Case 3 Empirical Chemicals

Morgan |1 Stephanie Morgan FIN 4424 Instructor Charles Evans June 4, 2011

Empirical Chemical Case (A)  Background Information

Empirical Chemical Company is a major competitor in the worldwide chemicals industry with two plants. Frances Trelawney, who had assumed responsibility for the Merseyside Works only 12 months previously, believed after a worldwide recession in the chemicals industry and earnings per share dropping 64.3% from $12.75 at the end of 1990 to $4.55 at the end of 1991, that the Merseyside Works needed to ask corporate for funding for a modernization program. Trelawney proposed an expenditure of $7 million for this program.

 Recommendation

I recommend Empirical Chemical continue with the Merse yside Project for reasons discussed below.

 Key Issues

There are five key issues involved in the decision to recommend renovation of Merseyside plant. Transport Division (TD) addition expenditures

Based on the information provided, I believe that the Merseyside Project should internalize the additional cost that would occur due to the additional purchase of rolling stock required for the project. I make this recommendation because a cost incurred by the project earlier than expected should be taken into account by the project and not by another division. That expense is not considered because they would have to expand anyway. Within the two years

Morgan |2 or so there will be excess capacity that they can use to continue to expand and either way they would need to buy new trucks to keep up with the demand. The company is growing over the years and the trucks will be needed in order to keep up with the projected growth that Merseyside Works will see after the modernization project has taken full affect. This should not be considered in this at all but as a separate project all together. Hawkins is merely making the recommendation that the TD incur the costs because of the skewed incentive structure for each division. Cannibalizing Sales

Cannibalizing sales from the other plant is a relevant issue, however, I believe that Hawkins is correct in not including it in the NPVcalculation, but for a very different reason than he stated. It is not that cannibalization is not relevant, it is very much so relevant; it's just that if  the project is not done it is entirely possible that another company will cannibalize the sales that Empirical Chemicals is trying to capture by making these improvements. So, either way there will be cannibalization and it is better that the other plant does it than an outside competitor. Therefore, my hope is that the increased sales through cannibalization will account for the loss of  sales that would otherwise occur from other companies stealing Empirical Chemical's market share. The shares that Empirical Chemicals will end up losing will be because of the closing of  the plant for the modernization improvements but they are expected to come back as soon as the plant is reopened. But even though cannibalization might occur from the Rotterdam plant, because the sales at one plant are going up and one plant is going down, the energy efficiency at the Merseyside plant will save the company enough money in the end to keep the NPV positive. It all, essentially, will balance itself out after the savings are realized and both plants are back up

Morgan |3 and running concurrently.  Modernizing EPC 

Modernizing EPC is completely irrelevant to the project. Just because the assistant manager believes that this is necessary for his survival, does not mean it is in the best interest for the company. It is an independent part of the company and has no relation to the project at hand. The assistant manager is simply trying to hide a bad project within a potentially good one, and this would be detrimental to the company as a whole. If this was projected out maybe 25 years rather than 15 years, the NPV may come out positive but, in this case it is not relevant. There is no way to tell what the benefit will be to the company in the long run but in the short term it is clear that the manager is more concerned with his own agenda than that of the company as a whole.  Inflation

Accounting for inflation is extremely important. You cannot simply ignore inflation on either the costs that you incur as a company, or on the sales that you make. To reflect the impact of inflation, I have increased the inflation in the excel graph provided to 4% and the discount rate to 17% to reach a real discount rate of 13% instead of a nominal rate of 17%. Even though Gross Margin does not change as a percentage, the real dollar sales increase due to inflation actually causes a higher NPV than without inflation.  Meeting Project requirements

The new numbers based on my analysis are as follows: Average Annual Addition to EPS: 0.01145084 Payback Period: 5 years Net Present Value: $3.77 Million Internal Rate of Return: 22.8%

Morgan |4 Based on these numbers projections, the project meets all four relevant requirements after the adjustments in issues 1-4. The project is profitable every single year and makes a substantial amount more than the original $7 million expenditure. I would definitely recommend this project to corporate to receive funds. Even though the Merseyside Works will have to close, the company will still realize gains in the end.