Question: Incremental cash flow: How should Greystock modify his Discounted Cash Flow analysis related to overhead costs, preliminary engineering costs, and inventories?

VICTORIA CHEMICALS PLC (A): THE MERSEYSIDE PROJECT

Exhibit 2
VICTORIA CHEMICALS (A)
Frank Greystock's DCF Analysis of Merseyside Project
(financial values in millions of British pounds)
Assumptions
Annual Output (metric tons)				250,000		Discount rate				10.0%
Output Gain/Original Output				7.0%		Tax Rate				30%
Price/ton (pounds sterling)				675		Investment Outlay (mill.)				12.0
Inflation Rate (prices and costs)				0.0%		Depreciable Life (years)				15
Gross Margin (ex. Deprec.)				12.50%		Salvage Value				0
Old Gross Margin				11.5%		WIP Inventory/Cost of Goods				3.0%
Energy Savings/Sales			Yr. 1-5	1.25%		Months Downtime, Construction				1.5
			Yr. 6-10	0.75%		Preliminary Engineering Costs				0.5
			Yr. 11-15	0.0%		Overhead/Investment				3.5%
				1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
		Year	Now	2008	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020	2021	2022
1. Estimate of Incremental Gross Profit
	New Output (tons)			267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500	267,500
	Lost Output--Construction			(33,438)
	New Sales (Millions)			157.99	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56	180.56
	New Gross Margin			13.8%	13.8%	13.8%	13.8%	13.8%	13.3%	13.3%	13.3%	13.3%	13.3%	12.5%	12.5%	12.5%	12.5%	12.5%
	New Gross Profit			21.72	24.83	24.83	24.83	24.83	23.92	23.92	23.92	23.92	23.92	22.57	22.57	22.57	22.57	22.57
	Old Output			250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000	250,000
	Old Sales			168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75	168.75
	Old Gross Profit			19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41	19.41
	Incremental Gross Profit			2.32	5.42	5.42	5.42	5.42	4.52	4.52	4.52	4.52	4.52	3.16	3.16	3.16	3.16	3.16
2. Estimate of Incremental WIP inventory
	New WIP inventory			4.09	4.67	4.67	4.67	4.67	4.70	4.70	4.70	4.70	4.70	4.74	4.74	4.74	4.74	4.74
	Old WIP inventory			4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48	4.48
	Incremental WIP inventory			-0.39	0.19	0.19	0.19	0.19	0.22	0.22	0.22	0.22	0.22	0.26	0.26	0.26	0.26	0.26
3. Estimate of Incremental Depreciation
	New Depreciation			1.60	1.39	1.20	1.04	0.90	0.78	0.68	0.59	0.55	0.55	0.55	0.55	0.55	0.55	0.55
4. Overhead				0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42	0.42
5. Prelim. Engineering Costs				0.50
Pretax Incremental Profit				-0.20	3.61	3.80	3.96	4.10	3.32	3.42	3.51	3.55	3.55	2.20	2.20	2.20	2.20	2.20
6. Cash Flow Adjustments
Less Capital Expenditures			-12.00
Add back Depreciation				1.60	1.39	1.20	1.04	0.90	0.78	0.68	0.59	0.55	0.55	0.55	0.55	0.55	0.55	0.55
Less Added WIP inventory				0.39	-0.58	0.00	0.00	0.00	-0.03	0.00	0.00	0.00	0.00	-0.04	0.00	0.00	0.00	0.26
7. Free Cash Flow			-12.00	1.85	3.33	3.86	3.81	3.77	3.08	3.07	3.05	3.03	3.03	2.04	2.08	2.08	2.08	2.34
NPV =			10.57
IRR =			24.3%