polypropylene pellets a year at a price of .5P(); per ton. The project would also result in seven percent /):0 greater manufacturing throughput@ however, the entire line would need to be shut down for A; days in the first year for construction. 5ased on the current annual 6;7,777 ton production figure, Victoria Chemicals would e-perience roughly a &8: decrease in production for that year upon implementing the project. The &8: figure was determined using the following e?uation where &.; /months0 e?uals A; days in which the plant would be shut down for construction1

The ta- rate re?uired in the capital<e-penditure analysis was 87:. .reystock also speculated that any new assets ac?uired would depreciate in &; years. In addition, he predicted that in the first year the company would incur .5P;77, 777 in engineering costs due to the renovation. VICTORIA CHEMICALS: CO%CER%S .ITH THE PROPOSED PROJECT #ven though the project seemed to have promising returns, there were some issues or concerns that were associated with the project. $enovating the at near<ma-imum capacity, which would cause erseyside plant would re?uire it to shut down for A; days. This was a problem because the $otterdam plant was already operating erseyside !orks4 customers to buy from competitors until the renovation was completed. #ven still, ,rank .reystock, a controller at Victoria Chemicals, assumed that this loss of customers would be temporary.

,urthermore, Victoria Chemicals owned the tank cars with which

erseyside !orks

received propylene gas from four petroleum refineries in #ngland. The Transport >ivision, which oversaw the movement of all raw, intermediate, and finished materials throughout the company and was responsible for managing the tank cars, reali2ed that it would be re?uired to be increase its allocation of tank cars to erseyside to support the growth that the renovation would bring. Currently, the allocation could be made out of e-cess 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 .5P6 million in 67&7. $olling stock would have a depreciable life of &7 years, but could operate much longer with proper maintenance. The rolling stock also could not be used outside of 5ritain because of differences in track gauges, which meant that the trucks could not be used to ship product to its primary customers in the #ast. The Transport >ivision believed that the cost of the tank cars should be included in the initial outlay of erseyside !orks4 capital program. %owever, .reystock disagreed, noting that they were doing the company a favor by using the e-cess capacity and that company has always operated in silos. *s such .reystock did not include the charge /cost of e-cess rolling stock0 in the proposal on the grounds that the division should carry the allocation of rolling stock. The Transport >ivision was not the only division with concerns. The IC. =ales and arketing department had some ?uestions of their own. The director of sales said that the .reystock4s analysis assumed that the company would be able to sell the increased output brought on by the renovation. %owever, the entire industry was e-periencing a downturn@ thus, an oversupply of polypropylene could occur. To combat the oversupply, the company would likely shift capacity from $otterdam to erseyside, which could result in erseyside cannibali2ing $otterdam. Bn 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. *fter hearing out both arguments, .reystock did not include charge for loss of business in his analysis as he felt a cannibali2ation charge was fictitious and including such charges would not allow them to maintain their cost competitiveness. iddle

.reystock4s discounted cash flow also suggested that the company would earn a &7: return on the project, even though the Treasury staff believed the real return to be ): due to a 8: in inflation per year. %owever, .reystock decided to continue to use a discount rate of &7: because it was the figure promoted in the latest edition of the company4s capital<budgeting manual. The high discount rate was problematic because, if the ): figure was more accurate, using the &7: rate would cause the company to accept projects /those that fall between seven and &7 percent0 that should be rejected. Bn another note, .riffin Tewitt, assistant plant manager and orris4s direct subordinate,

proposed that .reystock modify his proposal to include a renovation of the #PC production line at a cost of .5P& million. %e believed that the renovation would give Victoria Chemicals the lowest #PC cost base in the world and would improve cash flows by .5P6;,777. The 3PV of this project was C.5P);7,777, which Tewitt argued that the negative 3PV ignored strategic advantages from the project and increases in volume and prices when the recession ended. VICTORIA CHEMICALS: EVAL$ATI%# THE PROPOSED PROJECT The project was considered an engineering<efficiency and, therefore, was re?uired to meet certain criteria before being approved. The criteria included1 &. Impact on earnings per share: The net income had to be positive when calculated as annual earnings per share /#P=0 over its entire life, using the number of outstanding shares at the most recent fiscal year<end as the basis for the calculation. 6. Payback: The payback period ma-imum was si- years. 8. Discounted cash flow: The net present value of all future cash flows had to be positive. A. Internal rate of return: The I$$ had to be greater than &7:. orris wanted to review .reystock4s analysis in order to resolve the issue of the tank cars and the loss of business that could occur. %owever, she was afraid that further analysis could lead to rejection of the project. The criteria1 &. *verage annual addition to #P= of .5P7.766 erseyside project, according to .reystock, met all four investment

6. Payback period of 8.9 years. 8. 3et present value of .5P&7.( million A. I$$ of 6A.8: In the following paper, we will analy2e the four criteria based on .reystock4s findings to determine if the analysis was conducted accurately and reflects true numbers or e-pectations of return on the erseyside project investment.

VICTORIA CHEMICALS: EAR%I%#S PER SHARE (EPS) The impact on #P= 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 #P= needs to be .5P7.766. Ddiscuss howEif we met this re?uirement@ steps we took to meet itF VICTORIA CHEMICALS: S$%" COSTS The plant manager has included the preliminary engineering costs of .5P ;77,777 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. !hether 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 >C, analysis. VICTORIA CHEMICALS: PI##YBAC" PROJECT ETHICAL DILEMMA The assistant plant manager, .riffin Tewitt, proposed to moderni2e a separate and independent part of erseyside !orks, the production line for #PC. %is argument was to include the #PC project as part of the renovation project that is currently being analy2ed. To improve the #PC production line it would cost .5P & million, but it would improve cash flows by .5P 6;,777 indefinitely. The #PC project has a negative 3PV of <.5P);7,777, and his

contention was that the bigger renovation project with a positive 3PV of .5P &7.( million /under the original calculation0 can absorb the losses of the #PC project. The benefits of the #PC project will come through when the recession ends and increase in volume and prices happen. *lthough the #PC project has potential to become larger, the #PC market has not been largely successful since its inception. In addition, an ethical dilemma occurs where Tewitt is asking .reystock to add his renovation project as part of the polypropylene line renovations stating that Gin the last 67 years, no one from corporate has monitored renovation projects once the investment decision is made. #ven if there would be benefits to the company overall, the #PC 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: COMPETITIO% .ITHI% DIVISIO%S 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. %aving the Transport >ivision and the Intermediate Chemicals .roup reporting to separate e-ecutive vice presidents is a problem. .enerally, the logistics divisions and manufacturing divisions of a company report to a single e-ecutive 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. *dditional issues of concern is that the plant managers4 bonuses are tied to the si2e of the plants they operate, which is not necessarily the proper incentive plan because operation si2e does not always positively correlate with efficiency and profit margins. Bther 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 e-penditure 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 re?uire the analysis to include the appropriate depreciation methods and ta- rates, as these factors have a significant effect on 3PV and I$$.

VICTORIA CHEMICALS: CA%%IBALI/ATIO% The sales department is concerned that the project may lead to e-cess capacity and due to e-cessive competition, capacity would be shifted from the $otterdam plant to the $otterdam plant would have to produce less. %owever, the the e-cess production would yield benefits in a growth period, and erseyside, and arketing department opines that erseyside may be able to

cannibali2e sales from competitors rather than its own sister plant at $otterdam. If the plants do not meet their sales volume then they would simply be running the more productive and efficient plant / erseyside0 to capacity and have $otterdam fulfill the overflow. There is no ?uestion of adding a cannibali2ation charge to the project e-pense, but it is a matter of concern for such projects.

C*ite*ia 01: %et P*e ent Value (%PV) C*ite*ia 02: Inte*nal Rate (3 Retu*n (IRR 4(und t+i in3( (nline5 Ma! appl!6 )a! n(t6 &ut 7u t ()e t+(ug+t : $ecommendation1 It is recommended that the purchase of the tanks be charged to the project cost, so
you can put this e-pense into the cost of the project plus tanks and have direct ownership of the plant. It is not considered that this new project can cannibali2e the plant in $otterdam, as the market covered by each plant is different, and the location is difficult for an end to the other plant. Bf the four methods, the

two most favorable to use for evaluation would be 3PV and I$$ while the #P= and P5P would be less favorable to use because of its evaluation process. Hsing 3PV 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: CO%CL$SIO%S There are various problems that keep Victoria Chemicals from achieving its financial goals. Bne of the first major problems is the fact that the erseyside plant re?uired 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. 5y implementing these changes, they will save energy and improve productivity. The company is proposing to upgrade the polymeri2ation line in addition to a increasing the production of their #PC line. *lthough the plant desperately needs renovations, closing down production for A; 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. %owever, 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. #ven though .reystock4s initial analysis met all of the performance GhurdlesI, he missed some important factors that would have improved the analysis. This could have been accomplished by changing the calculations as discussed@ 3PV and I$$ would prove to be better for the project4s projections. VICTORIA CHEMICALS: RECOMME%DATIO%S ,rank .reystock said that, G3o one seems satisfied with the analysis so far, but the suggested changes could kill the project.I 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 re?uires a lot of time and money. It is important that the company function as a cohesive unit. *lthough various departments may not always concur, it is important for the sake of the company to come to a mutual decision. The organi2ational 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 managers4 bonuses with the si2e of the plant. Instead, they should create incentives for efficiency, revenue, or turnover. * 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 #PC, 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 3PV of <);7,777 .5P. >ue to the fact that the #PC market is so small, it would be wasteful to spend so much money on the project. ultiple 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.

*lthough Victoria Chemicals is depreciating their machines using double declining balance method, this may be beneficial due to ta- reasons, and it may not look good to potential investors. 5y 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.