This case involves the dilemma between two mutually exclusive projects that Victoria Chemicals wants to proceed with, but can only choose one earning them 7% increase in polypropylene output per plant. The two proposals will be proposed by the plant managers and evaluated according to corporate criteria. They are to be evaluated on four credentials; Net present value, IRR, payback, and growth in EPS. However the two proposals are fairly different. The Rotterdam projects calls for the expenditure of 10. 5 million GBP spread over three years, firmly committing Victoria Chemicals to the new process technology.
The Merseyside project calls for 12 million GBP for renovations, retaining the flexibility to later add the technology in the future. The question is which project should the company take on based on the financial calculations including the company decision criteria. Rotterdam Proposal The Rotterdam proposal consisted of a 90 page document with strategic analyses, and financial projections. The basic discounted cash flow (DCF) shows the project having a positive NPV of 11 million GBP with a IRR of 15. 4%.
The initial invest spread over 3 years would help convert the plants polymerization line from batch to continuous-flow technology and to install sophisticated state-of-the-art process controls throughout the operations. This process has already been installed in several other production facilities in Japan and the improvements in cost and output had been positive on average. This proposal consists of 90 pages and already is giving a hint. In this proposal there can be a lot of bogus information which cant lead to false and misleading predictions.
It can be looked at as very sketch as to why it seems to be the “better” proposal. In essence, the Rotterdam proposal seeks to accomplish their goals by having the option to purchase the pipeline for GBP3. 5 million in initial capital investment for overhauling the plant, having a value of 6 million GBP which can be later sold 15 years later for approx.. 40 million GBP. This violates the stand-alone principle. Subsequently, the plan calls for spending another GBP5 million in 2001, GBP1 million for 2002, and another GBP1 million for 2003. Total investments are roughly GBP10. 5 million, spread out in 3 years.
These initial investment figures have a negative impact on the firm’s finances, affecting a series of other factors, which raise concerns among board of directors and executives. One major concern is that in the financial associated with this project they include 40 Million GBP from the selling of sale of the right-of-way pipeline in there cash flows in year 15 when in fact this is not substantial cash flow directly associated with the project. Some senior Victoria Chemicals executives firmly agreeing with this speculation saying “Our business is chemicals, not land speculation.
Simply buying the right-of-way with the intention of reselling it for a profit takes us beyond our expertise. Who knows when we could sell it, and for how much? How distracting would this little side venture be for the executive committee? This then can affect the NPV as well as the IRR. The proposal also doesn’t account for the 3 percent inflation that is expected which also can change the estimates of gross profit also affecting the free cash flows for this project. As a result of these loses in output the first three years (from 2001-2003), there is also a reduction in gross profit.
The report shows loses of -7. 79 GBP for 2001, -GPB5. 73 for 2002, and –GBP3. 40 for 2003 caused from the initial investment of 10. 5. The total loses amount to a staggering –GBP16. 92, a substantial amount for the firm during these first three years of upgrades and preparation for the new technology. These loses have a direct impact in sales figures, noticeably, thus creating a longer payback period for this project around 11 years, meaning that the project is a bit more risky considering a given 10 percent discount rate.
I also noticed that this project seems to have the higher NPV of 14. 87 when they factor in the 40 million GBP from the sale of the pipeline in 15 years. Without that it then falls under the other proposal and is not the preferred project and has a lower NPV of 5. 29. Merseyside Proposal The Merseyside proposal consisted of a 12 million GBP expenditure creating significant opportunities for improvement in polypropylene production.
Other opportunities stemmed from correcting the antiquated plant design in ways that would save energy and improve the process flow: relocating and modernizing tank-car unloading areas, which would enable the process flow to be streamlined, refurbishing the polymerization tank to achieve higher pressures and thus greater throughput, and renovating the compounding plant to increase extrusion throughput and obtain energy savings. No question that Morris’ plan is the more conservative of the two, suggesting a phased-in approach to the upgrades. In essence, Merseyside sees the need to make some technological upgrades as well.
They want to slowly upgrade to the new controls system, and after a few years, make the full switch to the new software. In all, this 12 million GBP proposal retained the flexibility to add the technology in the future. The entire renovation would cause the plant to be down for 45 days causing the customers to go to other suppliers and competitors for the needed products due to the fact the other nearby plant (Rotterdam) is already working at maximum capacity. Some benefits of the renovations would be the improvement on gross margin up 1 % from 11. 5-12. 5.
As you look at the financials associated with this project you notice that Merseyside met all the requirements for the corporate criteria with a greater NPV that Rotterdam when they do not include the 40 million sale of the pipeline. They also include and take inflation into account when giving their proposals as well. The initial investment is a bit more that Rotterdam but essentially the payback period is lower with only around 4. 1 years. This means this proposal is less risky then the other, both assuring the expected return of 7%. However there is a crossover rate at 15. 2 meaning with the discount rate at 15. there is no proposal that is preferred to one another if Rotterdam includes the 40 Million. Without the 40 million Merseyside project will always be preferred to Rotterdam because the NPV will always be greater.
According to the case and my calculations I have come to the conclusion that it is best to accept the Merseyside project and reject the Rotterdam. Based on many financials and the corporate criteria Merseyside seems to be the best option. While evaluating both proposals I noticed that the Rotterdam project purchases a right-of-way pipeline for 3. 5 million included in the 10. million GBP investment to later sell in 15 years for 40 million GBP violating the standalone principle. However being that they are not in this type of business and are in the plastic manufacturing industry producing a wide variety of products; including medical supplies, carpet fibers, and automobile components, they should not account for the sale which would then put the NPV for this project from 14. 87 to 5. 29, which is then lower then the NPV for Merseyside which is 9. 12. When comparing mutually exclusive projects you want to focus on NPV and the project with the higher NPV is usually preferred to the other like in this case.
Also when making my decision to choose Merseyside I noticed there was a smaller payback period meaning it will take a shorter time to recover your initial investment proving that the project can be less risky as well. I was also a little sketched out when the plant manager for Rotterdam presented a 90-page proposal. This can mean the managers put in a lot of false and misleading info to get the project approved. This can rest my case as to why I would prefer to choose the Merseyside project to the Rotterdam.
Courtney from Study Moose
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