Empirical Chemicals
...troller, has previously prepared an analysis on the project. His assumptions take account of the followings: Project Costs 1. ? Million capital expenditure and the net assets will be depreciated using double declining balance depreciation over 15 years. 2. The production line will be halted for 60 days: because the Rotterdam plant is operating near its capacity, it would not be able to meet the demand of Liverpool’s customer. The shut-down period will dismiss parts of customer base; however, we assume this to be a short-term effect, so that only the losses during the shut-down period should be considered. 3. Other expenses: 1) Increasing work-in-process inventory costs: the increased throughput after the proposal is carried out would increase the plant’s work-in-process inventory costs simultaneously. Base on past experience, the work-in-process inventory cost is about 3.0 percent of cost of goods. 2) ?00,000 preliminary engineering costs: Jim Hawkins, the Controller to Ms. Trelawney, included the preliminary engineering costs in his analysis. 3) Increase in overhead costs: The corporate manual instructed that if overhead costs increase reflect after project is implemented, the overhead expenses is at the rate of 3.5 percent times the book value of assets acquired in the project, per year. Project Benefits 1. Energy saving: Energy saving could be characterized as a percentage of sales. Mr. Hawkins assumed the energy saving would be equal to 1 percent of sales in the initial 5 years, 0.5 percent of sales in year 6-10, and no energy saving after year 10. 2. Increase throughput by 7 percent. 3. Improve gross margin (before depreciation and energy savings) from 11.5 percent to 12.9 percent. Other Information 1. The Merseyside plant produces 135,000 metric tons of polypropylene pellets per year currently. 2. The price of polypropylene averaged ?11 per ton. 3. The tax rate is 35 percent. Hawkins’s analysis of discount-cash-flow is presented in Exhibit 1. It shows that the project will generate ₤2.36 million NPV, 19.2% IRR, 5 years of payback period, and ?.0103 average annual addition to EPS (92,891,240 shares outstanding at fiscal year ended 1991). The analysis reflects the project be acceptable by the management. However, we should carefully observe some of the assumptions on Hawkins’s analysis. Analysis After examining Hawkins’s discount-cash-flow summary, I found two significant errors. First, Hawkins included the preliminary engineering costs of ?00,000 in his analysis. These costs were spent over the preceding 9 months on efficiency and design studies of the renovation, which are considered to be “sunk costs?and should not be incorporated in the first year cash flows. Second, the added WIP inventory should be subtracted from the cash flows instead of adding. In Hawkins’s forecasting, a calculation error exists in the item line. Although “Less Added WIP inventory?was stated on the left column, Hawkins actually added the item instead of subtracting from the cash flows. The modified DCF analysis is explained by Exhibit 2. Furthermore, Hawkins’s forecasting also failed to recognize concerns brought by other divisions. Concerns of the Transport Division Hawkins rejected the Transport Division’s controller’s suggestion to include the cost of additional tank cars in the initial outlay. The Transport Division’s controller suggested that due to the project’s increased throughput, the division would have to increase its allocation of tank cars to Merseyside. This allocation could make out of excess capacity, and it would accelerate the purchase of the ? million rolling stocks, used to support the firm’s growth, from 1996 to 1994. Hawkins’s objection was based on two reasons. First, he believed the costs for the tank cars should go on the Transport Division’s book, not Empirical Chemical’s. Second, Merseyside is simply using the Transport Division’s excess capacity. However, I believe that without the early purchasing of tank cars it would be relatively difficult to evaluate the risk-adjusted costs and benefits of the project at Merseyside. Base on this ground, I included parts of the Transport Division’s cost in our capital budgeting. In a conservative view, omit the costs might lead to understate the project costs since capital budgeting usually involve several departments. The costs are allocated to Merseyside were amounted ?00,530, which is the costs to accelerate two years of purchasing tank cars. 1991 1992 1993 1994 1995 1996 Assumed Purchase: 0 0 0 0 (2,000,000) NPV (1,085,520) Projected Purchase 0 0 (2,000,000) 0 0 NPV (1,386,100) Cost of purchasing new tank cars (300,580) The DFC analysis modified after the cost allocation is showed in Exhibit 3. After take in the costs, the NPV is ?,438,304 and the IRR is 19.27%. The payback period is 4.27 years. Concerns of the ICG Sales and Marketing Department The director of the ICG Sales department declared that due to a highly competitive polypropylene market, the increased throughput of the proposal would come at an expense of the Rotterdam plant because capacity would have to be shifted away from Rotterdam toward Merseyside to move the added volume. The vice president of Marketing disagree with the view, hypothesizing that Merseyside might be able to take customers away from competitors with lower costs. I believe that Empirical Chemical’s management would consider the entire company’s benefit instead of focusing on any single plant when evaluating capital budgeting projects. Thus, since the added volume in the Liverpool plant might affect the sales volume at the Rotterdam plant, cannibalization should be considered. However, since the cannibalization effect at the Rotterdam plant could hardly be estimated, I would evaluate the consequences on the most conservative approach. Th...
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by Anna87