Empirical Chemicals Ltd: Merseyside Project

Case Study

Abstract:

Empirical chemicals Ltd is a chemical industry, and was a leading producer of propylene. Empirical Chemicals produced propylene at Merseyside (Liverpool) and in Rotterdam (Holland) the two plants were of identical scale, age and design the company positioned itself as a supplier to customers in Europe and Middle-east.

Jim Hawkins controller of Merseyside plant proposed a capital project of £ 7 Million expenditure to renovate and rationalize the propylene production line. The DCF analysis that Jim Hawkins made led to several concerns from different departments.

This whole case study is about the Capital budgeting and main emphasis is on Relevant Cash Flows that includes the concepts of;

* Sunk Cost

* Externalities (Negative)

o Cannibalization

* Effect of Inflation on cash flows and the consistency between the cash flows and discount rate.

Table of Contents

1 Introduction 1

1.1 Background: 1

1.2 Company policies: 2

1.3 Main Problems: 2

1.3.1 Concern of the transport division: 2

1.3.2 Concern of the ICG Sales and Marketing Department: 2

1.3.3 Concern of the Assistant Plant Manager: 3

1.3.4 Concern of the Treasury Staff: 3

1.4 Key Variables: 4

1.4.1 Impact on earnings per share (EPS) 4

1.4.2 Payback period 4

1.4.3 Discounted Cash Flows (DCF) 4

1.4.4 Internal Rate of Return (IRR) 4

2 Alternate Scenarios 5

2.1 Alternative 1 5

2.1.1 Assumptions 5

2.1.2 Results 5

2.1.3 Analysis 6

2.2 Alternative 2 6

2.2.1 Assumptions 6

2.2.2 Results 8

2.2.3 Analysis 8

2.3 Alternative 3 8

2.3.1 Assumptions 8

2.3.2 Results 8

2.3.3 Analysis 9

3 Comparison of Alternative 9

4 Conclusion 10

5 Recommendations 11

6 Annexure 12

1 Introduction

1.1 Background:

Empirical chemical is a major competitor in the worldwide chemicals industry and a leading producer of polypropylene. Empirical chemical produced polypropylene at Merseyside and in Rotterdam, Holland. Merseyside currently produced 135,000 metric tons of polypropylene pellets per year. The two plants were of identical scale, age, design. Company positioned itself as a supplier to customer in Europe and the Middle East.

Trelawney was plant manager of empirical chemicals’ Merseyside works in Liverpool, England. Her controller Jim Hawkins was discussing a capital project she wanted to propose to senior management. The project consisted of £7 million expenditure to renovate and rationalize the polypropylene production line at the Merseyside because the previous manager had limited expenditure for the maintenance of polypropylene production line so some of opportunities are stemmed from the deferral of maintenance over the preceding five year. Other opportunities stemmed from correcting the antiquated plant design in ways that would save energy and improve process flow:

* Relocating and modernizing tank car delivery areas, which would enable the process flow to be streamlined.

* Renovate the polymerization tank to achieve higher pressure and thus greater throughput.

* Renovating the compounding plant to increase extrusion throughput and obtain energy saving.

1.2 Company policies:

* Any plant facilities to be replaced had been completely depreciated.

* The company’s capital expenditure manual suggested the use of double declining- balance.

* New projects should be able to sustain a reasonable proportion of corporate overhead expense.

* Projects which are so marginal as to be unable to sustain these expenses and also meet the other criteria of investment attractiveness should not be undertaken.

* All new projects should reflect an annual pretax charge (Overhead) amounting to 3.5% of the value of the initial asset investment for the project.

1.3 Main Problems:

1.3.1 Concern of the transport division:

Transport division would have to increase its allocation of tank cars to Merseyside because of the increased throughput. The purchase would cost of £2 Million.

A memorandum from the controller of transport division suggested that the cost of these tank cars should be included in the Merseyside capital program. But the controller of EP Merseyside disagreed. He said to Trelawney that the way we have always evaluated projects in this company has been with the philosophy of “every tub on its own bottom”. So the transport division is not the part of our own intermediate chemical group, so they should carry the allocation of rolling stock.

1.3.2 Concern of the ICG Sales and Marketing Department:

Jim Hawkins analysis assumed that the added output can be sold and thus they can obtain the full efficiencies from the project however the director of sales said the market of propylene is extremely competitive and to move the added volume, they will have to shift the capacity away from Rotterdam to Merseyside.

Jim Hawkins however was of the opinion that with lower cost at Merseyside, EC might be able to take business from the plant of competitors.

1.3.3 Concern of the Assistant Plant Manager:

Harry Mulvaney the assistant plant manager and direct subordinate of Trelawney proposed a modification to Hawkins analysis that the production line for (ethylene, propylene, copolymer rubber) EPC should be modernize. Despite hopes that this oxidation-resistant rubber would dominate the market in synthetics, in fact EPC remained a relatively small product in eu0rpean chemical industry.

Harry Mulvaney proposed the renovation of EPC production line for a cost of £1 million the renovation would give the empirical the lowest cost base in the world and improve cash flows by £25,000 ad infinitum even so at current prices and volume NPV of the project was £-750,000. The main concerned of Harry Mulvaney was to include the EPC project as a part of the propylene line renovation because the positive NPV of the poly renovation can easily sustain the negative NPV of the EPC project.

1.3.4 Concern of the Treasury Staff:

Andrew deakins the analyst of EC treasury staff scanned Hawkins’s analysis and pointed out that the cash flows and discount rate need to be consistent in their assumption about their inflation.

According to treasury staff there is a long term inflation expectation of 4% per year. So the EC’s real target rate of return is 9%. However Hawkins’s took 13% as a hurdle rate for his DCF analysis (i.e. the nominal target rate of return).

1.4 Key Variables:

Following are the key variables which would determine the feasibility of the Project

1.4.1 Impact on earnings per share (EPS)

The contribution to net income from contemplated projects should be positive. This criterion was calculated as the average annual EPS contribution of the project over its entire economic life.

1.4.2 Payback period

The criterion for the pay Back was defined as the number of years necessary for free cash flow (FCF) of the project to amortize the initial project outlay complete for this project the maximum payback period is 6 Years.

1.4.3 Discounted Cash Flows (DCF)

The DCF is defined as the present value of future cash flows of the project, less the initial outlay of the project. This NPV of free cash flow (FCF) should be positive

1.4.4 Internal Rate of Return (IRR)

IRR is defined as the discount rate at which present value of future free cash flows (FCF) just equaled the initial outlay in other words the rate at which the NPV is zero and the IRR should be greater than Hurdle rate.

2 Alternate Scenarios

2.1 Alternative 1

The original DCF analysis had the following main facts

2.1.1 Assumptions

* Total initial investment will be £ 7 Million

* Annual output is increased by 7%

* The gross margin will increase from 11.5% to 12.9%

* The energy savings will be acknowledged i.e.

o Year 1-5 1 %

o Year 6-10 0.5 %

o Year 11-15 0 %

* The discount rate (Hurdle rate) is 13 %

* Overhead/Investment 3.5%

* WIP inventory will be 3% of cost of goods which is one time increase as per the instruction of the case

* The plant will remain closed for 2 months

* Tax rate will be 35 %

* Inflation will be 0 %

* The price per ton will be £611

* Depreciable life 15 years

2.1.2 Results

* The NPV of the project is £ 700,211

* The IRR of the Project 14.59%

* Payback Period is 5.65 Yrs

* EPS has an average increase of 0.0103

2.1.3 Analysis

On the basis of the above Results we conclude that the project is feasible under the considered assumption because it fulfills all the requirements of the project i.e. Positive NPV, IRR is greater than Hurdle rate, Payback period is less the 6 Years, There is an average increase in the earning per share.

2.2 Alternative 2

2.2.1 Assumptions

* Total initial investment will be £ 9 Million

o £ 7 Million for the renovation of production line

* £ 2 Million for the tank cars (This investment is also considered as part of the initial Investment because the increased throughput will necessitate the transport division to buy more tankers in order to meets its requirements. The point that Hawkins raised i.e. every tub on its own bottom is not really justified here because if the transport department doesn’t buy these trucks then Hawkins cannot really increase their sales to the level that he mentioned in his initial analysis.

* Annual output is increased by 7%

* The gross margin will increase from 11.5% to 12.9%

* The energy savings will be acknowledged i.e.

o Year 1-5 1 %

o Year 6-10 0.5 %

o Year 11-15 0 %

* The preliminary engineering Cost will not be included in the DCF analysis because it’s not a relevant cash flow (Sunk cost) regarding the life of the project and moreover this cost has incurred even before the project is initiated.

* The discount rate (Hurdle rate) is 13 % but for DCF analysis we will take real rate of return i.e. 8.65% calculated by fisher’s equation

o (1+i)= (1+rr)*(1+p) Where

* i is the Nominal rate

* rr is the Real rate

* p is the inflation rate

* Overhead/Investment 3.5% that will be charged to both, the renovation project and the investment in the transport department.

* WIP inventory will be 3% of cost of goods which is one time increase as per the instruction of the case and it will be accounted for in the following year i.e. it will be included in the cash flow of that year.

* The plant will remain closed for 2 months

* Tax rate will be 35 %

* Inflation will be 4 % as pointed by the treasury staff.

* The price per ton will be £611. The price or the sales are not inflated because the cash flows must show consistency with the discount rate in terms of inflation i.e. if the cash flows are inflated because of the inflation in the sale price then the discount rate used must also be nominal (13 %) which will also give a nominal NPV so in order to have the true NPV we haven’t considered the inflation in price.

* Depreciable life 15 years for the renovation project i.e. 10 years with double declining method and then the remaining five years with the straight line method so that the asset is completely depreciated

* Depreciable life for the tank cars is ten years with straight line method.

2.2.2 Results

* The NPV of the project is £ 2,750,336

* The IRR of the Project 13.32%

* Payback Period is 5.77 Yrs

* EPS has an average increase of 0.0088

2.2.3 Analysis

The above results improvise that the project must be selected or acted upon because it fulfills all the criteria’s set for the selection of any project.

2.3 Alternative 3

2.3.1 Assumptions

The rest of the assumption are the same as in the alternative # 2 with only difference that it includes the cannibalization charge i.e. the loss of the sales at the Rotterdam because of the increase in the sales of Merseyside.

2.3.2 Results

* The NPV of the project is £ 1,361,677

* The IRR of the Project 6.17%

* Payback Period is 8.70 Yrs

* EPS has an average increase of 0.0037

2.3.3 Analysis

Though the project will result in average increase in the EPS but on the basis of the above results it is clear that the project will not be selected as

* NPV is negative

* IRR is less than the real rate of return

* Payback is more than 6 Yrs

3 Comparison of Alternative

Criteria Alternative 1 Alternative 2 Alternative 3 NPV £ 700,211 £ 2,750,336 £ 1,361,677 IRR 14.59 % 13.32 % 6.17% Payback Period 5.65 yrs 5.77 yrs 8.70 Yrs Average Increase in EPS 0.0103 0.0088 0.0037

4 Conclusion

1. On the basis of the above comparison it is clear that the Alternative one is the most lucrative and makes the acceptance of the project certain but we will not recommend this alternative reason being.

a. The alternative # 1 is not taking the inflation into account so the NPV is nominal and not real, moreover they are also inconsistent in their treatment of the Cash flow and their hurdle rate i.e. they have not considered inflation in their cash flows but are using the hurdle rate for discounting purpose that includes the inflation so it leads to a biased NPV which is lower than the true NPV.

b. The alternative # 1 is inconsistent with its treatment of the onetime increase in the work-in-process i.e. it has deducted this amount in the first year since it wasn’t realized but no treatment of this amount is done in the coming years.

c. The first alternative also ignored the concerns of different departments i.e.

i. They haven’t included the charge of £ 2 Million of the tank cars.

ii. The analysis also overlooked the loss in the first year i.e. it should have been carry forward.

d. They have included 500,000 as preliminary engineering cost in their DCF analysis however in actual it is not a relevant cash flow i.e. it is a sunk cost, and it will not affect the future cash flows of the Empirical chemicals regardless of whether or not the project is acted upon.

2. The alternative # 2 is more consistent with its assumption and we should make the decision keeping it in mind

a. Firstly it is more consistent with the inflation in terms of both the cash flows and the hurdle rate i.e. The cash flows are not inflated and the real rate (Which is calculated by the fisher’s equation) is used for the discounting purpose.

b. Secondly it’s more realistic in a sense that it includes the cost of £ 2 million in its DCF analysis which come under the heading of “Externalities” i.e. the effects of a project on cash flows in other part of the firm.

c. This analysis is also consistent with the concept of relevant cash flow because it doesn’t include the charge of £ 500,000 as preliminary engineering cost which is a sunk cost and doesn’t need to be reported.

d. The analysis also treated the one time increase in the WIP in the coming years i.e. it assumed that the increase will be acknowledged as a cash flow in the following year.

e. The analysis didn’t take into consideration the loss of sales at Rotterdam (Cannibalization) because the probability of taking the sales away from other competitors is much more since they are operating at higher costs.

3. Alternative # 3 is also consistent in its assumption just like alternative # 2;

a. The loss of sale at Rotterdam is not deducted directly from the increased sales at Merseyside because if we do so then it will ignore the benefit that we will get from the cost saving at Merseyside from those sales so in order to be consistent with the assumption the decrease in the gross-profit at the Rotterdam is deducted from the incremental gross-profit of Merseyside.

5 Recommendations

1. The alternative # 1 is inconsistent with its assumption so it shouldn’t be considered.

2. The alternative # 2 is the most appropriate and also consistent with its assumption so we will recommend this project on its basis.

3. The alternative # 3 is also consistent but we are not making the decision on its basis because its not clearly mentioned that the Mersey side project will cannibalize the Rotterdam sale, If the marketing department is certain of it then we have to reject the project.

6

Annexure

12 | Case Report

1 |CASE STUDY

CASE STUDY