Victoria Chemica

Finance 475

VICTORIA CHEMICALS CASE

Case #22/23

1. Evaluate the capital budgeting criteria of Victoria Chemicals. Which criterion is an erroneous criterion? Name at least three reasons why it is erroneous.

a. Impact on EPS is erroneous because EPS:

i. Will be biased towards shorter term projects, because EPS focuses on the current cash flows instead of the future cash flows.

ii. Can be misleading due to

1. The degree of financial leverage (DFL)

2. Using a 15 year pro-forma based upon 2007 numbers of outstanding shares and not making any alterations

2. Were any irrelevant expenses included in the capital budgeting analysis for the Merseyside plant? If so, which one(s)? Why are they irrelevant?

a. Victoria Chemicals: “Prelim. Engineering Costs” a.k.a. Sunk Cost

i. The plant manager has included the preliminary engineering costs of GBP 500,000 spent over the past nine months on efficiency and design studies of the renovation. These costs are already incurred and are independent of the project decision. Whether or not the project is going to be approved, these costs are to be borne by the company. Therefore, these costs are not to be considered for the DCF analysis.

b. Victoria Chemicals: “Cost of Capital”

i. Greystock’s discounted cash flow also suggested that the company would earn a 10%return on the project, even though the Treasury staff believed the real return to be 7% due to a 3% in inflation per year. However, Greystock decided to continue to use a discount rate of 10% because it was the figure promoted in the latest edition of the company’s capital-budgeting manual. Going with the high discount rate will prove to be problematic because if the 7% figure were more accurate, using the 10% rate would allow the company to accept projects (those that fall between 7 and 10 percent) that should be rejected

3. For the Rotterdam capital-budgeting analysis, the estimated cash flow in one of its projected years is obviously wrong. A) Which one is it, and why is it wrong? B) Correct the cash flow and then re-calculate the NPV and IRR of the Rotterdam project.

a. Terminal Value: Land

i. The reasoning behind the flawed calculation is best spoken by Jeffrey Palliser Chairman of the Executive Committee at Victoria Chemicals. “Simply buying the right-of-way with the