# Victoria Chemicals

Victoria Chemicals Is a major competitor In the worldwide chemical industry. They are a leading producer of polypropylene, which is a polymer used in products such as medical products and automobile components. Victoria Chemicals started up in 1967 when they built two plants, one in Impressive, England and one in Rotterdam, Holland.

Both plants were identical to each other and produced an equal amount of goods.

In 2008 these two plants have an old-fashioned production process of polypropylene and the production costs are some of the highest in the industry. The lanes need to be renovated and rationalized. Victoria Chemicals was also under pressure from investors to improve their financial performance as the earnings per share had fallen from 250 pence in 2006 to 180 pence In 2007.

Both the plant managers have made suggestions on how to Improve the production In their plant. Investments will be made only In one of the plants.

Summaries of the suggestions have been produced as the discounted-cash-flow (DOC). These two projects have been analyses from an external perspective. Problem statement Should Victoria Chemicals make an investment into the renovation of the production nine in the Impressive or In the Rotterdam plant?

Discussion and analysis is based on the following main items: A comparison of the two different investment plans and a critical assessment of included cash flows Nominal rate and real interest rate The treatment of conflicts of interest and other ethical dilemmas that may arise in the investment decision The crossover problem Investment careerist’s at Victoria Chemicals Sensitively analysis and critical values Method By discussing the different posts and figures in the investment plans we have formed a report taking in consideration the different aspects of the two projects.

A file in Excel was created to be able to change numbers and do new calculations to find out how NP changes based on different figures in the cash flow to create a sensitivity analysis. Using both the excel sheets and the appropriate formulas we have been able to calculate the average annual addition to earning per share, the payback period, NP and the Internal rate of return . We also used the formulas from “Formulas for the course corporate finance” We had to calculate the Initial average annual Dalton to PEPS and the payback period for the Rotterdam project, since they were not presented in the calculations.

This we by our adjustments to the calculations. In the adjusted calculations for the Impressive project, we removed both the overhead cost and the sunk preliminary engineering cost, before also adding the centralization cost. We took the centralization cost from the original calculations made in the Rotterdam calculations, since they represented a centralization prognosis based on the same increase in output at both projects.

In the adjusted calculations for the Rotterdam calculations, we removed the speculative income of the terminal land value and chose to keep the centralization cost starting from year 3. It is important to note that in order to be perfectly accurate, you should discount the full centralization cost with the real loss of output for the first three years.

However, we chose not to because the overall effect of the outcome would have been very marginal and thus not changing the end decision.

Analysis A comparison of the two different investment plans and a critical assessment of included cash flow When considering investments it is important that the decisions, in regards to which projects to invest in, are based on analyses with relevant, forecasted, figures of venues and costs that will be used to indicate the cash flows of the project . These decisions are probably the most significant for a corporation and are critical for the overall objective to maximize shareholders wealth.

Only revenues and costs that will occur due to an investment decision, both direct and indirect, are relevant. When comparing the two different investment plans and the cash flows included, you can see that there are differences between the Impressive and Rotterdam projects. In Impressive tax has been included in the calculations but it is not included as a cost, this could easily be added on a separate post, as done for Rotterdam.

In Impressive a preliminary engineering cost of GOBO,5 million, which had been spent over the preceding 9 months, has been included.

This is a sunk cost, I. E. An unrecoverable cost for which the firm is already liable . This is a cost already paid for and is not incremental with respect to the current decision and should not be included in the investment plan. Overhead expenses are associated with activities that are not directly attributed to a single business activity but instead affect many different areas of the corporation.

These costs are not incremental to the project and should not be included. But additional overhead expenses caused by the decision to take on the project must be included.

Victoria Chemicals has a corporate-policy manual and according to the manual new projects should be able to sustain a reasonable proportion of corporate overhead expenses. Thus, all new capital projects should reflect an annual pre-tax has been included for Impressive but not for Rotterdam. Though, according to the literature, overhead expenses should not be calculated on the full amount of the investment, as declared in the corporate policy manual, it is only the extra costs that stems from taking on the project that are relevant.

Looking from an external perspective we have chosen to remove the overhead cost due to get a more accurate result when comparing two projects cash flows and disregarding the cooperate policy for the chance of getting mislead. Centralization is when sales of a new product displace sales of an existing product . A consequence of a decision to invest in any of the two plants will lead to a reduction in sales of the other plant; this cost should therefore be included in the project plan.

This has been taken into account in Rotterdam where NP and AIR have been calculated with and without compensation for centralization but in Impressive this cost has not been included at all. Victoria Chemicals managed the distribution of the main component (propylene gas) in their product through a fleet of self-owned tank cars, which was controlled by a cost centre called the Transport Division, to the Impressive plant.

In order to be able to supply Impressive with the extra quantity needed if the investment was realized, the Transport Division could use existing excess capacity of transport capability.

Even though this internal service would not come with a charge, an opportunity cost would emerge as the transport resource could have been utilized in a way that potentially could bring an income instead. Therefore it should be seen as an incremental cost to the value lost by not utilizing it the best alternative way . One possibility is to outsource the logistics to an external company and then buy it as a service. In the Rotterdam project we decided to remove the entire free cash flow income from the sales of the terminal land value.

This is because the sale of the land suggests hat the production is being discontinued after the 15 years, as the plant can’t operate without the continuous supply of gas. In order to include this value as a cash flow we would have to compare the effect of the end value both investments have on the factories. Because a liquidation of the factories also would inquire a lot of cost and the end value is highly speculative, we choose to not include the speculative land value at all in our calculations made on the Rotterdam project.

However if the investment in Impressive is chosen, we should think about the opportunity of selling the right-of-way before the option expires in six months. If the investment is made in the Impressive project, we have the opportunity to sell the option. There is no information of how much the option was bought for several years earlier.

Regardless of that sunk cost and assuming that the right-of-way could be sold, as the consultant believed, it would still generate a positive cash flow to the firm. This cash flow would be in favor for the decision of going forth with the investment in Impressive.

However, we don’t know for sure if the right-of-way could e sold, if there is a buyer at all, and therefore we chose not to include the highly think that the decision maker should consider the opportunity of selling the option if the Impressive project is chosen. Nominal rate and real interest rate One employee at Victoria Chemicals’ Treasury staff discussed the difference in nominal and real interest rate. Nominal interest rate is adjusted for inflation and real interest rate is the rate without adjustment for inflation .

Nominal rate minus the inflation equals to the real interest rate.

When one discounts free cash flow one shall SE the nominal rate if the cash flows are nominal, I. E. Includes the inflation and real rate if cash flows are real, with no inflation included. In these two cases it is difficult to say what cash flows that are used. New sales (in millions) for example are the same every year, which indicates a real cash flow, but we do not have information about the price or demand over time.

If the plans include real cash flows and the nominal rate is used for discounting, the NP will be lower than if the real interest rate would have been used.

If the firm has used the nominal interest rate to discount ell cash flows they have consequently underestimated the NP of their projects. This might lead to the wrong investment decisions. We do not know for sure if the cash flows included in the plans are real or nominal so we choose to use the nominal interest rate, 10% in our calculations. The treatment of conflicts of interest and other ethical dilemmas that may arise in the investment decisions Problems occur when people involved in projects have different agendas.

Often it comes from people’s own self-interest and their focus on bonuses or credit. This is commonly known as the Agency problem . Referring to the text, ethical dilemmas are found at many places. The goal for companies is to maximize the profit . It is also commonly known that shareholders should be the ones to take in consideration investing in new projects.

In this situation investing in either Impressive or Rotterdam is filled with different arguments. Many of these arguments are built on self-interest connected to bonuses and does not prioritize the shareholder wealth.

First example is the Transport Division that does not want to take any responsibility over the need of a new car in Impressive project since that could affect their onuses negatively, something that should not be a reason for letting the project bare the costs. Another example also being an ethical dilemma is Morris calculations of standard deviation done on the Rotterdam case. Since she is a competitor of to the project we would not say that she is totally unbiased, therefore we should not fully trust her. Dewitt, the assistant plant manager, wants to include an EPIC project to the Impressive project.

The EPIC project has been up before and has a negative WV’, which is the reason it has not been implemented. Since Dewitt still believes in the reject he would now like to include it even though it is negative. That would not be for the shareholders best but for his best. Taking every opportunity to talk about the project and the other keeps a low profile. This can affect the decision makers and personal feelings can affect the final decision. The crossover problem When choosing between projects we have to take in consideration both the NP and the AIR.

The AIR describes the expected return when investing in a specific project.

The theory says that AIR is not to use when the projects differ either in scale, timing r rockiness . Comparing the Impressive project with the Rotterdam one by looking at AIR is not to recommend in this situation. The timing of the projects is the same since they both cover a time of 15 years but their scales are not the same. Investments at Impressive are much higher than at Rotterdam witch gives us the wrong conditions to make a fair comparison. Looking at the risk level at the two projects we see that they differ here as well.

Impressive has a more stable and less risk while Rotterdam risk is higher.

This is based on thoughts about how uncertain the Rotterdam project s. Since the project is totally new, with a new technology that will have to fit with the existing and guessing about efficiency rewards, the risk is higher than the improvement planed at Impressive. Also, once the pipeline is in place there is no turning back. Another uncertainty is how the learning curve will progress.

This makes net present value calculations being the most reliable alternative to use. We will choose the alternative between the two projects with the highest NP . Investments careerist’s at Victoria Chemicals The Impressive project original calculations vs.. Ousted calculations Average annual addition to PEPS is unadjusted GOBO,022 per share and adjusted GOBO,019 Payback Period is unadjusted 3,8 years and adjusted 3,9 years Net present value is unadjusted GOBI,5 million and adjusted Septillion Internal rate of return is unadjusted 24 % and adjusted 1 % The Rotterdam project original calculations vs.

. Adjusted calculations Average annual addition to PEPS is unadjusted GOBO,052 per share and adjusted GOBO,018 Payback Period is unadjusted 9 years and adjusted 9,8 years Net present value is unadjusted GAP,32 million and adjusted GAP-1,27 million

Internal rate of return is unadjusted 140% and adjusted 9,1% The Impressive project adjusted calculations The Rotterdam project adjusted calculations adjusted calculations. However this economic indicator doesn’t take in to account the cost of interest rate impact of early investment in relations to later large investment and thus the average annual addition to PEPS doesn’t give a fair picture even if it is positive. Initially, before adjustment been taking in account at the first glance the project in Rotterdam looks more profitable because of the higher NP and AIR compared in Impressive.

Sensitivity analysis and critical values To conduct a sensitivity analysis we must first identify an uncertainty amongst the variables. In the Impressive factory the construction will shut down the production for 45 days, which during this period the customers can buy the good from the competitors.

The controller for Impressive project who firmly believes that they have loyal customers is assuming that the output lost during these days, apart from the first year, have less or no effect on the years that follows. However, the polypropylene market is very competitive but both the controller and the vice president of

Marketing are assuming that the lost business volume would return. This makes the output an uncertainty because an assumption is not a guarantee. Therefore, we used the excel sheet to make NP close to zero to then compare the current gross profit with an average gross profit which has been presented below. Impressive Average gross profit can shrink % which gives a NP of 0.

071 Rotterdam Average gross profit must increase 1,2 % which gives a NP of To make it as straight forward as possible the variable that has been modified was the new gross profit.

The reason behind choosing to focus on the new gross profit lies n the fact of not having the information in hand about the variable and fixed cost. Therefore, we choose to compare the two projects in this sensitivity analysis on the basis of the change on the percentage change of the new gross profit. This analysis has been conducted through trial and error with a constant perceptual factor that has been multiplied with new gross profit in every project to the point where NP is close to zero.

The result gives us the indication of the bottom line for the new gross profit in respective project that will make project attractive. For all years the project in Impressive could face a lower gross profit and still have a NP over zero which indicates the level of sensitivity in this variable.

On average the new gross profit can shrink down of a total of 6. 8 % per year. These results indicate that the Impressive gradually steal back their customers from their competitors during the 15 years period and give the project a good buffer.

Rotterdam project display a different case. With an already negative NP, the Rotterdam project has to increase their profit Just to sustain the discount rate. The average gross profit must at least increase with a perceptual factor of 1,2 % per year.

Compared to Impressive, the Rotterdam project is much more sensitive to reduced sales if that would occur, as the project is already negative. This means that in a competitive market there is a fair likelihood of losing money on the project.

It is worth noting that these results are based on removing the sale on land at the end on year 15 which already gave a negative NP. Another variable we chose to consider in this sensitivity analysis is the diversity of the internal rate. We wanted to see the change of the NP when given different interest rate.

The chosen rates to discuss are a lower rate of 8% and a higher rate of 2%. We applied these rates on both projects. The results are the following: 0. 08 gives a Neff 1. 84 r= 0. 08 gives a NP of 11,03 r= 0.

12 gives a NP of -3,72 r=o. 2 gives a NP of When lowering the internal rate to 8 percent, both project increases their NP. The biggest affect are shown in the Rotterdam project, where the NP goes from being negative to positive. However, the Impressive project still generates a higher NP in all interest rate scenarios, thus making it the preferable investment. When choosing a higher interest rate, the NP will consequently be lower for both projects. As the Rotterdam project already where generating a negative NP, it’s even less desirable at the higher interest rate with a more negative NP.

However the Impressive project sustains the higher interest rate generating a positive NP. Hence the Impressive project can withstand a more fluctuating interest rate whereas for the Rotterdam project, only a lower rate would make a positive NP. Analyzing both these results in the sensitive analysis gives us the indication that the Impressive project is a more sustainable investment. Conclusion After a thorough analysis and after adjusting the investment calculations we have mom to a conclusion that the Impressive project is most profitable and preferable.

The four different values included in the firm’s investment careerist’s: Impressive Rotterdam Average annual addition to PEPS (GAP) 0,019 98 -1,27 0,018 Payback period (years) NP (million) AIR 9 11,2 when making decisions and also when choosing among projects.

To maximize shareholders wealth one has to maximize the discounted cash flows in an investment project. As pointed out earlier AIR is uncertain though it has pitfalls. When comparing the figures for the two projects one can see that the Impressive project is he most favorable one, with a positive NP as well as the other criteria for the investment are fulfilled.

The Rotterdam project has a negative NP which tells us not to invest in this project even though we only had one choice. The Rotterdam project does not fulfill the criteria for Payback period (10%). In addition the Rotterdam project has a higher risk and cannot be reversed if the new technology is implemented.

New technique is the foundation for growth, but is now the right time to invest in the new technology or should the firm wait until it is more established?

Lastly we would like to highlight the fact that Victoria Chemicals in future decisions should be aware of the sensitivity AIR has in sense of timing, scale and different risk levels. We also want them to reflect if they use real or nominal cash flows so that they can use the right interest rate when discounting cash flows.