Late one afternoon in January 2008, Frank Greystock told Luey Morris, “No one seems satisfied with the analysis so far, bt the suggested changes could kill the proj- ct, If solid projects like this ean’t swim past the corporate piranhas, the company will never medemnize.” “Morris was plant manager of Victoria Chemicals’ Merseyside Works in Liverpool, England, Her controler, Frank Greystock, was discussing a capital project that Mortis ‘wanted to propose to senior management. The project consisted of a (British pounds) GBP12 million expenditure to renovate and rationalize the polypropylene production line at the Merseyside plant in order 10 make up for deferred maintenance and to ‘exploit opportunities to achieve increased production efficiency. Victoria Chemicals was under pressure from investors to improve its financial per- formance because of the accumulation of the firm's common shares by a well-known, corporate raider, Sit David Benjamin. Earnings had fallen to 180 penct per share at the end of 2007 from around 250 pence per share at the end of 2006, Morris thus believed that the time was ripe to obtain funding from corporate headquarters for a ‘modernization program for the Merseyside Works—at least she had believed this until Greystock presented her with several questions that had only recently surfaced, Victoria Chemicals and Polypropylene ‘Victaria Chemicals, a major competitor in the worldwide chemicals industry, was a lead {ng producer of polypropylene, a polymer used in an extremely wide variety of prox ‘ucts (ranging from medical products fo packaging film, carpet fibers, and automobile “Tis cnc was prepared by Rober F Brute a a ase for ls dseusion rae than oust effectve to infective hing ofan amiistatve station, itr Chemical is ftiona company retin, ‘he sues facing actual fis, The ator wishes seksonedge the bepfl comments of. Frank H. ‘Metin te lierry color of Aion Trollope, athe feancialsopprt ofthe Ceo Global bolas Program Cop ght © 2008 by the Univesity of Virgina Dalen School Poadaton, Charlot, VA Allright ered To onfer copies, send an emai sles @dadentsinespublising com. No part of this paication my be rpodce, stored ina reival stem sed ina speaishet or tanamted i any form or by ay meaner, mechanical. phosoeopyin, recon, or herise—mithou the ‘pemistion of te Doren Schoo! Roundaton Re, 3/1at Fou Capital Bdgting and Resource Allocation components) and know for its sirength and mallesblity. Polypropylene was esse) priced as a commodity. 4 ‘The production of polypropylene pellets at Merseyside Works began with propslene ‘refined gas received jn tank ears. Propylene was purchased ftom four relinrios = England that produced it inthe Course of refining crude oi into gasoline. n the fir = of the production process, polyinerization, the propylene gas was combined with s = cnt (or solvent) in a large pressire vessel. In a catalytic eaction, the polypropylene p= Cpitated to the bottom of the tink and was then concentrated in a centrifuge. ‘The second stage of the production process compounded the basic polyprop= With stabilizers, modifiers, filers, and pigments to achieve the desired attributes fe © particular customer. The finished plastic was extruded into pellets for shipment to = customer, ‘The Merseyside Works production process was old, semicontinuous at b therefore, higher in labor content than its competitors’ newer plants. The Meney# ‘Works plant was constructed in 1967, Victoria Chemicals produced polypropylene at Merseyside Works and in Ro dam, Holland, The two plants were of identical scale, age, and design. The man of both plants reported to James Fawn, executive vice president and manager 0! Intermediate Chemicals Group (ICG) of Vietoria Chemicals. The eompany posi itself as a supplier to customers in Europe and the Middle East. The stategic-aay staff estimated that, in addition to numerous small producers, seven major come tors manufactured polypropylene in Victoria Chemicals” market region. Their p operated at various cost levels. Exhibit 1 presents a comparison af plant sizes indexed costs f ‘The Proposed Capital Program Morris had assumed responsifility for the Merseyside Works only 12 months ‘ously, following a rapid ise from the enty positon of shift engineer nine years bei ‘When she assumed responsibility, she undertook a detailed review of the operat and discovered significant opportunities for improvement in polypropylene p> tion. Some of those opportunites stemmed from the deferal of maintenance ovr preceding five years. In an effort tenance the operating results of Mersey ‘Works, the previous manager had limited capital expenditures to only the mos! es= tial. Now what previously had been routine and deferrable was becoming esser== Otter opportunites stemmed from correcting the antiquated plant desiga in ways ‘would save energy and improv the process low: (1) relocating and moderniz ar unloading areas, which would enable the process flow tobe streamline; (2) 1 bishing the polymerization tank to achieve higher pressures and thus greater thre: puts and (3) renovating the compounding plant to nerease extrusion throughput st ovain enerey savings. Morris proposed an expeaditure of GBPI2 million on this program. The ext polymerization line would need tbe shut down for 45 days, however, an because i Rotterdam plant was operaing near capaciy, Merseyside Works’ customers would hy froin competitors, Greysock believed the los of customers would not be perma‘case 24. Vict Chemical ple (A): fhe Merseyside Project 35 “The benefits would be «lower energy requirement’ as well as a 75 greater manufae- {uring throughput. In ation, the project was expected to improve gross margin (before Alepecition and energy savings) from 11.5% to 125%. The engineering group at 4 ‘Merseyside Works was highly confident thatthe efiiencies. would be realized “Merseyside Works currently produced 250.000 metric tons of polypropylene pel lets a year. Currently, the price of polypropylene averaged GBPO7S per ton for Victoria Chemicals’ product nix. The tx rate required in capita-expenditure analy- ses was 30%. Greystock discovered that any plant feiltes to be replaced hd been Completely depreciated. New assets could he depreciated on an accelerated basis” over 43 years, the expected life oF the sets. The increased throughput would necessitate an crease of work-in;process invenlory equal in value to 3.0% of cost of goods. Greystock included in the fst year of his forecast preliminary engineering costs of {GBP500,000 spent over the proveding nine months on efficiency and design studies fof the renovation. Finally, she corporate manual stipulated that overhead costs be relleted in project analyses the rate of 3.5% times the book value of assets aequired in the project per year? | GGreystock hd produced the discounted-cash-low (DCF) summary given in Exhibit 2 It soggested thatthe capital program would easily hurdle Victoria Chem- ieals’ required rtum of 10% for engineering projects Concerns of the Transport Division ‘Victoria Chemicals owned the tank eats with which Merseyside Works received propy- Jene gas from four petroleum refineries in England. The Transport Division, a cost cen- ter, oversaw the movement of all raw, intermediate, and finished materials throughout the company and was responsible for managing the tank cars. Because of the project's ‘Gram characrza the energy saving ba percentage of ales ad asumed that the savings woul be quan 125% of ale ache fist ve years and 0.79% sn years 6-10. heer, witht added agressive ‘Stenapening the every etic’ ofthe plat would eer oso level and be savings would te ro He lieved ta the Gesnon 0 ake further evitomneily cient vests was a erate ‘he aed ove at shld Be mace much ts) td, berfoe that 1 nla such Heels (of resum bly ner imeament devo) tbe projet Being conser tay on be appropriate. Ste comp’ caital-xpend manual suggested th ws of doube-detining-balaee (DDI depecia tion eating oer more agressive prosedresmiht be permite by te tax coe. The reason fois otcy nas to isourage jockeying fr corporate appeals ase on ox ponsions ht could apply ier Thu Tor diferat pec aml in siows Privo senor matagemens val, the conte’ Saf would ret onndependa ans fel tax fects tht igh app. Divison mages, went wre “TScsuraged frm yng heavily gn thous plying the DDB approach, acsered depreciation es tne ut ne suaight in eaeuaton gave bigher numer at wich pone depesiaion mas canted sighting busi The comve'sion otal ie was commonly dove otha he asset would depec be fully wins camomile | She conte -oliey manual sah toe projets shoud beable o ssa reasonable proportion of out ovread expense. ross ht vere sb warital so Be mabe oan hse expenses and areuat ne eherctet of vestment atractiveacs shuld ao be undertaken, Ths all ew cpt proj Ta thoi wert anal tay charge amowating wo 3.5% ofthe vale ofthe nia se investent for the projetat Four Cais Budting an Resource Alloson ‘increased throughput, the Transport Division would have to increase its allocation of tank cars t Merseyside Works. Curren, the Transport Division ould make this allo ‘ation out of excess capacity, although Going, so would accelerate from 2012 to 2010 the need to purchase new rolling stock 9 support the nteipated growth ofthe firm in bother areas, The purchase was estimated fo be GBP2 millon in 2010, The rolling tock svonld have a depreciable life of 10 years, but with proper maintenance, the eas cout Spernte mach longer. The rolling stock could got be used outside Britain because of difereness in rack gauge . "A memoranda from the concoll of the Transport Division suggested that the cost of the tank cars should be included in the intial outlay of Merseyside Works capital program. But Groystock disagreed. He told Mortis “The "Transport Division isn’t paying one pence of actual cash because of what we're doin ai Merseyside. In fat, we're doing the Gompany a favor in wsing is excess capacity. Even allocation has o be made somewhere, it should goon the Transpo Divisions books “The way we've always evalate projet in his company has ben wth the philosophy “every tub ents on botton”—eery vision hast fer for set. The Transport Dit sion pat of our owe Intermediate Chemicals Group so they sould cry the alos 2 tion af olin stk ‘Accordingly, Greystock had not releted any charge forthe se of excess ralling stock in his preliminary DCF analysis, given in Exhibit 2. “The Transport Division and Intermediate Chemicals Group reported © separate executive vice presidents, who reporel to te chairman and chet executive officer of the company, The executive vice presents received an annual inentive bonus pegged to the performance of their divisions, Concerns of the ICG Sales and Marketing Department Greystock’s analysis had Jed to questions from the director of sales. In a recent moc ing, the director had told Greysteck: | ‘Youe analysis assumes that we ean Sell headed output and thus obtain the full efficiencies from the projec, but as you know, the market fr polypropylene is extremely competitive Right now; the industry sina down and it ook ike an oversupply i inthe works. “This means that we will probably hay to shift capacity away from Rovterdam toward ‘Merseyside in order to move the ade volume. I this really agin for Victoria Chemicals? ‘Why spend money just so one plant can cannibalize another? “The vice president of marketing vas less skeptical. He said that with lower costs at Merseyside Works, Victoria Cheniicals might be able to take business from the plants of competitors such as Saine-Poulet or Vaysol. Inthe eurrent severe recession, Competitors would fight hard to keep customers, but sooner or later the market would Frac ianson isin deprecated ling tock xing DDB depron othe fit ight yas and staighclinedopsiaton fore ast two yea(se Vicia Chemicals le (A: The Meese Prost revive, and it would be reasonable 6) assume that any Jost business volume would return at that time, Greystock had listened to both the director and the vice president and chose to reflect no charge fora loss of business at Roterdam in his preliminary analysis of the Merseyside project. He told Mortis Cannibalization really isn't a cash flow; there is no check writen in this instance Anyway, if the company starts burdéning is cost-eduction projects with fcttious charges like this, we'll never maintain our cost competitiveness. A cannbalieation ‘charg is eubbish! Concerns of the Assistant Plant Manager Gritin Tewit, the assistant plant manager and Morris's diceet subordinate, proposed an unusual modification t Greystock’s analysis during a lateafteroon meeting ith Greystock and Mortis. Over the past few months, Tewitt had been absorbed with the development of a proposal to modemize a separate and independent part of the Merseyside Works, the proluction ine for ethylene-propylene-copolymer rubber (ERC). This product, «variety of sythetic rubber, hal been pioneered by Vitoria Chemicals inthe early 1960s and ws sold in bulk to Exropean tire manufacturers Despite hopes that this oxidation-resigant rubber would dominate the market in sy thetcs, EPC remained a relatively small product in the European chemical indus. Victoria Chemicals, the largest supplier of EPC, produced the entte volume at Merseyside Works. BPC had been arly marginally profitable to Victoria Chemicals because of the entty by competitors and the development of competing synthetic- ruber compounds over the past five yeas, ‘Tewit had proposed «renovation of the FPC production line at a cost of GBPI nillion, The renovation would give Vieloria Chemicals the lowest EPC cost base in the world and would improve cash flows by GBP25,000 ad infinitum. Even so, at current Prices and volumes, the net present yilue (NPV) of this project was ~GBP750,000. Tewit and the EPC product mangger had argued strenuously to the company’s exee~ tive commit that dhe negative NPV ignored strategic advantages from the projet and increases in volume and prices when the recession ended, Nevertheless, the exceu- Sve committer had rejected the projet, basing its rejection mainly on economic grounds Tn a hushed voice, Tewit said to Morris and Greystoc: ‘Why don’ you ined the EPC projec pat ofthe polypropylene line renovations? The positive NPV ofthe poly renovations can easily sustain th egaive NPY ofthe EPC pro «this isan extemely important prec the company, pit Bat senior management loca see to get If We inves no, el be ready to explo the market when the rece sion ends we don't invest om, you an expec that we wil have exit the business alo- setter inthe years. Do you ook frat more ao? Do you watt manage a stinking plant? Recall hat our anne! bonuses re pegged the ie a his operation ‘Als remem: tha in he ast 20 yeu, o one fom corporate hts manioeenovation projets one the investnent decision as madeas Pt Four Capital Budgeting and Rescurce Alation Concerns of the Treasury Staff ‘After a meeting on a different matter, Greystock described his dilemmas to Andrew Gowan, who worked as an analyst or: Victoria Chemicals’ treasury staff. Gowan scanned Greystock’s analysis and pointed out: ‘Cash flows and discount rate need tobe ednsistent in thee assumptions about inflation, The 105 hurdle rate you're using is amma target rate of return. The Treasury staff inks ‘is imponds longer inflation expectation of 3% per yar. Thus, Viewria Chemicals” real thai, zero ination) target te of rum is 7%, “The conversation was interrupt=4 before Greystock could gain foll understanding ‘of Gowan's comment. For the time being, Greystock decided to continue to use a dis ‘count rate of 10% because it was tre figure promoted in the latest edition of Victoria Chemicals? capital-budgeting manval Evaluating Capital-Expenditure Proposals at Victoria Chemicals {In submitting a project for senior management's approval, the project's initiators had identify it as belonging to one of four possible categories: (1) new product oF market {Q) product or market extension, (3) engineering efficiency o (4) safety or environment, ‘The first three categories of proposals were subject to a system of four performance “undles," of which atleast three had to be met for the proposal 10 be: considered. The Merseyside project would be in the engineering-elficiency category. i 1. Impact on earnings per share: For engineering-eficiency projects, the contribu | tion to net income from contemplated projects had to be positive. Ths criterion ‘as calculated as the average annual earnings per share (EPS) contribution of project over its entre econom.e life, using the numberof outstanding shares atthe ‘ost recent fiscal year-end (FYE) asthe basis forthe calculation, (At PYE2007, ‘Vietoria Chemicals had 92,891,240 shares outstanding.) 2. Payback: This criterion was dfined asthe numberof years necessary for fee cash flow of the project to amortize the inital project outlay completely. For engineer ing efficieney projects, the meximum payback period was six yeas, 13, Discounted cashflow: DCF w xs defined as the present value of future cash flows of the project (at the hurdle rate of 10% for engineesing-cfficiency proposals) less the inal investment outlay. ‘This 2et present value of free cash flows had co be positive 4. Internal vate of return: IRR ves defined as being the discount rate at which the present value of future free c:sh lows just equated the inital outlay—in other Sords, the rate at which the NPV was zero, The IRR of engineering-efficiency projects had to be greater than 10%. Conclusion Morris wanted to review Greystick’s analysis in detail and setle the questions sut- rounding the tank cars and the potential loss of business volume at Rotterdam. As‘case 24 Vitis Chemical ple (A: The Meeysde Pojct, 385 Greystock’s analysis now stood, the Merseyside project met all four investment criteria: 1. Average annual addition to EPS = GBP).022 2. Payback period = 3.8 years 3, Net present value = GBP1O6 rallion 4, Taternal rate of retun = 24.3% ‘Morris was concerned that further tinkering might seriously weaken the attractiveness Cf the project. EXHIBIT 1 | Comparative Information on the S2ven Largest Polypropylone Pants in EWrOP®. Production Cost Plant ‘perTon Plant Yeartiant Annual Output ——_(indexed to fow- Location uit (in metze tons) ‘cost producer) CBT AG ‘Saaibrn rot 50,000 1.00 ‘itoria Chemicals Liverpool 197 250,000, 1.08 ‘Vetoria Chemicals oterdam 1057 250,000, 1.09 Hosen AS. Hamburg 1977 ‘300,000 02 Montecassino SpA Genoa. 1031 120.900 un ‘Sate Foulot S.A. Marsoite 1872 175,000 tor Vaysol SA Artwerp 178 220000 108 ‘New 10 largest plants 450,000, 119 Nee ee __—_—- ee ‘Sour Caso wer ss.“ep ena oem op ees wpa aig