Assignment 2:

Due date:    Hard copy of the assignment to be delivered to the Bioscience Student Centre by 4.00 pm on Friday 1 June 2012. Cover sheet available from BSC.

NOTE:        The due date is an amendment from the Course Outline to enable the lectures to be completed prior to submission.       

Marks:        This assignment contributes towards 30% of the final assessment

BIOTECHNIQUE CHEMICALS LTD.

THE UPGRADE PROJECT

In January 1992, Roger Dawkins told Frank Stanaway, “No one seems satisfied with the preliminary analysis so far, but the suggested changes could kill the project. If projects like this can’t get accepted, the company will never modernise.”

Stanaway was plant manager of Biotechnique’sGlenlines Plant. His controller, Roger Dawkins, was discussing a capital project he wanted to propose to senior management. The project consisted of a $7 million expenditure to renovate and rationalise the polypropylene production line at the Glenlines Plant in order to make up for deferred maintenance and to achieve increased production efficiency.

Biotechnique was under pressure from investors to improve its financial performance. Earnings per share had fallen to $4.55 at the end of 1991 from $12.75 at the end of 1990. Stanaway thus believed that the time was right for a modernisation program for the Glenlines Plant – at least he had believed so until Dawkins presented him with several questions that had only recently surfaced.

Biotechnique Chemicals Ltd and Polypropylene

Biotechnique, a major company 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 fibers, and automobile components) and known for its strength and malleability.

The production of polypropylene pellets at Glenlines began with propylene, a refined gas received in rail tanks. Propylene was purchased from four refineries in Australia that produced it in the course of refining crude oil into gasoline. In the first stage of the production process the propylene gas was combined with a solvent in a large pressure vessel. In a catalytic reaction, polypropylene precipitated to the bottom of the tank and was then concentrated in a centrifuge.

The second stage of the production process combined the basic polypropylene with arange of compounds to meet the requirements of particular customers.

The Glenlines production process was old (the plant was constructed in 1967), semi continuous at best, and therefore, higher in labor content than some competitors’ newer plants.

Biotechnique produced polypropylene at Glenlines and in Sydney, Australia. The two plants were of identical scale, age and design. The managers of both plants reported to the Biotechnique manager of the Intermediate Chemicals Group (ICG). The company positioned itself as a supplier to customers in South East Asia and the Middle East. In addition to numerous small producers, seven major competitors manufactured polypropylene in Biotechnique’s market region. Their plants operated at various cost levels. The Exhibit(attached) presents a comparison of plant sizes and indexed costs.

The Proposed Capital Expenditure Program

Stanaway had assumed responsibility for the Glenlines Plant only twelve months previously and undertook a detailed review of the operations and discovered significant opportunities for improvement in polypropylene production. Some of these opportunities stemmed from the deferral of maintenance over the preceding five years. In an effort to enhance the operating results of the Plant, the previous manager had limited capital expenditures to only the most essential. Now, what had been routine and deferrable was becoming essential. Other opportunities stemmed from changing the current plant design that would save energy and/or improve the process flow:

(1) relocating and modernising rail tanks unloading areas.

(2) refurbishing the polymerisation tank to achieve greater throughput; and

(3) renovating the compounding plant to increase extrusion throughput.

Stanawayanticipated expenditure of $7 million on this program. The entire polymerisation line would need to be shut down for 60 days, however, and because the Sydney plant was operating near capacity, Glenlines’ customers would buy from competitors. Hawkins believed the lost customers would not be permanent. The benefits would be a lower energy requirement¹ as well as a 7 percent greater manufacturing throughput. In addition, the project was expected to improve gross margin (before depreciation and energy savings) from 11.5 percent to 12.9 percent.

Glenlines currently produced 135,000 metric tons of polypropylene pellets per year. Currently, the price of polypropylene averaged $611 per ton for Biotechnique’s product mix. The tax rate required in capital-expenditure analyses was 35 percent. Dawkins discovered that any existing plant facilities to be replaced had been fully depreciated. New assets would be depreciated on a straight line basis² over 15 years, the expected life of the assets. The increased throughput would necessitate a one-time increase of  inventory equal in value to 3.0 percent of cost of goods. Dawkins included in the first year of his forecast “preliminary engineering costs” of $500,000, which had been spent over the preceding 9 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 3.5 percent per yearof the cost of assets acquired in the project³.

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1. Dawkins characterized the energy savings as a percentage of sales and assumed that the savings would be equal to 1 percent of sales in the first 5 years and .5 percent in years 6-10. Thereafter, without added aggressive “green” spending, the energy efficiency of the plant would revert to its old level, and the savings would be 0. 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.
2. The company’s capital-expenditure manual suggested the use of straight line depreciation, even though other more aggressive procedures might be permitted by the tax code. The reason for this policy was to discourage jockeying for corporateapprovals based on tax provisions that could apply differently for different projects and divisions.
3. The corporate policy manual stated that

new projects should be able to sustain a reasonable proportion of corporate overhead expense. Projects which are so marginal as to be unable to sustain these expenses and also meet the other criteria of investment attractiveness should not be undertaken. Thus, all new capital projects should reflect an annual pretax charge amounting to 3.5 percent of the value of the initial asset investment for the project. 

Concerns of the Transport Division

Biotechnique owned the rail tanks with which Glenlines received propylene gas from four petroleum refineries in Australia. The Transport Division, a cost center, oversaw the movement of all raw, intermediate, and finished materials throughout the company and was responsible for managing the rail tanks. Because of the project’s increased throughput, Transport would have to increase its allocation of tanks to Glenlines. Currently, the Transport Division could make this allocation out of excess capacity, although doing so would accelerate from 1996 to 1994 the need to purchase new rolling stock to support anticipated growth of the firm in other areas. The purchase would cost $2 million. The rolling stock would have a depreciable life of 10 years, but with proper maintenance, the tanks could operate much longer.

A memorandum from the controller of the Transport Division suggested that the cost of these rail tanks should be included in the initial outlay of Glenlines’ capital program. But Dawkins disagreed. He told Stanaway

The Transport Division isn’t paying one cent of actual cash because of what we’re doing at Glenlines. In fact, we’re doing the company a favor 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 that 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 rail tanks.

The Transport Division and Intermediate Chemicals Group reported to separate managers, who, themselves, reported to the chief executive officer of the company. The managers received an annual incentive bonus pegged to the performance of their divisions.

Concerns of the ICG Sales and Marketing Department

Dawkins’s analysis had led to questions from the director of Sales. In a recent meeting, the director told Dawkins,

Your analysis assumes that we can sell the added output and thus obtain the full efficiencies from the project, but as you know, the market for polypropylene is extremely competitive. To move the added volume, we will have to shift capacity away from Sydney toward Glenlines. Is this really a gain for Biotechnique? Why spend money just so one plant can cannibalise another?

The manager of Marketing was less skeptical. He said that, with lower costs at Glenlines, Biotechnique might be able to take business from the plants of competitors such as Seille or Sauay. In the current severe recession, competitors would fight hard to keep customers, but sooner or later, the market would revive, and it would be reasonable to assume that any lost business volume would return at that time.

Dawkins had listened to both the director and manager and chose to reflect no charge for a loss of business at Sydney in his preliminary analysis of the Glenlines project. He told Stanaway,

Cannibalisation really isn’t a cash flow; there is no cheque written in this instance. Anyway, if the company starts burdening its cost-reduction projects with fictitious charges like this, we’ll never maintain our cost competitiveness. A cannibalisation charge is rubbish!

Concerns of the Assistant Plant Manager

Harry Mulvaney, the assistant plant manager and direct subordinate of Stanaway, proposed an unusual modification to Dawkins’s analysis during a late-afternoon meeting with Dawkins and Stanaway. Over the past few months, Mulvaney had been absorbed with the development of a proposal to modernise a separate and independent part of the Glenlines operations, the production line for ethylene-propylene-copolymer rubber (EPC). This product, a variety of synthetic rubber, had been pioneered by Biotechnique in the early 1960s and was sold in bulk to American tyre manufacturers. Despite hopes that this oxidation-resistant rubber would dominate the market in synthetics, in fact, EPC remained a relatively small product in the American chemical industry. Biotechnique, the largest supplier of EPC, produced the entire volume at Glenlines. EPC had been only marginally profitable to Biotechnique because of entry by competitors, the development of competing synthetic rubber compounds, and the slump in tyre sales over the past five years.

Mulvaney had proposed a renovation of the EPC production line for a cost of $1 million. The renovation would give Biotechnique the lowest EPC cost base in the world and improve cash flows by $25,000 in perpetuity. Even so, at current prices and volumes, the net present value (NPV) of this project was -$750,000. Mulvaney and the EPC product manager had argued strenuously to the executive committee of the company that the negative NPV ignored strategic advantages from the project and increases in volume and prices when the recession ended. Nevertheless, the executive committee had rejected the project, mainly on economic grounds.

In a hushed voice, Mulvaney said to Stanaway and Dawkins,

Why don’t you include the EPC project as part of the polypropylene line renovations? The positive NPV of the poly renovations can easily sustain the negative NPV of the EPC project. This is an extremely important project to the company, a point that senior management doesn’t seem to get. If we invest now, we’ll be ready to exploit the market when the recession ends. If we don’t invest now, you can expect that we will have to exit the business altogether in three years. Do you look forward to more layoffs? Do you want to manage a shrinking plant? Recall that our annual bonuses are pegged to the size of this operation. Also remember that in the last 20 years no one from corporate has monitored renovation projects once the investment decision was made.

Concerns of the Treasury Staff

After a meeting on a different matter, Roger Dawkins described his dilemmas to Andrew Deakins, who worked as an analyst on Biotechnique’s Treasury staff. Deakins scanned Dawkins’s preliminary analysis, and pointed out that:

Cash flows and discount rate need to be consistent in their assumptions about inflation. The 13 percent required rate of return you’re using is a nominal target rate of return. The Treasury staff think this impounds a long-term inflation expectation of 4 percent per year. Thus, Biotechnique’s real (i.e., zero-inflation) target rate of return is closer to 9 percent.

The conversation was interrupted before Dawkins could gain a full understanding of Deakins’s comment. For the time being, Dawkins decided to continue to use a discount rate 13 percent, because it was the figure promoted in the latest edition of Biotechnique’s capital budgeting manual.

Evaluating Capital-Expenditure Proposals at Biotechnique Chemicals

In submitting a project for senior-management approval, the proposers had to identify it as belonging to one of four possible categories: (1) new product or market, (2) product or market extension, (3) engineering efficiency, or (4) safety or environment. The first three categories of proposals were subject to a system of four performance “hurdles”, of which at least three had to be met for the proposal to be considered. The Glenlines project would be in the engineering efficiency category. The performance hurdles are:

1.               Impact on earnings per share. For engineering-efficiency projects, the contribution to net income from contemplated projects had to be positive. This criterion was calculated as the average annual EPS contribution of the project over its entire economic life, using the number of outstanding shares at the most recent financial year-end used as the basis for the calculation. (At financial year end 1991, Biotechnique Chemicals had 92,891,240 shares outstanding.)

2.               Payback. This criterion was defined as the number of years necessary for free cash flow of the project to amortize the initial project outlay completely. For engineering-efficiency projects, the maximum payback period was six years.

3.               Discounted cash flow. DCF was defined as the present value of future cash flows of the project (at the discount rate of 13 percent for engineering-efficiency proposals), less the present value of the initial investment outlay. This net present value of free cash flows had to be positive.

4.               Internal rate of return. IRR was defined as being that discount rate at which the present value of future free cash flows just equaled the initial outlay (in other words, the rate at which the NPV was 0). The IRR of engineering-efficiency projects had to be greater than 13 percent.

Conclusion

Stanaway wanted to review Dawkins’s preliminary analysis in detail and settle the questions surrounding the rail tanks and potential loss of business volume at Sydney. As Dawkins’s analysis now stood, the Glenlines project met all four investment criteria.

Required:

Analyse the data provided in the same way as Dawkins preliminary analysis and include all of the issues you consider relevant for a submission to be made for senior management approval.

Exhibit

BIOTECHNIQUE CHEMICALS LTD.

THE GLENLINES PROJECT

Comparative Information on the

Seven Largest Polypropylene Plants

SOLUTION

1. Introduction

Bio-Technique Chemicals is considering an up gradation of the current facilities at the plant. The management of the corporation is not satisfied with the preliminary analysis of the project. For this paper the investment and the capital expenditure in question is studied in detail, and an analysis report is prepared for the project. The paper evaluates the rail tank project in detail and considers all expenditures and returns associated with the project. A complete analysis of the proposed modernization plan is undertaken in the analysis, and the suggestions and recommendations are made on the results proposed. Therefore let us undertake the discussion below to analyse the situation of then proposed capital expenditure.

2. The Proposed Capital Expenditure Concerns

Bio-technique Chemicals Ltd and Polypropylene a chemical major is considering an expansion program at Sydney as well as evaluating the production facilities and the process at the Sydney plant. The proposed modernization is likely to increase organizational efficiency as well as in reduce the financial pressure on the organization. The proposed capital; expenditure had been proposed over a long period of time, but comparing the modernized production techniques of the competitors as well as levels of efficiency, the expense cannot be deferred any longer. The main aim of the proposed capital expenditure is to introduce efficiency in the current production process.

A capital expenditure of $7million is being proposed, which would be invested in the corporation over a 60 day period.  The expected cash flow from the project over the one year period is obtained by multiplying the total output of the firm with the price of the product in the market currently at $611 per ton Thus,(135000 x $611) is $ 82485000 per year . The proposed rate of taxation is 35% of the initial capital outlay which is equivalent to $2.45 per year.  The proposed engineering costs amounted to $500,000 and the additional overhead costs were equivalent to 3.5% of the total assets acquired in the business equivalent to $24500. Therefore to analyse the feasibility of the project the NPV and the IRR analysis is undertaken analysis is undertaken.

(Eugene F. et al 2011).

Therefore undertaking the above data we have

(The sunk costs and the overhead costs are not considered in the calculation of the NPV)

A 3 year time period is considered and based on formula the project yields a return of   $ 2, 90, 12,344 million over a 15 year period of time. Thus, the investment would prove to be profitable after a three year period. As the NPV of the current project in question is positive the investment should be undertaken. Also to analyse the returns of a particular project with such high costs on investment the NPV method should be preferred over the IRR because of the reasons listed below. The IRR for the 15 year period is reflected at 83%, thus the investment is likely to yield an 83% return after the 15 year period.

When NPV = 0 the IRR is calculated.

The NPV and the IRR produce the same results if the investments are independent of each other. An independent investment implies that the cash flows of one project do not affect the cash flows of the other project or investment. Thus in such a case when the investments are independent of each other the cash flow remains the same they can be discounted eventually producing the same results or both NPV and IRR. Therefore, after determining the nature of the investment and the potential cash flows that the investment is bound to generate the NPV as well as the IRR are suitable analysis to determine the undertaking of the investment. As in the case of most capital budgeting decisions the NPV is a better measure to evaluate the present value of the investment as it accounts both time value of money and takes cares of long term goals and profitability considerations.

(Bringham et al, 2009)

Despite the project offers a positive NPV return on the project certain concerns still accrue to the project. The proposed capital expenditure and the modernization program involve the shutting down of the production facilities at the Sydney plant to undertake the modernization process. Despite the fact that the shutting down of the facilities would involve loss of the current production, as well as loss of capacity for the current plant. This could possibly result in the customer base being shifted to the competitors as the industry in which it operates is highly competitive. The company has established itself as a major exporter in the South Asia. The loss of the customer is however not permanent because the market and the customers can be effectively regained with an effective marketing and sales incentive program. But, however the poor efficiency of the current capacity cannot be ignored. Thus despite the shutting down of the plant and the loss, the step would have to undertake to ensure the long run profitability of the business.

3. The Proposed Elimination of a Product Line

An individual at Stanaway has also proposed an expansion of the existing product line. The project is under consideration by the management of the corporation. The existing manufacturing system is the production line for ethylene-propylene-copolymer rubber (EPC) which was exported in bulk to American tyre manufacturers. The corporation had been a market leader in the manufacture of the product, but in the current time the product forms a very small proportion of the American tyre industry. Moreover the Proposed investment of $1million in the modernization of the existing plant and equipment yields a negative NPV of the project was -$750,000 along with the expected cash flows of $25,000. The investment in the project clearly seems to be unprofitable because of the following reasons

1. Firstly, The NPV of the project is clearly negative and the cash flows of $25,000 to perpetuity have not contributed to giving postie returns on the project.
2. Secondly, the decline in the  share of the production line for ethylene-propylene-copolymer rubber (EPC), despite experiencing robust growth and expansion in 1960’s the current situation is very grim .The product forms only a small proportion of the American exports as well as the faces stiff competition from the domestic American market producers.
3. Thirdly, The Australian economy has fared better than some of the global economies in 2009. The Reserve Bank of Australia has ensured relative insulation of the economy from the global markets. In fact the RBA was the first to increase the interest rates in an attempt to tighten liquidity to safeguard against the financial crisis. In October 2009 the RBA increased the interest rate by 25 base points to 3.25%. Now after successfully evolving from the financial crisis from 2008-2011 and the growth expectations of the economy has been relatively better. The financial crisis which originated in the US has been the one of the worse performing and has still not recovered from the crisis , the exports have been affected because of the low demand in the US economy.  (www.qfinance.com- accessed on 30/5/2012)

Thus, keeping in mind the current market conditions of the US economy as well as the performance of the Bio technique corporation it is advisable to the eliminate the product from the current product line of the company, as it has experienced no growth in the past 5 years, as well as any modernization is not likely to contribute to increasing profitability of the manufacturing unit. Thus, the elimination of the product line would reduce the financial losses as well give additional capacity to the corporation to expand its operations arising from the energy saving as a result of the elimination of the product line from the company.

 4. The Market Expansion

The combined production of the Bio-technique chemicals comprising of both the plants at Sydney and Glenlines is 270,000 tonnes which is the largest in comparison to any of the other chemical manufacturers in the area. Thus Bio-technique is a clear market leader in the production of the product. The Corporation is also relatively low cost in comparison to its competitors.

Thus the low cost index in comparison to the competition set at 1.09 indicates the organization is relatively low cost and efficient. But however the corporations in Thailand are more low cost. Thus , there is an efficiency loss to some extent and therefore the efficiency needs to be introduced in the manufacturing process , the proposed capital expenditure and the modernization techniques introduced is likely to increase the efficiency in the system. This may also result in returns to scale and eventually economies of scale in the long run.

Economies of scale occurs when with the increase in the scale of production it leads to lowering the average costs in a production process .Most of the economies of scale are based on the production processes which are largely technological. Thus, with the proposed modernization and the introduction of the new technology in the production process returns to scale is likely to set in the production process. With the setting up of returns to scale in the production process the cost index of Bio-technique is almost set to be lowered indicating of high output production at low costs in  the long run.

(Case and Fair, 2009)

5. Centralization of the Management

5.1 Removal of Conflict of Interests

It is important for the management to establish internal control activities as there appears to be a certain conflict of interest between the different departments of the same organization. Therefore it is necessary to establish a degree of coordination and internal control mechanisms to ensure that there is no conflict of interest between the various management levels. The internal control activities are affected by each level in the organization. With the main objective of managers is ensuring organizational efficiency in the business. Though there is no guarantee that the control mechanisms result in the attainment of the long term goals of the organization but result definitely in ensuring efficiency of operations.

(Ucop.edu- accessed on 12/05/2012)

A centralized internal control environment eliminates the existence of conflict of interest in the organization. Bio-technique needs to establish a centralised finance controlling operations department which ensures that the interests of all the departments are taken care of. There is a clear presence of conflict of interest as can be seen in the transport department of the organization not willing to incur a capital expense of $200,000, and depreciating on a straight-line basis for a period of 10 years. This conflict of interest is a result because the managers of both the transport department as well as the Intermediate Chemicals Group report to separate managers thus, there no clarity in flow of information and the allocation of resources. This has resulted in the conflict of interest between the two subordinate departments of the company. The corporations CFO needs to establish control over all the resources and determine their effective allocation based on the evaluation of risk and return for each project as well as each of the departments in the organization. The removal of conflict of interest would lead to the restoration of organizational efficiency which would be essential to ensure the success of the project.

5.2 Concerns of the Marketing Department

The marketing department of the corporation established certain concerns related with the incurring of the capital expenditure. The proposed capital expenditure and the modernization program involve the shutting down of the production facilities at the Sydney plant to undertake the modernization process. The shutting down of the facilities would involve loss of the current production, as well as loss of capacity for the current plant. This could possibly result in the customer base being shifted to the competitors as the industry in which it operates is highly competitive The loss of the customer is however not permanent because the market and the customers can be effectively regained with an effective marketing and sales incentive program. The resources to the marketing department also need to allocate centrally by the CFO and appropriate strategies have to be developed to regain the customers.

6. Conclusion

Thus the proposed capital expenditure on the expansion and the modernization of the plant is likely to introduce efficiency and result in the long run gain to the organization. With the new technology the organization is likely to benefit from the returns to scale as well. But however the effective allocation of resources is recommended , the CFO of the corporation should establish the risk- return on each of the project and determine effective allocation , and this would result in the long run efficiency gains.

7. References

• Ehrhardt, Michael C., and Eugene F. Brigham. Financial management: theory and practice. 13th ed. Mason (OH): South-Western, 2011. Print.
• Case, Karl E., Ray C. Fair, and Sharon M. Oster. Principles of macroeconomics. 9th ed. Upper Saddle River, NJ: Prentice Hall, 2009. Print.
• Ucop, Education. “Understanding Internal Controls.” Ucop education 1.1 (2012): 1-21. Print.
• Fraser, Ian, Anthony Harrington, January 11, and 11 2011. “Australia – Economy and Trade of Australia – QFINANCE.” Financial resources, articles, concepts and opinions from QFINANCE – QFINANCE. N.p., n.d. Web. 23 Apr. 2012. <http://www.qfinance.com/country-profiles/australia

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