Case Victoria Checmicals Plc (B)

James Fawn was presented with two projects to improve polypropylene output for Victoria Chemicals: one for its Merseyside plant, the other for the plant in Rotterdam. Each project had the potential for increasing production by 7%. Since a combined increase of 14% was unwarranted, James could only support one of the proposed projects.

Victoria Chemicals used four criteria in the evaluation of project proposals: net present value, internal rate of return, payback period, and growth in earnings per share. The Merseyside project showed an NPV of £10.45m compared to Rotterdam’s £11.37m. The IRRs were 24% and 15.4% for Merseyside and Rotterdam, respectively. Merseyside would take 3.8 years to pay back the initial investment, and Rotterdam would take 6.8 years. Growth in earnings per share was £0.022 for Merseyside and £0.048 for Rotterdam. The differences in rankings were due to a substantial difference in the respective projects’ initial outlays and expected cash flows. The Merseyside project had a higher IRR and a much lower payback period. Rotterdam had a higher NPV by almost a million pounds, and a larger growth in EPS. The Rotterdam project failed to meet the payback period of 6 years, however. This immediately excluded it from further consideration.

Rather than simply accept the Merseyside project, we decided to explore the future investment in the technology that the Rotterdam project proposed, but with respect to installation in the Merseyside plant. For the analysis, Black-Scholes option value pricing was applied. To evaluate the price, we created a new cash flow analysis utilizing assumptions from the text. Our resulting DCF was £8.03m, which we set to P in the equation. The X parameter was set to £7m, or the investment less the pipeline expense. We set t to 15, to match the time horizon of the project. Lastly, the risk-free rate and standard deviation parameters were set to the values given in the case. We then calculated an option value...