The organization, Victoria Chemicals, must determine whether or not to improve engineering efficiency through facility improvements at its production plant Merseyside Works.
The Merseyside Project was evaluated with respect to the following criteria: (1) Impact on earnings per share (2) Payback (3) Discounted cash flow (â€œDCFâ€) and (4) Internal Rate of Return (â€œIRRâ€). The initial assessment of this project was based on assumptions challenged by the experts at Victoria Chemicals. This analysis reflects a more conservative approach that includes potential risks of cannibalization, loss of sales following reconstruction of Merseyside and the purchase of rolling stock in 2010.
The Merseyside Project met Victoria Chemicalsâ€™ internal criteria for consideration of projects despite the introduction of potential risks into the analysis of the projection (Exhibit 1). The NPV was GBP 9.24 million with an IRR of 20.2%. The payback period is 5.5 years and the average annual addition to EPS was minimal but positive. The cannibalization of sales from Rotterdam was included by reducing sales volumes by 5% for the first five years (Exhibit 2). Further, the affect of closing the factory for construction was modeled by reducing sales volumes to 99% for the first five years to reflect the fact that certain purchasers (approximately 1%) may be lost during this time but eventually recovered.
Lastly, the purchase of rolling stock in 2010 was included because it reflected the anticipated growth of the firm in other areas that were included in the projection and as such neglecting to include this cost would be false representation of the anticipated growth.
Factors that were ignored in the initial projection that increase the attractiveness of the project were added to this analysis including the inflation rate of 3% and the removal of preliminary engineering costs.
It is recommended that Victoria Chemicals go forward with the Merseyside Project. This project meets the specified performance hurdles despite the inclusion of potential threats. One major concern of the project is that the payback period is delayed to over 5 years under this assessment and the average annual addition to EPS is minimal. The declining EPS during the initial stages of the project make the organization more vulnerable to a corporate raid. However, polypropylene is priced as a commodity and as such, the only way to improve financial performance is to improve manufacturing cost efficiency. Further, the educated shareholder will recognize that the declining EPS is due to investment in capital assets and is not necessarily a reason to sell shares. Thus, while the capital investment in this project and shutdown for construction may be damaging in the short-term to EPS, in the long-term it will improve profit margins significantly has potential to earn an NPV of GBP 9.24 million.
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