VICTORIA CHEMICALS PLC

GROUP 5
FEBRUARY 10, 2014
Introduction
This case talks about Victoria Chemicals, a leader in the production of polypropylene,
whose plant manager wanted to undertake a new project that required an initial investment
of GBP 12 million. The old production process, high labor content as compared to
competitors and falling earnings were some of the key reasons behind this project.
Morris, the then plant manager, found significant opportunities for the improvement of
production process like improving old fashioned plant design that would, according to her,
save energy and improve the process. Other opportunities arose from the deferral of
maintenance over the past five years.
Greystock, the controller of Morris, calculated the discounted cash flow with a required
return of 10%.But her calculation gave rise to a number of concerns from different
departments. The controller of transport division asked to include cost of the tank cars in
the initial outlay of capital program. The director of sales department showed concerns
regarding the probable cannibalization that could happen. Tewitt, the assistant plant
manager, wanted to include EPC project as part of the capital program. Gowan, an analyst,
suggested using real return of 7% instead of nominal return of 10% as the hurdle rate.
Analysis & Recommendation
Following is our take on some of the concerns highlighted in the case regarding DCF
analysis.
Discount rate
The required rate of return used in DCF analysis is 10%. This is a nominal rate and for it to
be used, all cash flows must also be nominal which does appear to be the case here. Thus
the NPV/IRR calculation is correct as far as appropriate use of required rate of return is
concerned.
The real required rate of return can also be used for DCF analysis. Accounting for the 3%
rate of inflation, it comes out to be 6.8%. In order to use real required rate of return for
DCF analysis, all cash flows must be in real terms. When cash flows are adjusted for
inflation and NPV computed, it turns out to be the same as when nominal cash flows and
nominal discount rate were used. This makes sense logically too. NPV shouldnt be
affected by whether real or nominal discount rate is used. It is the same in either case.
Preliminary Engineering cost
The preliminary engineering expense of half million has already been incurred and hence
should be regarded as a sunk cost. This will result in ignoring these expenses in the DCF
analysis.

Depreciation
The current version of the analysis uses accelerated depreciation, however, we feel that
using the straight line method will be more efficient. This is due to the fact that accelerated
depreciation causes tax saving. Therefore, the management may select the project only to
avail this tax saving. Hence, we will depreciate the new asset on a straight line basis.
EPC project
The project is too much influenced by the personal incentives and hence the decision will
be biased. Moreover, this project already has a negative NPV and hence shouldnt be
accepted.
Capitalizing tank cost
We are of the opinion that the cost of acquiring the new tank is not an incremental cost of
the project and is going to be incurred regardless of whether the project is undertaken or
not. Therefore, it should be ignored in DCF analysis.
Cannibalization of sales of Rotterdam plant
In discounted cash flows analysis, only incremental cash flows to the firm should be
considered. Any sales that Merseyside plant gains through cannibalization of Rotterdam
plants sales do not represent additional sales to the firm and shouldnt be factored in DCF
analysis. Therefore, such sales should be subtracted from cash inflows to the project under
consideration.
Result
Hence, if we were to incorporate all these recommendations, the project would still yield a
positive NPV of GBP10.56, a payback period of less than four years and an IRR of 24.1%.
Thus, the company should accept the project.