Lynx Chemicals plc Late one afternoon in January 2022, Robert Green told Laura Smith, "No one seems satisfied with the analysis so far, but the suggested changes could kill the project. If solid projects like this can`t swim past the corporate piranhas, the company will never modernise." Laura was a plant manager of Lynx Chemicals` Liverpool Works in Liverpool, England. Her controller, Robert Green, was discussing a capital project that Laura wanted to propose to senior management.
The project consisted of a (British pounds) £400 million expenditure to renovate and rationalise the polypropylene production line at the Liverpool plant in order to make up for deferred maintenance and to exploit opportunities to achieve increased production efficiency. Lynx Chemicals was under pressure from investors to improve its financial performance because of both the worldwide economic slowdown and the accumulation of the firm`s common shares by a wellknown corporate raider, William Bright. Earnings per share had fallen to 20.00 pence at the end of 2023 from around 40.00 pence at the end of 2022. Laura thus: believed that the time was ripe to obtain funding from corporate headquarters for a modernisation program for the Liverpool Works-at least she had believed so until Robert presented her with several questions that had only recently surfaced.
Lynx Chemicals and Polypropylene Lynx Chemicals, a major competitor in the worldwide chemicals industry, was a leading producer of polypropylene, a polymer used in an extremely wide variety of products {ranging from medical products to packaging film, carpet fibres, and automobile components) and known for its strength and malleability. Polypropylene was essentially priced as a commodity. The production of polypropylene pellets at Liverpool began with propylene, a refined gas received in tank cars. Propylene was purchased from four refineries in England that produced it in the course of refining crude oil into petrol. In the first stage of the production process, polymerisation, the propylene gas was combined with a diluent (or solvent) in a large pressure vessel. In a catalytic reaction, the polypropylene precipitated to the bottom of the tank and was then concentrated in a centrifuge.
The second stage of the production process compounded the basic polypropylene with stabilisers, modifiers, fillers, and pigments to achieve the desired attributes for a particular customer. The finished plastic was extruded into pellets for shipment to the customer. The Liverpool production process was old, semi continuous at best, and, therefore, higher in labour content than its competitors` newer plants. The Liverpool plant was constructed in 1990.
Lynx Chemicals produced polypropylene at Liverpool and in Rotterdam, Holland. The two plants were of identical scale, age, and design. The managers of both plants reported to Ronald Gibs, executive vice president and manager of the Intermediate Chemicals Group (ICG) of Lynx Chemicals. The company positioned itself as a supplier to customers in Europe and the Middle East. The strategic- analysis staff estimated that, in addition to numerous small producers, seven major competitors manufactured polypropylene in Lynx Chemicals` market region. Their plants operated at various cost levels. Exhibit 1 presents a comparison of plant sizes and indexed costs.
The Proposed Capital Programme Laura had assumed responsibility for the Liverpool Works only 12 months previously, following a rapid rise from the entry position of shift engineer nine years before. When she assumed responsibility, she undertook a detailed review of the operations and discovered significant opportunities for improvement in polypropylene production. Some of those opportunities stemmed from the deferral of maintenance 3 over the preceding five years. In an effort to enhance the operating results of the Works, the previous manager had limited capital expenditures to only the most essential. Now, what previously had been routine and deferrable was becoming essential. Other opportunities stemmed from correcting the antiquated plant design in ways that would save energy and improve the process flow: (1) relocating and modernising tank-car unloading areas, which would enable the process flow to be streamlined; (2) refurbishing the polymerisation tank to achieve higher pressures and thus greater throughput; and (3) renovating the compounding plant to increase extrusion throughput and obtain energy savings.
Laura proposed an expenditure of £400million on this program. The entire polymerisation line would need to be shut down for 48 days, however, and because the Rotterdam plant was operating near capacity, Liverpool`s customers would buy from competitors. Robert believed the loss of customers would not be permanent. The benefits would be a lower energy requirement as well as a 6 percent greater manufacturing throughput. In addition, the project was expected to improve gross margin (before depreciation and energy savings) from 10 percent to 12 percent. The engineering group at Liverpool was highly confident that the efficiencies would be realised. Robert characterised the energy savings as a percentage of sales and assumed that the savings would be equal to 1.3 percent of sales in the first 5 years, 0.8 percent in years 6-10 and 0.1 percent in years11-15. He believed that the decision to make further environmentally oriented investments was a separate choice (and one that should be made much later) and. therefore, that to include such benefits (of a presumably later investment decision) in the project being considered today would be inappropriate
Liverpool currently produced 4,500,000 metric tons of polypropylene pellets a year. Currently, the price of polypropylene averaged £1200 per ton for Lynx Chemicals` product mix. The tax rate required in capital-expenditure analyses was 21 percent. Robert discovered that any plant facilities to be replaced had been completely depreciated. New assets could be depreciated on an accelerated basis over 15 years, the expected life of the assets. The increased throughput would necessitate a one-time increase of work-in-process inventory equal in value to 4.0 percent of cost of goods. Robert included in the first year of his forecast preliminary engineering costs of £20,000,000, which had been spent over the preceding nine months on efficiency and design studies of the renovation. Finally, the corporate manual stipulated that overhead costs be reflected in project analyses at the rate of 5.0 percent times the book value of assets acquired in the project per year.
The company`s capital-expenditure manual suggested the use of double-declining-balance (DDB) depreciation, even though other more aggressive procedures might be permitted by the tax code. The reason for this policy was to discourage jockeying for corporate approvals based on tax provisions that could apply differently for different projects and divisions. Prior to senior-management`s approval, the controller`s staff would present an independent analysis of special tax effects that might apply. Division managers, however, were discouraged from relying heavily on those effects. In applying the DDB approach to a 15-year project, the formula for accelerated depreciation was used for the first 10 years, after which depreciation was calculated on a straight-line basis. This conversion to straight line was commonly done so that the asset would depreciate fully within its economic life.
The corporate-policy manual stated that new projects should be able to sustain a reasonable proportion of corporate overhead expense. Projects that were so marginal as to be unable to sustain those expenses and also meet the other criteria of investment attractiveness should not be undertaken. Thus, all new capital projects should reflect an annual pre-tax charge amounting to 4 percent of the value of the initial asset investment for the project.
Robert had produced the discounted-cash-flow (DCF) summary given in Exhibit 2. It suggested that the capital program would easily hurdle Lynx Chemicals` required return of 11.6 percent for engineering projects.
Concerns of the Transport Division Lynx Chemicals owned the tank cars with which Liverpool received propylene gas from four petroleum refineries in England. The Transport Division, a cost centre, oversaw the movement of all raw, intermediate, and finished materials throughout the company and was responsible for managing the tank cars. Because of the project`s increased throughput, Transport would have to increase its allocation of tank cars to Liverpool. Currently, the Transport Division could make this allocation out of excess capacity, although doing so would accelerate from 2025 to now the need to purchase new rolling stock to support the anticipated growth of the firm in other areas. The purchase would cost £75 million. The rolling stock would have a depreciable life of 10 years, but with proper maintenance, the cars could operate much longer. The rolling stock could not be used outside Britain because of differences in track gauge. The Transport Division depreciated rolling stock using DDB depreciation for the first eight years and straight-line depreciation for the last two years.
A memorandum from the controller of the Transport Division suggested that the cost of the tank cars should be included in the initial outlay of Liverpool`s capital program. But Robert disagreed. He told Laura: The Transport Division isn`t paying one pence of actual cash because of what we`re doing at Liverpool. In fact, we`re doing the company a favour in using its excess capacity. Even if an allocation has to be made somewhere, it should go on the Transport Division`s books. The way we`ve always evaluated projects in this company has been with the philosophy of "every tub on its own bottom" -- every division has to fend for itself. The Transport Division isn`t part of our own Intermediate Chemicals Group, so they should carry the allocation of rolling stock.
How does Lynx Chemicals evaluate its capital-expenditure proposals? Why is such a complicated scheme used for evaluation of proposals? Suggest simplification of this scheme providing your rationale.
Evaluate the Transport Division’s suggestion? Does it have any merit?
Evaluate the director of sales’ suggestion? Does it have any merit?
Why did the assistant plant manager offer his suggested change? Does it have any merit?
What did the analyst from the Treasury Staff mean by his comment about inflation? Do you agree with it?
Explain the difference between the free cash flows and the equity cash flows mentioned by the senior analyst of Treasury.
Calculate the cost of capital for The Liverpool Project using weighted average cost of capital of debt and equity and also confirming with your own calculations that the cost of equity capital for Lynx Chemicals is indeed 12% as stated by the senior analyst of Treasury.
How should Robert modify his DCF analysis?
Evaluate the Liverpool project worth to Lynx Chemicals with and without cannibalism?
Examine the sensitivity of the project to changes in the manufacturing throughput, discount rate and gross margin with cannibalism
Assess the impact of the project on the earnings per share of the company and explain how EPSEBIT analysis helps in deciding the financial policy of a company.
