Critiques of the Grand Metropolitan Case

Århus School of Business

19 November 1999

Corporate Finance

1. Merseyside

The Mersyside factory belongs to the group ICG (Intermediate Chemicals Group ). In this factory polypropylene is produced from propylene. This polymere is used for a large variety of products (for example components of automobiles automobiles, …) ; they get the propylene from four refineries in England made from crude petroleum.

The process of production is old, and this makes the throughput semi continuous. This factory has one of the biggest position in chemical industries in the world.

The project.

It is becoming urgent to improve the process of production of polypropylene, because the EPS has come down from £12.75 to £4.55. Trelawney proposed a plan in three points, relocating and modernizing tank car unloading areas, refurbishing the polymerization tank to achieve higher pressures and thus greater throughput and renovating the compounding plant to increase extrusion thruoghput and obtain energy savings.

The plan consisted in the renovation of existing facilities to optimize the throughput, without using new technology.

Initial Investment : £ 7 millions (closing the factory : 60 days)

Preliminary engineering costs : £ 500 000

Increase in production : 7%

Necessary amount of WIP : 3.0% cost of goods

Discount rate : 9%

NPV : £ 4938529

IRR : 20.1%

1.3. Investment criteria.

(3) Discounted cash flow must be positive

(4) Internal rate of return must be greater than the discount rate used (9%)

B. Rotterdam

The factory at Rotterdam had the same cost and process structure. This factory with the one at Merseyside creates the group EC (Empirical Chemicals).

The project.

The proposed project for Rotterdam consisted of the conversion of the polymerization line of the factory into a sofisticated control process for the elaboration of the polymere. The continuous flow of materials would be assured by a pipeline. The factory had acquired the option to buy the pipeline and the land at a price of £ 3 millions, and currently the price is supposed to be worth £ 6 millions, which means an overvalue of 3 millions in comparison with the price payed (estimations in 15 years ahead give a price of £35 millions).

Initial investment : £ 7.5 millions 3 millions now, 2 millions at the end of 1992, and 1.5 million in 1993, and finally 1 million in 1994

Preliminary engineering costs : £ 500 000 (sunc costs)

Increase in production/Prior year : 2% per year

Discount rate : 9%

NPV : £ 2458392

IRR : 10.76%

The conditions expected to be achieved are exactly the same than for A.

(2) As far as the EPS is concerned....

(3) According to the payback period it is better the Merseyside project because it is of 4.36 years whereas in Rotterdam project is approximately 12 years. (Exhibit 8)

(4) Because of the different outlays overtime we can´t compare the IRR.

This is a comparative table of the two factories.

Assumptions

In the english project, we don´t take into consideration the supplementary costs generated by the charge of the transport costs assumed currently by the Transport Division. Anyway the costs of the accelerating the purchase of new trucks (2 million) is only the marginal cost of doing it in 1994 instead of 1996.

The concesion of the pipeline is not a sure figure of £ 35 millions, and thus can change its value or become simply unsellable or unuseful. Makes project B very sensitive for changes in the market.

In our opinion, there are mistakes in the calculations in these several points :

In addition, preliminary engineering costs shouldn´t be considered in the calculations of the NPV. We assume that they are part of a previous study and therefore should be considered as sunc costs.

As far as depreciation is concerned we think it is not a good idea to make a double declining depreciation and a straight line one in one of the cases but not in the other one. Coherence should be showed to have comparable results in both cases.

We consider that the discount rate that should be used in both cases is the 9% discount rate due to the fact that all the figures have been obtained in real terms, already considering inflation.

For the calculations of the growth of the gross margin we found mistakes because every figure is obtained by multiplying twice by the discount factor, instead of just once. For the gross margin itself, we assume the calculations are OK, and that the energy savings are included in the calculations in A.

Results of the calculations of the overhead costs are wrong in case B.

Conclusion

They should take the Merseyside project because it gives them an improvement in the production process with the flexibility to even improve it to a larger extent in 5 years. In our opinion, taking the Rotterdam project is too risky because they are relying too much on the value of the pipeline in 15 years, and there are many conditions that can change in 15 years, including prices, types of energies,etc.