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Copy of Victoria Chemicals PLC (A):

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NoorusSubah Hassan

on 8 February 2014

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Transcript of Copy of Victoria Chemicals PLC (A):

Attractiveness of Project
Promotion for Funding
Victoria Chemicals PLC (A):
The Merseyside Project

Changes to DCF Model
Transport Division

Concern: cost of tank cars should be included in the initial outlay of the Merseyside Works Program, rather than in the books of Transport Division

Demand for the product is below what VC is supplying
No reflection for use of excessive rolling stock in preliminary DCF analysis
Scenario: project is rejected
Tanks remains idle
Scenario: accelerating purchase from 2012 to 2010
Recognition of depreciation expense 2 years earlier
Time value of money
Opportunity cost: using the rolling stock now means that there will be less capacity for the future

Director of Sales

Concern: ability to sell added output despite current industry downturn.
“Why are we spending money so that one plant can cannibalise the other?”
Transfer capacity away from Rotterdam toward Merseyside
Produce products at lower costs --> sell at a lower price
Reach out to a broader number of customers, and sell off our products more effectively
Shift from Rotterdam to Merseyside: Rotterdam will lose sales --> accounted for a 6% loss
Risk associated with our decision: possibility of incurring inventory storage costs resulting from oversupply

Executive: Griffin Tewitt
Concerns: include the renovation of the EPC production line as part of the polypropylene line based on the argument that it would give VC the lowest cost base , and improve cash flows by £25,000 indefinitely.
EPC had only been marginally profitable due to the entry of competitors and the introduction of other competing materials.
Tewitt’s argument: investing now increase competitive positioning --> only an assumption
negative NPV of -£750,000: disadvantages outweigh the benefits
Our decision: ignore proposal of the EPC project
Positive NPV associated with the polypropylene project could be used to exploit more attractive opportunities the future

Director of Sales – Assistant Plant Manager
Response to Executives
Director of Sales – Assistant Plant Manager

Concern: “in the last 20 years, no one from the corporate has monitored renovation projects once the investment decision was made” - Tewitt
Ethical dilemma: executive bonuses pegged to performance of individual divisions
Executives try to maximise the operations --> may not be in the best interests of the company/shareholders
Initial outlay of £1 million could be added to the polypropylene project which offers a positive NPV

Analyst from Treasury Staff

Executive: Andrew Gowan
Concern: 10% hurdle rate excludes inflation. Greystock continued with discount rate because it was promoted in VC’s capital budgeting manual.

3% inflation rate
Our decision: proceed with a 7% real hurdle rate

Company’s current condition
The Merseyside project
The NPV and IRR from the original DCF analysis
New DCF analysis with consideration of relevant issues
Address concerns of the managers
Attractiveness of the project

Company Overview
Pressure from investors for a better financial performance
Earnings decline from 250 pence in 2006 to 180 pence in 2007
Threat of takeover from corporate raider: Sir David Benjamin
Old production process
Less competitive

The Merseyside Project
£12 million initial outlay
Renovate and rationalize the production line at the Merseyside plant
Make up for deferred maintenance and increase production efficiency
Increased gross margin from 11.5% to 12.5%
Achieve energy savings

NPV= £10.57m
The project can create shareholders’ wealth
Should accept the project
did not consider issues from other departments
Issues from other Departments
Transport division- rolling stock purchasing costs and depreciation
Sales department- cannibalisation charge
Assistant plant manager- EPC project
Treasury staff- discount rate 10% vs. 7%

Modifications to DCF model
Our Approach
Look in-depth into the Original DCF
Identify wrong assumptions
Adjust each of these wrong assumptions
Assess the impact on the DCF
Develope the overall DCF model

Non-financial: Cannibalisation of Rotterdam plant
Production output increased after the renovation
excess in supply for the Merseyside plant
Capacity in the Rotterdam plant shifted towards Merseyside
Concerns for Rotterdam employees

Greystock’s Original DCF
NPV £10.57m
IRR 24.3%

Wrong Assumptions: Greystock's DCF
1. Close-down period is too short
2. Included sunk cost of preliminary engineering cost
3. Double-Declining-Balance depreciation method (increase the tax shield benefit in the beginning years)
4. Discount rate of 10% was used: nominal rate rather than real rate
5. Did not account for sale cannibalisation
6. Ignored the earlier outlay of rolling stock

1. Close-down period
Close-down period of 1.5 months is too ambitious considering the size of the project
Sensitivity anlaysis: down-time increased to 2, 2.5 & 3 months
Still shows positive NPV & IRR of >20%

2. Sunk Cost
Preliminary Engineering cost of 0.5 million is already spent over the last 9 months
Sunk cost should be excluded in the DCF
Impact on DCF:

3. Depreciation
Original model used an aggressive double-declining-balance method for depreciation --> increases the tax shield benefit of earlier years
To be conservative and eliminate chances of approving investment based ONLY on tax shield benefit, we changed to straight line depreciation
This only had a marginal impact on the DCF

4. Discount Rate
The 10% used in the original model is the nominal rate which includes the inflation
The estimated long term inflation rate is 3% (as suggested by the analyst from the Treasury department)
To find “real” NPV: use real discount rate of 7%
Impact on the DCF (increased NPV):

5. Sales Cannibalisation
If the Merseyside project were to continue resources has to be re-allocated from the Rotterdam plant to this project
original DCF did not account for this reduction in resources over at the Rotterdam plant
Since this reallocation would not have happened had the project not been implemented
incremental cost and should be account for in the DCF.
To account for this sale cannibalization, decreased the estimated sale of the new project

Non-financial: Ethical Issues
EPC rubber project rejected: negative NPV
Tewitt’s suggestion
Include EPC production line as part of the Polypropylene renovations
Achieve the lowest EPC cost base
Opportunity to exploit the market when economy recovers
Scenario: EPC renovations are not completed however
Company will exit the business within 3 years
Managers’ bonuses will fall --> agency cost
Recommendation: reject the EPC operation as part of the renovations
Allocation the £2 million cost for the rolling stock to the other division
Non-financial: Management Issues
Diffuse the conflict between departments once the project is accepted
Issue: in the last 20 years, none of the renovation projects have been monitored by corporate once the investment decision was made
Recommendation: devise a strategy for project monitoring

Instead of earning the full 100% of the new sales, because of sale cannibalisation only a portion of this amount is earned.
Sensitivity analysis – decrease new sales by 4%, 5% 6%
Impact on NPV and IRR:

6. Bring forward rolling stock expense
If they continue with the project they would have to incur a estimated $2 m expense in rolling stock 2 years earlier, moving the cash outlay from 2012 to 2010
Time value of money, by incurring the cost earlier they lose out on the interest that the £2m could have earned instead
This is not accounted for the original model
incremental expense --> should be considered
Added the opportunity cost interest revenue in the DCF
2 year UK risk free rate of 2.8%

Overall model
Adjusted the 6 wrong assumptions in the original model we made the following adjustments:
Increasing shut down period to 3 months
Excluded sunk cost
Change depreciation to straight line
Used ‘real’ discount rate
Accounted for sale cannibalisation
Included opportunity cost of purchasing rolling stock

Since NPV is positive, IRR >10%, EPS contribution is positive they should proceed with this project
Economic Downturn
Investing when the economy is in recession
When the economy strengthens, the project has established competitive positioning

Cost Reduction
Increase the competitive environment
Leader in the industry
Achieving benefits during period when competitors are catching up

Creation of Synergies
Loss of business at Rotterdam--> reduce sales volume and revenue
Encourage a positive change in margin channel, improve cash-flows from growth of new product sales
Increase market share

Shareholder Value
EPS can enjoy upturn from profit
Dividend cumulated and paid to shareholders next period
If profit gained is lower than expectation, the dividends will be sustained at most the same as previous period to retain shareholder confidence

Jess Chen
Antonia Yeung
Thuy Pham
Eunice She
Brian Lau

Merseyside project
Satisfaction of Investment Criteria
Satisfied 3 out of 4 performance 'hurdles' for engineering-efficiency projects
Average annual addition to EPS = GBP0.012: remains positive
Payback period of
9 years
: exceeds maximum of 6 years allowed
NPV of £4.32m: positive
IRR of 12.2%: above the 10% hurdle rate
Financially attractive to senior management
Full transcript