Case Study: Victoria Chemicals Is Considering a Plan

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Victoria Chemicals is considering a plan to modernize its Merseyside plant, which was built in 1967 and is more labour-intensive and therefore costlier to run than the plants of competitors. The upgrade is currently going through the capital budgeting process, and is running into a number of pitfalls. Frank Greystock is the financial manager in charge of the analysis, and must make recommendations to his superior, Lucy Morris.

All capital projects at Victoria must fall into one of four categories, of which this project would be classed as an "engineering efficiency" project. There are four different metrics against which this project is to be evaluated, being the impact on earnings per share, payback, discounted cash flow and IRR. The process also involves consultations with other divisions.

There is benefit to performing a complex and sophisticated analysis for capital budgeting decisions. These are serious decisions that require serious consideration, after all. However, there are a few issues in Victoria's process that could be construed as overcomplicating the matter. The first such issue is the use of four different metrics. Ultimately, what adds value to the firm is the discounted cash flow. It is good to know these numbers, but ultimately the firm must base its financial analysis on the critical concept of how much value does this project add to the firm. The discounted cash flow number best reflects that. The IRR does not distinguish between projects of different sizes, and payback period makes no sense because it does not incorporate cash flows from beyond the payback point. EPS is essentially a re-stating of the discounted cash flow. However, it is important to look beyond the financials and see where the project fits into the firm's strategy. In this case, modernization is important to maintain competitiveness, and the opportunity cost of not modernizing is something that should be taken into account. The loss of customers during the plant shutdown, however, should not be dismissed with the wave of a hand as Greystock would do it.

The Issues

The first set of issues comes from the Transport Division. The division has concerns that it will need to buy new rolling stock to help accommodate the increased production, and wants to include the cost of the new rolling stock in the budget for the plant upgrade. That idea should be categorically rejected. The new rolling stock is a capital decision in its own right, and should be subject to its own analysis. This is especially true given that the Transport Division is its own cost centre. The Transport Division's concerns should be rejected outright.

The second issue comes from the ICG Sales and Marketing Department. This department's concern is that the industry is facing an impending downturn and overcapacity. There is the idea that there should be some sort of charge for production shifted from Rotterdam is absurd, in that Greystock is right. Not only is cannibalization not a cash flow, but the idea that selling more is a problem is laughable. The company should of course take its total business into consideration, but it should also strive to produce in the most efficient way. If Merseyside is more efficient than Rotterdam, the company should sell from Merseyside, and figure out ways to sell the production left over at Rotterdam. The argument put forth by sales sounds like that division would prefer not to work too hard, rather than seeing an opportunity in increased capacity. Indeed, the sales division should be focused on issues like estimating the loss of business from the shutdown, and the rebound in business that will happen when the new, more efficient plant comes in line and the company can improve its pricing. It is disheartening that the Sales Department is not willing to make a more positive contribution to the decision-making process, when its demand modeling is actually very important to the revenue side of the capital budgeting process.

One of the problems here is organizational. The Sales Department is looking at sales from a system-wide perspective, but the individual plants are both cost centres, and therefore not considering a systems-wide perspective. Thus, the root problem is a little bit deeper than simply the immediate capital budgeting issue. However, using this capital budgeting decision as a mechanism for sorting out issues with the organizational design is not the right approach.

The third issue comes from the assistant plant manager. This manager wants to tack on his own personal pet project -- which was already rejected by senior management -- to the line renovations. This project is clearly not a cash flow incremental to the line renovations, and Tewitt has no business suggesting that his project be included in this one. Separate projects need to succeed on their own merits. Tewitt is treading dangerous waters here, and there is no conceivable reason for either Greystock or Morris to become involved in Tewitt's personal quest. They are both answerable to senior management, Morris especially. For Morris to risk the wrath of senior management for Tewitt's pet project is a non-started, so for Greystock to propose it should be a non-starter.

The fourth issue comes from the Treasury Staff. The department is claiming that the 10% discount rate used is nominal, while the real rate of 7% should have been used. This is technically correct (Probst, n.d.), but Greystock should stick to the number that is in the manual. If the manual is incorrect, that is something the Treasury Department should address as a separate issue, given that making such change in 2008 is not exactly complicated. Issuing a memo or correcting the mistake in the document is as simple as a few keystrokes, so the Treasury staff should address this with the relevant parties. It is worth noting that a 7% discount rate increases the NPV of the project. Given that this is a go/no-go decision, the decision will not be affected by the change in discount rate unless something else changes. But if the manual says to use 10%, then Greystock is recommended to use 10% until he received official notice otherwise.

There is also a fifth issue, in the original figures. The inclusion of overhead in Greystock's figures should be eliminated. Overhead is not an incremental cash flow. Only incremental overhead should be included, so the formula for the inclusion of overhead into the calculation is incorrect. It should not be included in this calculation for that reason (Evans, no date). Depreciation is calculated in a somewhat convoluted manner. This could be simplified without compromising the results. Essentially, however, the objective is to ensure that the depreciation tax credit is included in the cash flow projections while the actual depreciation is not.

Overall, most of these issues are in fact non-issues from a financial perspective. It is natural that there is a political dimension to major capital budgeting decisions, but as Cremers, Huang and Sautner (2009) note, internal politics represents an inefficiency. The primary advantage of such politicking is that it can help overcome information asymmetry. For example, Greystock probably was unaware of how some of his assumptions affected other divisions. It is worth giving voice to those other divisions, so that the best decision for the company can be made. Ultimately, however, Merseyside is a profit centre of its own, and that means that according to the organizational design, his decision only needs to take into account Merseyside. Issues with respect to corporate-wide design making and information asymmetry are better addressed directly, than through division-specific capital budgeting decisions. Given that this project improves organizational competitiveness and does not threaten the future of the business, it is reasonable that Greystock focus his analysis on his own division and let the company's senior managers address their organizational design issues separately.

Recommendations

Greystock does not need to make too many changes to his analysis. Most of the complaints from other divisions are not related to the decision at hand. They either relate to issues that are larger than this decision (i.e. organizational design) or they are simply not relevant to this particular project. Greystock does need to eliminate the overhead. The other suggested changes are rejected. As a consequence of making the necessary changes, Greystock's figures will be altered slightly. The project now has a net present value of $12.69 and an IRR of 26.6%. From a financial perspective, this project should be accepted. From a strategic perspective, it is believed that management has already established that improving the efficiency of the Merseyside plant is good for the cost centre.

It is also worth considering that using a real discount rate is something that might be integrated, pending revision of the company's policy document. With a 7% discount rate, the NPV is $17.28 and the IRR remains the same. As noted, lowering the discount rate only improves the value of the future cash flows, which makes the project more attractive.

It is recommended, therefore, that Greystock remove the overhead expense, or at the very least recalculate it to include only… [END OF PREVIEW]

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