This report contains two case studies in the discourse of Corporate Finance, more specifically capital investment strategy. The cases are applied on the fictional company Victoria Chemicals and are divided into (A): “The Merseyside Project and Victoria Chemicals” and (B): “The Merseyside and Rotterdam project”. The cases are picked from the book “Case Studies in Finance – managing for Corporate Value Creation” written by Robert. F. Bruner.
Victoria Chemicals is a fiction company that processes polypropylene. The company is in fact even a leading producer of the substance, used in a variety of different products such as medical products and packaging films. The company has two factories; one in Merseyside, Liverpool and one in Rotterdam, Holland. The plant in Liverpool is old and therefore has a higher demand for the factors of production. Otherwise, the two factories are identical (design, scale, age & etcetera). Victoria Chemicals has six tough competitors in the market for Polypropylene production, operating at various cost levels. The years previous to 2008 were tough times for Victoria Chemicals. The earnings per shares (EPS) fell from 250 pence per share to 180 pence. This resulted in a higher pressure from the investors for the company to improve the financial performance.
In 2008, the new plant manager, Lucy Morris came up with a plan containing a capital expenditure of GBP 12 million to renovate the producing plant in Merseyside and there through reach an optimal level of producing with maximum production profitability. Lucy Morris brought this idea to the company’s senior management for approval. The idea was then referred for consultation. Different concerns came up from the Transport Division, ICG Sales and Marketing Department, the Assistant Plant Manager and the Treasury Staff. We will look into these concerns and also inspect possible costs and benefits of this capital expenditure in this report along with other possible issues related to the project.
In order for Lucy Morris to have her idea considered, she had to make sure that the investments related to the project, fulfilled at least three out of four criteria set up by the senior management of Victoria Chemicals: 1 The net present value (NPV) of future cash flows must be positive with a nominal rate of return on 10 % 2 The internal rate or return (IRR) need to be higher than 10 % (the rate when the NPV of the cash flows equals 0)
3 The payback time should not exceed 6 years
4 The investment should generate a positive impact on the average earnings per share.
2.0) Theoretical framework
A sunk cost is money already spent, and can’t be recovered and that the firm is already accountable for. Sunk costs have been or will be paid regardless of the decision about whether or not to proceed with the project. A sunk cost is different from other costs that a firm may face, for example variable costs, because it has already happened and therefor it’s totally irretrievable and, therefore should be considered irrelevant to future decision making. Sunk costs are therefore independent of any event that may occur in the future of the firm. Also called embedded cost, prior year cost, stranded cost, or sunk capital. A good rule to remember it that “If our decision does not affect a cash flow, then the cash flow should not affect our decision” (Berk & DeMarzo, 2014).
Inflation measures the change in the Consumer Price Index. The CPI is an index that measures the price level of a collective goods and services. When the CPI increases, it means that the average price level of goods and services in the sociality has increased. If the CPI would decrease, then the prices were to fall, then that would be called a deflation.1 Inflation can arise in a number of ways. One way is if a central bank supplies too much money. Then prices will rise and the value of the money will be undermined. Another way that inflation can arise is if people want to buy more goods and services than the companies can produce. Yet another is if the costs of producing the goods and services increase. This may be because wages have risen, for instance. The companies may then need to raise their prices as compensation for rising production costs. But inflation can also arise if companies and households believe that everything will become more expensive.
Cannibalization is the negative effect of a company’s new launched product on the sales performance of its existing related product. It refers to that the new product replaces the demand of another product. The sales of the already existing product will get lower instead of expanding the company´s market base. (Berk & DeMarzo, 2014)
Internal Rate of Return – IRR
The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. Generally speaking, the higher a project’s internal rate of return is, the more desirable it’s to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. The project with the highest IRR would probably be considered the best and undertaken first. IRR is sometimes referred to as economic rate of return (ERR) or simply the rate of return (ROR). In theory should companies undertake all projects or investments available with IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the firm or by the companies capacity or ability to manage numerous projects (Berk & DeMarzo, 2014).
NPV is used in capital budgeting to analyze the profitability of an investment or project. When estimating the value of an investment it is best to use cash flows in terms of cash today, in other words using the present value of every cash flow. The Net Present Value (NPV) is thus defined as the sum of our present value benefits and our present value costs. Because NPV is expressed in present values, it helps simplify the decision process. As long as the costs and benefits are all captured correctly, an investment, which yields a positive NPV-value, will increase the value of the firm and its investors. This logic is also captured in the NPV decision rule: “When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV in cash today” (Berk & DeMarzo, 2014).
Earnings per share
Earnings per share (EPS) measures the amount of a company’s net income that is theoretically available for either dividend to the shareholders or reinvesting into the company’s infrastructure. Whatever choice, a high EPS ratio indicates a potentially worthwhile investment, depending on the market price of the stock (Berk & DeMarzo, 2014).
The Payback Rule
Also called the payback period, it’s the amount of time required to recover the cost of an investment, or to reach the break-even point. The payback period of a given investment or project is an important factor in determining whether to undertake the project, as longer payback periods are typically not desirable for investment positions. Pitfalls with using the Payback Rule, (1) it ignores the project’s cost of capital and the time of money, (2) it also ignores any cash flows after the payback period, and (3) it also relies on an ad hoc decision doctrine; what is the right number of years you should set as your pre-specified period? (Berk & DeMarzo, 2014).
We started with a clean excel –sheet in which we included the books values for the different projects. We noticed several errors and incorrect assumptions that we later on corrected in a way we thought were the right. The major adjustments we did was: Inflation – We had two options when we considered the inflation. The first option was to use real terms, that is to say to calculate without the inflation. The other was to use nominal terms, which we did when we included the inflation in our calculations (e.g. DCF) Depreciation – Here we discussed whether to use book value or market value, where the book value explains the value of an asset according to its balance sheet account balance. The Market value is the price buyers are willing to pay for the asset. We interpret the investment of the rolling stock to be depreciated with a linear depreciation over 10 years or 15 years depending on which investment we consider.
Weighted average cost of capital – We choose to use 10% in nominal rate (minimum return tha Victoria Chemicals plc. must earn to satisfy the creditors, owners, and other providers of capital,). WACC is the real rate + inflation. EPS (Earning Per Share) – We simply used the pretax incremental profit and divided it with the amount of shares. Discounted investment (rolling stock) – Since the payment will be in year three we choose to discount the investment of the rolling stock. We have included the inflation in the discounted value because our discount rate is with inflation included.
Payback for each investment – We used this method in order to see how long the time period is for our initial cash outflow of this investment to be recovered from the cash inflows. We used the formula: Initial investment / cash inflow per period. Included Taxes – The tax is included in our tax flow with 30%. Sunk cost – In our opinion the assumption of the sunk cost to be included in the cash flow is wrong. Therefor we have eliminated sunk cost in our free cash flow. The sunk cost is consumed no matter what.
4.0) Basic conditions and results
4.1) Merseyside project
Victoria Chemicals has two plants, one located in Merseyside Liverpool UK, and the other one located in Rotterdam, Holland. Victoria Chemicals was under pressure from investors to improve it’s financial performance. So the plant manager in Merseyside Liverpool named Morris proposed an investment for enhanced efficiency and increased production to the top management of Victoria Chemicals. The investment would cost GBP 12 Million. The proposition was to (1) relocate and modernize tank cars unloading areas, which would enable the process flow to be streamlined (2) refurbishing the polymerization tank to achieve higher pressures and thus greater throughput and (3) renovate the compounding plant to increase extrusion throughput and obtain energy savings.
In order to perform the renovation of the plant, the factory needs to be closed for 45 days. The plant staff didn’t believe that the customer losses would be permanent because of the stop of production. The investment is set to increase the manufactured throughput with 7 %. The energy saving is 12,5% plus Greystock characterized the energy savings as a percentage of sales and assumed that the saving would be equal to 1.25% of sales in the first 5 years, and 0.8% in years 6-10. The rate is 3.5% and is used in the overhead calculated as: (the investment *0,035)
Following changes has been performed in the new DCF-analysis compared to the original:
The utilized discount-rate is set to 10 % (Nominal rate)
The inflation is set to 3%
The investment of GBP 2 Million in new vehicles has been incorporated in the project Increased total depreciation for 10 years caused by the vehicles A worst case scenario has been performed where 100 % cannibalization of the Rotterdam plant is displayed The work-in-process inventory is calculated as 3 % of the cost of goods. The output has increased by 17500 ton, therefore slightly increasing the annual WIP costs. 4.2)
Rotterdam using Japanese Technology
The heart of the Rotterdam project would be the possibility of using Japanese analog computer technology. The upgrade to the new technology will imply: (1) the technology will rise Rotterdam margin by 0,5% a year to a maximum of 15%. (2) The contract would cost GBP 0,4 million a year, and would obviate the need of a pipeline, resulting in an investment at Rotterdam of GBP 7 million spread over three years. But to acquire the needed propylene gas, they would be required to enter into a 15- year’s contract with a local supplier. (3) The cost of the contract and the investment costs were expected to rise by the rate of the inflation. (4) The estimated cash return from the Japanese technology had a standard deviation of 35%. (5) The nominal rate of return was about 5.5%. (6) The controls would not result in an incremental volume gain.
We have decided not to calculate the use of the Japanese Technology, due to the fact that the technology is relatively new. The management of the company was conscious that there was a chance that the technology would not work as well as hoped, and due to the complexity of the technology and the extent to which it would permeate the plant, there would be no going back once the technology would be installed. Another concern is being the first major company in Europe using the technology. And there was still the uncertainty as how valuable it was, if at all the technology would prove to be, and the fact that the technology hadn’t been tested with the machinery that was being used at Rotterdam. 4.3)
The Rotterdam projects proposal is to purchase a pipeline. In essence the proposal called for the expenditure of GBP 10,5 million over three years to upgrade the plant’s polymerization line. The heart of the new project would be a software program from Japan. A large part of the project is to obtain a gas pipeline for transporting gas to the plant and is incorporated in the estimated expenditures of GBP 10,5 million. Furthermore the estimated value of the right-of-way and the pipeline over a 15 years period is GBP 40 million, and is still a part of the DCF (discounted cash flow). In order to make a comparison with the Merseyside proposal possible, the real target rate of return of 10% is utilized in this case as well. The value of selling the option of the pipeline has not been a part of this analysis. The reason for this being is that this investment was made in the past and can now be seen as a sunk cost.
We have chosen to present the different projects separate, and divide the positive factors and the negative factors that affect the different projects.
6.1) Merseyside project
The negative factors that affect the Merseyside project is that the plants need to be closed down in 45 days, in order to go ahead with the renovation. This will result in the loss of revenue, for the days the plant is closed down. The investment was proposed to cost 12 Million pounds, which includes the relocate and modernize of the plant and modernize of tank car unloading areas. Merseyside projects calculate its energy saving for the next 10 years ahead. That can be heard do predict so long in advance, and to predict the advances in energy savings technology.
The positive factors that affect the Merseyside project the investment is set to increase the manufactured throughput with 7 %. The plan to refurbishing the polymerization tank to achieve higher pressures and thus greater throughput, and the renovation of the the compounding plant to increase extrusion throughput and obtain energy savings. The plant staff didn’t believe that the customer losses would permanent because of the stop of production.
6.2) Rotterdam project
The negative factors that affect the Rotterdam project is that the investment in the Japanese technology means high risk because of the initial investment is high, comparing to the knowledge about the outcome. But by waiting to invest in the Japanese technology there is a certain risk that competitors achieve to implement the new technology first, then the Rotterdam plant will lose the advantage. The investment in a new pipeline to supply the need for more gas, this is also a contributing factor if the investment is implemented. The offer about the pipeline expire in 6 months, if the offer is not taken the earlier cost, that was paid for obtaining the lower price for the pipeline, will become an sunken cost. But there is an possibility to sell the pipeline for GBP6 million. The Rotterdam project predicts the return of GBP40 million in 15 years. Therefor a high value of NPV. However, this calculation is hard to predict due to the market is unsure, and the risk of a lower return is high. This also contributes to the high risk that the investment contains.
The positive factors that affect the Rotterdam project is that in the projects succeeds it will get an advantage over its competitors, of being the first one with the new technology, which means that the plant will get more efficient, and that will generate decreased cycle time and eliminated downtime. The new pipeline will cut the transport cost. And several market operators are interested in acquiring the pipeline, the sale of the pipeline in 15 years could therefore be a realistic prediction. The Rotterdam project predicts the return of GBP40 million in 15 years. Therefor a high value of the NPV. But again this calculation is hard to predict due to the market is unsure, and the risk of a lower return is high. The geographical area of the Rotterdam fabric is to prefer due the harbor is close and also access to the European market.
7.0) Conclusions and recommendations
At last we have different concerns to consider. These are:
– The proposed capital program, where Morris propose an expenditure of GBP 12 Million on this project. One trouble will be the fact that the entire Merseyside plant would need to be shut down for 45 days. This will cause a loss of customers during the shutdown when the plant cannot supply.
– The concern of the transport division where the division needs new tank cars to anticipate growth of the firm in other areas because of increased throughput of the machine. This is a major investment for the firm, the estimation is to be GBP 2 million in year 2010. This will increase the manufactured throughput with 7 %.The possible tank cars will have a depreciable life of 10 years linear .With the new investment in the plant the firm will be able to take business from other competitors.
– The concern of the treasury staff is about the cash flows and the discount rate. These need to be consistent in matters of nominal or real rate. The treasury staff thinks the inflation in a long term will be 3% per year. Thus Victoria Chemicals real target rate of return is 10%.
– ICG sales and the marketing department had a concern about the business as a whole. The market for polypropylene is extremely competitive. The industry is in a downturn. Potential oversupply. Why spend money renovating one plant just so it can cannibalize from the other plant?!
– Also the company had various concerns about e.g. potential pipeline, land acquisition and Japanese technology. We understand that the management of Victoria Chemicals do have an extremely difficult decision to make. Our first recommendation to the Merseyside project is to modernize the machine and plant to increase the throughout and lower cost of energy, and to purchase the new tank cars. Else we expect the company may have to leave the business altogether in three years or so. But if they invest now, they may be ready to exploit the market when the recession ends.
Our recommendation is to fully invest in the Merseyside project. We base this recommendation on the facts that the Merseyside project pass all four criteria for further consideration (IRR>10%, EPS contribution is positive, NPV is positive and the payback period is less than six years). In our point, compared to the Rotterdam and the Japanese technology investment, Merseyside feels like a more “safe” investment. The Merseyside investment is more flexible since we can choose to add new technology in the future.
8.0) Reference list
Berk, J. & DeMarzo, P. (2014). Corporate Finance, (Third edition). Pearson
Bruner, R, Eades, K & Schill, M. (2014). Case Studies in Finance (Seventh edition) Mcraw- Hill international edition Internet Sources:
Ekonomifakta 2014, ” Inflation – internationellt”
Available at: http://www.ekonomifakta.se/sv/Fakta/Ekonomi/Finansiell-utveckling/Inflation/ cited: 11/9 2014
Sveriges Riksbank 2014, “What is inflation?”
Available at: http://www.riksbank.se/en/Monetary-policy/Inflation/What-is-inflation/ cited: 11/9 2014