Case #22 Victoria Chemicals Synopsis and Objectives go/no-go decision
1. The identification of relevant cash flows; in particular, the treatment of: a. sunk costs b. cash flows obtained by cannibalizing another activity within the firm c. exploitation of excess transportation capacity d. corporate overhead allocations e. cash flows of unrelated projects f. inflation.
2. The critical assessment of a capital-investment evaluation system.
3. The treatment of conflicts of interest and other ethical dilemmas that may arise in investment decisions.
1. What changes, if any, should Lucy Morris ask Frank Greystock to make in his discounted cash flow (DCF) analysis? Why? What should Morris be prepared to say to the Transport Division, the Director of Sales, her assistant plant manager, and the analyst from the Treasury Staff?
2. How attractive is the Merseyside project? By what criteria?
3. Should Morris continue to promote the project for funding?
1. Why are the Merseyside and Rotterdam projects mutually exclusive?
2. How do the two projects compare on the basis of Victoria Chemicals' investment criteria?
3. Is it possible to quantify the value of managerial flexibility associated with the Merseyside project? How, if at all, does this flexibility in style affect the economic attractiveness of the project?
4. What are the differences in the ways Elizabeth Eustance and Lucy Morris have advocated their respective projects? How might these differences in style affect the outcome of the decision?
5. Which project should James Fawn propose to the chief executive officer and the board of directors?
Exhibit 1 VICTORIA CHEMICALS Excerpts from Morris’s Expenditure Proposal Memo Regarding the Merseyside Project
VICTORIA CHEMICALS To: James Fawn From: Lucy Morris and Frank Greystock Subject: Capital Expenditure Proposal: Polypropylene Line Enhancements (Merseyside) This memo summarizes the rationale and financial impact of capital improvements to the polypropylene line at Merseyside. The investment requested is ? 12 million.
Strategic and operating benefits were summarized in our previous memo to you. We have made, however, some changes to our investment analyses, which appear below. Two discounted cash flow analyses accompany this memo. Part A contains an adjustment for possible business erosion at Rotterdam, while part B does not make that adjustment.
- * The results are: ErosionNo Erosion NPV? 8. 8 m ? 17. 1 m IRR22. 3%31. 0%
- * The costs of the engineering study and corporate overhead allocation have been excluded from the analysis, per discussions with John Camperdown. Tank-car expenditure occurs earlier in time, and changes in depreciation tax shields are reflected herein.
- * The discount rate used is 10%, and the cash flows used are nominal, rather than real cash flows. We would be happy to respond to any remaining questions you or the board may have.
Being a major competitor in the worldwide chemicals industry Victoria Chemicals is trying to keep up with modern productions. Top managers of Victoria Chemicals are indecisive in on the cost of completely updating one of their plants to modernize the company.
Our team has analyzed the Greystock’s DCF Analysis on Exhibit 2 and has come across some errors we believe are essential for the company to take into consideration to make the final decision. Our team has reanalyzed Greystock’s DCF Analysis and has included the following assumptions:
- Take into consideration the 3% inflation because the previous analysis did not consider it. It is essential to take inflation into consideration because in an investment it is susceptible to the systematic risk which is comprised partly of inflation. Increase the discount rate to 13% because it should include the inflation which hedges against the increases in prices that that minimizes our return.
- The engineering cost of GBP500,000 should not be included in the 1st year of cash flows because it is a sunk cost. Sunk cost should not be included in an NPV analysis calculation.
- Overhead/Investment was increased from 3. 5% to 4. 5% to allow for anticipated complications in the production process which would result in increases in cost.
- Lastly we also assume that the investment will still have a 0. % energy savings in the last five years. Our team believes that it is important to take into consideration the concerns of other members of the Victorian Chemicals management team.
Based on our recalculation of Greystock’s DCF analysis our team recommends that Victoria Chemicals accept the cost of upgrading one of their plants to modernize the company. After adjusting the assumptions to include the necessary inputs we believed were important to recalculate the four investment criterions; which were, the NPV, IRR, PBP, and EPS.
After the made adjustments the investment still passed all of the Victorian Chemical company’s four investment criteria’s. The NPV value decreased mainly because we took into consideration a 3% inflation, but still above GBP10 million. Although we find the IRR irrelevant the change was an increase of 3%, the IRR is still high which means that the investment will be profitable and should be undertaken. The payback period is 6 months faster than projected payback period of Greystock’s original analysis. Lastly, out of the 15-year projected cash flow we had an average of ...