M o r g a n | 1Stephanie MorganFIN 4424Instructor Charles EvansJune 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 Merseyside 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

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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

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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 yearsNet Present Value: $3.77 Million Internal Rate of Return: 22.8%

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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.