FINA2303 PET Chemicals Case Study on Capital Budgeting

8/20/2019 FINA2303 PET Chemicals Case Study on Capital Budgeting

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PET Chemicals Holdings Company Limited1

PET Resin Industry

Introduction

Polyethylene terephthalate (PET) was patented in 1941 by two British chemists, and was

commercialized for use in packaging applications starting in early 1980s. PET is a versatileplastic polymer produced by reacting purified terephthalic acid (PTA) with monoethylene

glygol (MEG) in the presence of catalysts and heat. The PET resin production and

downstream manufacturing is illustrated in the diagram 1.

PTA is the primary raw material used in the generation of PET. It is produced by oxidizing

PX (paraxylene), which is manufactured from toluene and mixed xylenes. MEG is normally

produced from naphtha, gas oil or liquefied petroleum gas. It can also be produced from

biomass. However, chemical companies in Mainland China are currently developing newer

catalysts that are expected to enable polyester-grade MEG to be made from coal, using

dimethyl oxalate and methanol-to-olefins processes.

1 This case was written and modified by M. K. Lai for the purpose of class discussion. While

inspired by a real life firm, the author creates certain fictitious names, situations and figures,

either to protect confidentiality or to illustrate a particular concept in finance. It is not

intended to show either effective or ineffective handling of an administrative issue.Copyright © 2016 M. K. Lai.


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Diagram 1: The Polyester Value Chain

source: Polyester Analysts Ltd.

The production of PET is a continuous process comprising two steps: melt phase

polymerization (MPP) and solid state polymerization (SSP). Through the MPP process, the

base resin is produced in the form of amorphous pallets. Through the SSP process, the

amorphous pallets are converted in crystallized pellet form. Diagram 2 shows the production

process of PET.

Diagram 2: The Production Process of PET



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The PET market has grown significantly in recent years due to technical advantages of PET

as a packaging material compared to other materials such as glass, paper and metal. It also

has the advantages in terms of versatility, packaging, freight costs and a relatively small

carbon footprint. The general properties of standard PET have been progressively improved

in order to develop specific formulations or grades suitable for specific applications.

Product innovation is a very important component in the industry.

Applications of PET

PET offers characteristics such as transparency, strength, durability, light weight, recyclability

and design flexibility. The standard PET is principally used for packaging including the

manufacturing of bottles for carbonated beverages, water, isotonic energy drinks, vegetable

oils and other beverages and PET sheet modeled into clam shells for food packaging, as well

as other non-food applications. The recent uses include packaging for hot-filled drinks,custom foods and oxygen-sensitive food and drinks, such as beer, wine, juice and baby food.

In a nutshell, it can be divided into the following grades: carbonated soft drinks, water, sheet,

customer food, hot-fill, barrier and non-food.

Furthermore, there are environmentally sustainable PET resin formulations, such as

post-consumer resin-grade and bio-grade PET, which can be used for the same applications as

standard PET.

Post-consumer resin-grade PET is derived from post-consumer recycling. The technology

allows chemically breaking down recycled PET into its component parts, PTA and MEG,

which are then used to produce standard PET. It can also be done mechanically by mixing it

with standard PET in a ratio of one part recycled PET to nine parts standard PET. However,

the resulting PET is of a lower quality product than the chemically recycled PET. Bio-grade

PET is produced from raw materials derived from biomass.

Global Demand for PET resin

Annual global standard PET resin demand grew from 9.1 mMT (million metric ton) in 2002

to 18.6 mMT in 2012, representing a cumulative average growth rate of 7.4%. However, PET

resin demand grew at a cumulative average growth rate of 5.4% from 2007 to 2012, because

of the global financial tsunami in 2008, the increased use of recycled materials and

light-weighting, or the reduced use of plastic in packaging for both cost savings and

environmental sustainability. Anyhow, PET demand still had positive growth due to the fact

that the PET industry was more closely related to the demand profile of the consumer food

industry rather than other chemical and petrochemical industries which suffered negative

growth after the global financial crisis. Diagram 3 shows the historical growth for global


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packaged goods, which in turn drives increased demand for PET. As the population

growth is expected to be significant in Asia, South America, the Middle East and Africa,

these areas have potentially high growth for PET.

(2)

Global gross domestic product (GDP) per capita: As a country’s GDP increases, it

becomes richer and consumption tends to increase. In less mature markets, such as

Mexico, South America, Mainland China and India, PET demand is expected to grow at

rates above GDP growth with increased per capita consumption.

(3) Replacement of metal, glass, paper, Tetra Pak and other plastics: PET’s durability, heat

resistance, light weight, barrier properties, versatility, cost competitiveness and

transparency are the main advantages over other packaging materials. It also allows

consumers to see the contents of the package more clearly and it is 100% recyclable.

Diagram 4 shows a comparison of the key properties and characteristics of PET, glass,

paper/Tetra Pak and metal packaging.

Diagram 4: Comparison of PET, Glass, Paper/Tetra Pak and Metal Packaging

source: The Plastic Packaging Market Outlook in Food and Drinks, 2011, NAPCOR

(4) End-use packaging markets: In 2012, the traditional markets of carbonated soft drinks,

water and sheet for PET accounted for 66%, of total standard PET demand. New


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applications of hot-fill, barrier-grade and non-food, accounted for 33% of global

standard PET demand. Diagram 5 shows the PET consumption by end product.

Diagram 5: PET Consumption by End Product


(5)

New applications for oxygen-sensitive drinks and food: Technical advancements inPET-polymer production have improved PET’s barrier properties, minimizing

permeation through the container. This makes barrier-grade and hot-fill PET viable

alternatives for the packaging of oxygen- and moister-sensitive products such as baby

food, milk, juice and alcoholic drinks and has made PET sheet a viable alternative for

the packaging of oxygen-sensitive foods such as cheeses and red meats. In addition, beer

packaging is a new PET application with growth potential.

Threats to Global Standard PET Market

The global standard PET market is subject to the following threats:

(1) Bottle-to-bottle recycling: The production of new PET bottles from used, recycled PET

bottles rather than from standard PET resin could cause demand for standard PET to

decline in some countries. Currently, it represents about 5% of the total market only

because the lack of an effective infrastructure for the collection of used PET material,

the high cost of collection and transportation to recycling centers, the need to sort and

process the materials collected by the color of the resin, the high market prices of

recycled as compared to standard PET, and the risk that customers will perceive recycled


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PET to be of lower quality because of a risk of impurities. Most recycled PET is

produced by blending PCR that has been mechanically washed and cut into flakes or

chips with standard PET. In principle, all PET is recyclable, even if for the most part in

textile rather than bottle applications. In fact, there is a large demand for recycled PET

for fiber production where quality is less critical, particularly in Mainland China, mostly

in the form of flakes and crushed bales of PET bottles.

(2) Light-weighting: Light-weighting is the reduced use of plastic in packaging. These

technological advancements have been driven by, and have allowed manufacturers to

counteract, the risking cost of crude oil and corresponding PET price increases. It is also

a response to criticism over packaging waste and other environmental concerns. As

much of the optimization in packaging has already taken place, it is expected that only

modest further weight reductions may be seen in mature markets.

(3)

Product substitution: There is little likelihood of reverse substitution by aluminum, TetraPak or competitor plastics. However, even the right conditions, various other materials

could become substitutes to PET.

Supply of Standard PET Resin

The key competitive factors for the PET industry are technology, scale, vertical integration,

co-location with raw material production facilities, logistics costs and availability and cost of

raw materials. The ten largest producers of standard PET globally accounted for 59% of total

installed capacity in 2012.

Additional PET capacity is now primarily developed through investment in new lines and

plants, as older, less efficient plants are replaced by larger, more efficient plants. Diagram 6

shows the capacity evolution of standard PET packaging resin. Diagram 7 shows the

production evolution of standard PET.

Global PET capacity in 2012 was 24.3 mMT, and planned investments in the industry could

add 12-19 mMT of additional capacity worldwide by 2017, which represents the risk of

overcapacity in almost all regions.


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Diagram 6: Capacity Evolution of Standard PET Packaging Resin


Diagram 7: Production Evolution of Standard PET



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Technology and Costs

The technology used by plants in PET production is a key determinant of costs and efficiency.

While the chemical process is the same, the number and size of reactors varies, with smaller

single lines [220-270 kMT (thousand metric ton) per year] requiring higher energy costs and

an initial US$450-US$500 per metric ton capital expenditure.

The continuous polymerization melt process, using its proprietary solid state polymerization

(SSP) technology, results in a high nominal capacity per single line (1.1 mMT) because it is

able to employ a horizontal SSP unit, compared to lines limited by the height of a vertical

SPP unit. This process provides the flexibility to continuously make different grades of PET

resin, changing the mix as necessary, without shutting down any cleaning lines. It saves time,

reduces costs and limits production of non-prime grade material that would otherwise have to

be sold at a lower price.

Another process, melt-to-resin, bypasses SSP, resulting in lower energy costs and per metric

ton capital expenditures than smaller plants, but has some operational and quality

disadvantages compared to larger plants.

Benefits of Integration in the Polyester Value Chain

The price of PET resin is determined mainly by market dynamics and is influenced by the

price of crude oil. Producers must manage production costs and formulate a cost-effectivesales strategy. Co-location and integration of raw material production is an important way of

reducing costs and its benefits include:

(1) Logistics costs savings: The proximity of PX, MEG and PTA to PET manufacturing

facilities reduces or, in the case of co-located plants, eliminates the cost of packaging,

freight, shipping and delivery of PX to PTA plants and PTA and MEG to PET plants.

(2) Energy optimization: Integration of raw material production optimizes energy resources

in a PTA/PET factory, as energy generated in the manufacture of PTA can be used in the

production of PET.

(3) Raw material supply: Co-locating PTA and PET plants ensure a stable supply of, and

consistent quality in, raw materials for the PET or fiber facility, reducing the risk of

delivery delays or volatility in spot raw material prices.

(4) Profit optimization: Co-locating PTA and PET or polyester fiber plants captures added

profit from another part of the value chain, while eliminating marketing and sales costs

and customer credit. Typically, both PET and PTA plants achieve higher capacity

utilization than a merchant PTA seller.


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Spread Between PET and Raw Material Costs

The spreads between PET and raw material costs are different in various regions. The North

American market is largely protected by import duties and ocean freight costs, and therefore

has a higher price spread than other regions. As South America is a net PET importer, the

spread is influenced by transportation costs and import prices from Asia. Brazil, however, has

a higher spread than other countries in the region due to tax incentives for local production,

which allows PET sellers to retain part of the value added tax charged on top of the price to

clients instead of paying it back to the states in which they operate.

Asia is a net exporter of PET and therefore the spread for Asian PET has historically been

determined by the export market. The domestic spread is approximately half that achieved in

the US because of intense competition among regional producers. However, Asian PET

producers are generally not competitive with domestic sellers on the East Coast of the USwith export costs including ocean freight, export duties and local handling.

The spread between PET and raw material contract prices has been relatively stable

(averaging approximately US$300 per MT in the US, US$335 per MT in Brazil and US$140

per MT in Asia), except in Europe, which has recently experienced a significant decline due

to continuing domestic oversupply and competition from Asian and Middle Eastern imports.

This is particularly true in comparison to the fluctuations in the prices of underlying

commodities. Diagram 8 shows the global spread trends in recent years.

Diagram 8: Spread Between PET and Raw Material Contract Price



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PET Supply and Demand By Region

Diagram 9 shows a summary of PET supply and demand by region.

North and South America Europe, Middle East and

Africa

Asia

Size as % of total

demand in 2012

29% or 5.4 mMT 35% or 6.6 mMT 36% or 6.7 mMT

Cumulative average

growth rate from 2017 to

2012

North America: 0.4%

South America: 5.5%

Europe: 0.1%

Middle East and Africa:

15.4%

Asia: 11.5%

Customers Mainly large Large and small; very

fragmented

Large and small

Internal logistics Less expensive Very expensive Less expensive

Applications Very sophisticated, liquid

and rigid food packaging

needs

Traditional food and drink

applications

Polyester fibers are main

driver and PET is

complementary; mainly

beverage applications with

some custom

food/non-food

Availability of raw

materials

Efficient supply in the Gulf

of Mexico adjacent to the

US for PX/PTA and MEG

PTA available with MEG

increasingly imported from

Middle East

PTA available with MEG

and PX imported from

Middle East

Barrier to entry for new

producers

Relatively high – import

duties; ocean freight; large

customers, rail delivery

required; high quality

applications

Low – import duties to EU,

but not to non-EU and

Middle East; many small

customers, easy to supply

Europe from Middle East

Low – Mainland China is a

main producer with fiber

synergy; Asia is a regional

market with large exports

Supply concentration Highly concentrated supply

base

Very fragmented supply

base

Mainland China is

concentrated with largeproducers; other

consuming countries have

small domestic producers

Supply source model Large integrated local

plants

Small local plants with

some integration

Large local plants and

companies, some co-sited

with PTA/fiber

Diagram 9: PET Supply and Demand by Region

Source: Polyester Analysis Ltd.


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PET Chemicals Holdings Company Limited

Historical Development

The PET Group was founded in 1953 in Italy, with its operations in the plastic processing

industry. Since its foundation, it has developed its capabilities in the conversion of polymers

into plastic containers (particularly bottles) as well as in serving large international brand

owners.

Capitalizing on its decades of experience in plastic conversion technology and its

understanding of brand owners’ requirements, the Group realized the packaging potential of

polyester and adapted the chemistry and process technology of this polymer to serve the

plastic application needs of mineral water packaging. It has continued to develop through

both organic growth and acquisitions, and has been able to maintain a leading position in theindustry.

In 1985, it built one of the world’s largest PET plants in Italy with a nominal capacity of 50

kMT per year. In 1989, it set up a joint venture with a major US company for the manufacture

of PET resin. In 1995, it started the manufacture of PET resin and pre-forms for a major soft

drink company in Europe. In 2000, it acquired the major US company’s global PET business,

with assets in, inter alia, Italy, Mexico and the US for approximately US$255 million in order

to expand internationally as a PET producer. In 2002, it acquired some Brazilian PETbusiness for US$195 million in order to enter the fast growing Brazilian market. In 2003, it

built the world’s largest PET plan in Mexico with a single line nominal capacity of 490 kMT

per year. In 2004, it acquired the Japanese engineering company for US$20 million in order

to acquire in house engineering capabilities and experience in the construction of large PET

plants. In 2007, it built the world’s largest PET plant in Brazil with a nominal capacity of 650

kMT per year. In 2010, it divested its European-based PET operations, consisting of two lines

with a normal capacity of 100 kMT per year each. In 2012, it started upstream integration

into PTA-MEG production, through the planned construction of the world’s largest PTA-PET

plant in Texas of the US and the planned construction of a bio-MEG project in Anhui of

Mainland China with expected nominal capacity of 220 kMT per year.

Ownership and Group Structure

Starting from 2010 onwards, the PET Group carried out a reorganization of which PET

Chemicals Holdings Company Limited was incorporated in Luxembourg as a holding

company and the head offices. The company applied for listing on the Hong Kong Exchanges

and Clearing Limited (HKEx) with a global offering of 2,353,060,000 shares subject to

adjustment and the over-allotment option. The Group structure after the reorganization but


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before global offering is shown in diagram 10.

Diagram 10: Group Structure after Reorganization but before Global Offering

Business Operations

PET Chemicals is one of the largest producers of PET resin for packaging applications in the

world. Currently, its total PET nominal capacity is 1,600 kMT per year and it has three

production sites strategically located in the US, Brazil and Mexico, from which it principally

sells its products to the North and South American markets.

It comprises a PET division and an Engineering division which accounted for 92.8% and

7.2%, respectively, of the company’s combined revenues in 2012.

The production and sale of PET resin of the PET division is the principal business of the

company. The PET revenues had a well-balanced geographical distribution among Brazil

(39%), the US (38%) and Mexico (24%) in 2012. The PET division manufactures and offers

the full range of PET grades, such as carbonated soft drinks-grade, water-grade, hot fill-grade,

barrier-grade and sheet-grade.

It is the only company that can build a single 1.1 mMT horizontal PET line, allowing for low

variable and capital expenditure costs compared to competitors. It is currently the only PET

producer of chemically recycled PCR-grade PET in North America and South America. It is

the only PET producer with exclusive and proprietary access to second generation

bio-technology to produce PET raw materials from biomass, a technology which is expected

to be implemented in its new facilities in Mainland China. The demand for PET in Mainland

China is likely to fluctuate depending on local political and demographic conditions as well

PET S.p.a. (Italy)

PET Finanziaria S.r.l. (Italy)

100%

PET Chemicals (Luxembourg)

100%

PET International (Luxembourg)

100%

many subsidiaries


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as new investment in PET resin, perform manufacturing and bottle-filling lines.

The company has focused on organic growth and leveraging its proprietary technology

although some competitors have increased their capacities through acquisitions. It employs

the continuous polymerization melt process.

The Engineering division of the company provides technological development, research and

engineering services for the construction of plants for customers in the polyester chain

(including PET, polyester fiber and PTA production) and the liquefied natural gas (LNG)

industry. Its expertise in plant engineering allows it to enjoy significant synergies and cost

savings.

The Business Model of PET ChemicalsThe business model of PET Chemicals involves procuring the principal raw materials, PTA

and MEG, required for the production of PET, and applying those raw materials towards the

manufacture and sale of the full range of PET grades. It currently operates three PET plants

with an aggregate nominal capacity of 1,600 kMT per year and an aggregate installed prime

capacity of 1,400 kMT per year, concentrated in five PET production lines.

The company procures its raw materials from major suppliers which have multiple

production sites, and typically has contractual provisions pursuant to which it can procureraw materials from its suppliers’ other production sites in case of supply disruptions at a

particular site.

The company has a strong and stable customer base, which includes companies that convert

PET into containers and brand owners. It has enjoyed long-term relationships with each of its

key customers, and in my cases has been doing business with them for over ten years.

Usually, it sells products under multi-year contracts with its customers as well as, to a lesser

extent, on a spot basis. The nature of the contracts allows the company to effectively pass

through fluctuations in the published PTA and MEG market prices to its customers.

Research and Development

Research and new product development is an important part of the company business. It

focuses on the development of new and improved products and processes for various markets

and applications, as well as developing proprietary technologies.

The current focus of the company’s research and development includes the following

activities:


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(1) Development of 100% bio-PET, in which all the raw materials are derived from

biomass.

(2) Formulation of a barrier-grade resin that allows improved physical properties and

bio-content.

(3)

Optimization of the PET formulation to best adapt it to injection and blowing

technologies, by which the molten polymer is formed into the final container shape.

The key technologies that the company relies on for its business are set out below:

(1) A technology for the construction of horizontal solid state polymerization plants, which

eliminates the size limitations associated with traditional vertical SSPs and allows the

company to build larger PET production lines.

(2)

Barrier PET technology, other PET patents and PET process patents for the productionof different grades of PET, including (a) a technology for the production of monolayer

barrier PET, which inhibits oxygen and carbon dioxide from passing through the

container and is used in packaging oxygen- or carbon dioxide-sensitive foods and drinks

and carbonated liquids; (b)a resin technology for the production of compartmentalized

pallets, which enables the delivery of two or more polymers within the same pellet and

allows performance-enhancing additives to be added directly into the PET pellets; and (c)

a technology for the production of chemically recycled PCR-grade PET, a recyclable

grade of PET which can be chemically broken down into its component parts during therecycling process.

(3) A hydrogenation technology for production of bio-MEG, which involves the use of

hydrogen to convert the soluble sugars produced from the SSP technology into a mixture

of glycols from which ethylene glycol can be obtained through a separation and

purification process.

The company has exclusive rights to the following technologies from the affiliates in the PET

Group:

(1) A pretreatment technology for PET raw materials, which involves the production of

fermentable sugar, or a precursor of fermentable sugar, from any biomass, including

non-food agricultural plants and agricultural waste from wheat, corn and sugar cane

crops.

(2) A technology for production of bio-BTX (a mixture of bezene, toluene and mixed

xylenes) from lignin, which can produce “green” PET and is in the early stages of

development.

(3)

“Bio-barrier”, a renewable oxygen scavenger barrier solution, which will be sold a


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ready-to-use additive to be mixed with the standard PET grade.

Competition

The key competitive forces for the PET industry are technology, scale, vertical integration,

co-location with raw material production facilities, logistics costs, and availability and cost of

raw materials. The ten largest producers of standard PET globally accounted for 59% of total

installed capacity in 2012. In 2012, approximately 54 other producers accounted for the

remaining global total installed capacity.

Of the top 10 global PET producers, three companies (including PET Chemicals) are

currently the only ones solely producing PET resin, while the others are major polyester fiber

companies or produce film or other products.

Additional PET capacity is now primarily developed through investment in new lines and

plants, as older, less efficient plants are replaced by larger, more efficient plants with nominal

capacity of at least 220 kMT per line.

The key competitive forces for plant construction services in the polyester industry are

amount of invested capital, equipment, technology, professional expertise and qualifications.

These factors are high barriers to entry in the industry.

There are three primary companies (including PET Chemicals) providing plant construction

services in the polyester industry. To a lesser extent, two Chinese companies have limited

market share outside Mainland China and have not historically had the ability to build

individual lines larger than approximately 250 kMT. There are also some minor companies

and subcontractors.

Competitive Strengths

PET Chemicals has the following competitive strengths.

(1) Leader in product innovation: With decades of experience in plastic processing, a

significant commitment to research and development and in-depth knowledge of the

applications for plastic polymers, the company is a leader in product innovation in the

field of PET resins.

(2) Largest single line PET plants allowing reduced capital expenditures and operating costs

per metric ton of output: The company’s proprietary technology eliminates the typical

size limitations of off-the-shelf technology of 220-270 kMT per year and allows it to

enjoy economies of scale not available to those competitors using traditional technology.


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As a result, the company’s plants have lower capital expenditures and production

operating costs per metric ton than those of its competitors using traditional technology.

(3) Strategically positioned in selected PET markets: The company is the second largest of

the major producers in the Americas in terms of nominal capacity. It has selectively

positioned itself in North America, which is a large, mature market that enjoys a strong

demand for PET resin and high spreads between PET and raw material prices. It has also

strategically established its presence in South America, which is a fast growing

emerging market with PET demand forecast to grow. Considering the fiber-driven nature

of the Mainland Chinese polyester demand growth and the large stock of available PET

capacity, it has chosen to participate in the high growth potential of the Mainland

Chinese market not as a PET producer, but as a technology provider through its

Engineering Division and as a polyester raw material supplier through its planned Anhui

bio-MEG project in Mainland China. It has been able to establish an importantcompetitive advantage through its business model, which is based on large-scale,

integrated high-quality plants and fits with the region’s large customer structure,

relatively inexpensive logistics and efficient oil-refinery and petrochemical

infrastructure.

(4) Long-term customer contracts with raw material pricing pass-through mechanisms: The

company has large-scale, long-term relationships with its key clients, who are major

brand owners and packaging companies requiring a reliable supplier capable of

providing a consistent high-quality product in the Americas. Most of its contracts alsocontain some form of volume protection in the company’s favor or provide it with the

right to supply an agreed percentage of a customer’s PET consumption. It also allows

the company to effectively pass through raw material price fluctuations to its customers,

thereby maintain relatively stable returns through industry cycles.

(5) Stable low-cost raw material procurement: The company’s leading position in the

industry, its stable customer base and its consistently high production capacity utilization

levels enable it to commit to high-volume, long-term contracts with its suppliers.

(6)

Experienced management team, with proven execution capabilities: The Group has been

operating in the PET industry, initially as licensor of technology and subsequently as a

manufacturer since the 1980s. The company’s senior management team is composed of

highly experienced managers who have been with the Group for a significant period of

time after holding long-standing positions in leading multinational chemical companies,

each with over 15 years of experience in the industry.

Strategies

The company focuses on a long-term investment horizon and prudent, long-term business

management, with the intention of continuing to invest in new product development and new


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production facilities. It plans to implement its growth strategy primarily through

technology-driven greenfield investments. Due to its technology and engineering skills, it is

more cost efficient for the company to build new production facilities rather than purchase

existing assets from third parties.

The company has established the following strategies:

(1) Investment in vertically integrated PTA/PET production and capacity expansion: A

principal element of the company’s strategy is to invest in fully integrated PTA/PET

production by constructing a new large scale facility in Texas, US, in which its

proprietary PET technology is integrated with new PTA production technologies, and

which will allow the company to achieve cost efficiencies and expand production

capabilities, while replacing a portion of the older and inefficient capacity now presentin the market.

(2) Expansion into the bio-ethanol and bio-polyester markets: The company has acquired

from its affiliates exclusive rights to use newly developed technologies to produce PET

raw materials, including bio-PX and bio-MEG, and are developing its proprietary

hydrogenation technology for the production of bio-MEG. It plans to use these new

technologies at its planned bio-ethanol plants in Mainland China, which are expected to

have an aggregate nominal capacity of 220 kMT per year of bio-ethanol, which will be

used by its planned ethanol-to-ethylene glycol (E2E) plant to produce bio-MEG.(3)

Expansion of its Asian presence: The high-growth Asian polyester fiber industry, in

particular the Chinese polyester textiles and liquefied natural gas (LNG) markets,

represents an important growth opportunity for the company. It plans to expand its

presence in this region as a technology and engineering player, through its Engineering

division’s presence in the region and its Anhui bio-MEG project in Mainland China.

Projects Under Construction

The company has two major projects under construction. Firstly, it intends to construct a

latest-generation technology PET plan in Texas, US, i.e. the Texas PET Project. Secondly, it

plans to build two bio-ethanol plants and an ethanol-to-ethylene glycol (E2E) plant in Anhui

of Mainland China, i.e. the Anhui Bio-MEG Project.

In addition, the Engineering division of the company is involved in the construction of

several other projects including LNG, polyester and PTA plants.

Texas PET Project

The company plans to launch a project to construct a vertically integrated PTA/PET plant in


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Texas, US. The PET plant is expected to have a nominal capacity of 1,100 kMT per year and

to be fully integrated with a co-sited PTA plant with expected nominal capacity of 1,300 kMT

per year. It expects that the Texas plant will begin production in 2016 and will be the largest

vertically integrated single line in the world and the largest PTA plant in the Americas. In line

with the company’s strategy to achieve cost efficiencies and expanded production capabilities,

the lower capital expenditures and production cost savings that it expects to realize with its

investment in the Texas plant will result in significant competitive advantages, enabling it to

compete effectively with producers in Asia and the Middle East, as imports from those

regions incur significant shipping costs and customs duties.

Anhui Bio-MEG Project

The company is also planning the construction in Anhui of Mainland China of two

bio-ethanol plants implementing new biotechnologies, and one ethanol-to-ethylene (E2E)glycol plant, with expected nominal capacity of 220 kMT per year. All three plants are

expected to become operational in 2016. It will allow the company to capture the additional

margins of upstream petrochemical businesses with lower investment costs, and to capitalize

on the growth in global demand for sustainable polyester.


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Capital Budgeting Decision

Anhui Bio-MEG Project

In December 2012, PET Chemicals is planning the construction of two bio-ethanol plants

with expected nominal capacity of 110 kMT per year each, and an ethanol-to-ethylene glycol

(E2E) plant with expected nominal capacity of 220 kMT of bio-MEG per year, all of which it

expects to become operational in mid-2015 in Anhui of Mainland China. A discussion of the

MEG market is shown in Appendix 1.

While the company does not intend to enter the Mainland Chinese market as a PET producer,

it plans to expand its operations into Mainland China as a technology provider and polyester

raw material supplier of bio-MEG which is expected to be able to take advantage of the lower

costs of bio-mass resources in Mainland China. The planned expansion into Mainland Chinamay expose it to any adverse change in Chinese demand for MEG or industry oversupply of

MEG could also reduce its margins, which would have a material adverse effect on its

business, financial condition and results of operations.

The two bio-ethanol plants will use the pretreatment proprietary technology for the

production of fermentable sugars from any biomass, which are then used to produce

bio-ethanol. The technology is owned by one of the affiliates of the PET Group, which has

already successfully executed a similar demonstration plant in Italy, to which managementhas access and in which management has expertise. It has entered into a memorandum of

understanding with one of the partners in the joint venture, pursuant to which the partner is to

supply necessary enzymes for the Anhui bio-MEG Project on an exclusive basis for a period

of 15 years. It has an exclusive license to the above technology in relation to all PET raw

materials applications, including bio-PX and bio-MEG. In fact, PET Chemical acquired the

exclusive license at US$10 million in early 2012. The term of the license was the later of 20

years and the last valid claim of the patent rights of the technology to expire. The useful life

of the license is estimated to be 10-20 years. The licenses will be amortized, as soon as they

commence being utilized in the production process in the Anhui bio-MEG Project, i.e.

starting in 2016. The accounting treatment of licenses is discussed in Appendix 2.

The E2E plant will use existing technology available on the market to produce bio-MEG

from the bio-ethanol produced at the bio-ethanol plants. It will select the supplier of such

existing technology prior the commencement of the construction of the E2E plant and

appropriate licenses will be obtained from the relevant technology supplier at that time. Its

management has experience with this technology and its Engineering division has already

constructed similar E2E plants for third parties. The above affiliate of the PET Group is


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developing its proprietary hydrogenation technology for the production of bio-MEG. This

technology involves the use of hydrogen to convert the soluble sugars from one of the newly

developed technology streams into a mixture of glycols (polyols) from which ethylene glycol

can be obtained through a separation and purification process. PET Chemicals also plans to

purchase the proprietary license at US$8 million from the affiliate towards the end of 2013.

PET Chemicals intends to sign a letter of intent with the Lingshan Group, which it is

considering as a potential joint venture partner in its Anhui bio-MEG Project. Lingshan

Group operates a biomass power plant in Anhui, PRC, with relevant experience in biomass

and other environmental activities. Lingshan Group is an independent third party. In the

proposed joint venture, the Lingshan Group will have responsibility for the supply of one

million metric tons of straw biomass, as well as project approval, land provision and utilities

procurement for the Anhui bio-MEG Project. Lingshan Group will use lignin resulting as aby-product from the bio-ethanol plants to feed a 45 MW cogeneration plant, which will be

co-sited and constructed simultaneously with the Anhui bio-MEG Project. PET Chemicals

will be the majority partner in the Anhui bio-MEG Project and a minority partner in the

power plant. It also expects that the Anhui bio-MEG project will help to promote its

bio-MEG technology for fiber production as well as for non-PET plastic applications in Asia.

Lingshan Group is the owner of land use rights of a piece of land with a market value of

US$40 million, which will be used as a site for building the Anhui plants.

It is expected that the engineering and construction for these plants will be carried out by its

Engineering division and will commence in mid-2014. It estimates that the capital

expenditure associated with the construction of the plants will total approximately US$440

million, to be incurred over the 24 months following the expected listing date of the global

offering in December 2013. It plans to finance this project with a combination of the proceeds

of the global offering and other sources.

It is expected that the production will begin in 2016, and that the bio-MEG produced at these

plants, together with by-products such as diethylene glycol, triethylene glycol and lignin, will

principally be sold in local markets with an annual nominal capacity of 100 kMT, minimizing

logistics costs. The current price of these by-products (including the lignin used for the

cogeneration plant) is US$100 per metric ton. It has received indications of interest from, and

has held initial discussion with, potential customers interested in purchasing bio-MEG

produced at its planned Mainland Chinese plants.

In particular, it plans to sell the bio-MEG produced at the E2E plant to the Chinese branches

of large, global food- and beverage-brand owners. It expects to enter into agreements with


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these customers pursuant to which they will purchase bio-MEG from the company to produce

bio-PET locally, providing them with logistical and working capital efficiencies. In exchange,

these purchasers will commit to purchase at market prices a corresponding amount of

standard PET from the Texas PET plant. Since the Anhui E2E plant’s expected nominal

capacity of 220 kMT per year of bio-MEG can be converted into approximately 600 kMT per

year of PET, it believes that such arrangements would ensure the full loading of its Texas

plant from its new Anhui E2E plant without incurring the freight cost it would otherwise

incur if it were to ship the bio-MEG from Mainland China to the port near the Texas plant.

It has selected Anhui as the location for its bio-MEG Project. This location offers convenient

access to transportation, and is located in a major agricultural region in Mainland China. It

also has access to large supplies of biomass, mainly consisting of wheat straw and cornstalk

(as agricultural waste from wheat and corn crops grown in the region). Current industryestimates of biomass prices are lower than those of petroleum-based raw materials and are in

the range of US$200-250, inclusive of feedstock costs, yields and logistics costs.

The company is planning to sign a joint venture agreement with its local partner for the

bio-ethanol plants by the end of 2013. In the first quarter of 2014, it expects to finalize site

selection and complete engineering plans for the plants. It also plans to buy the emission

permits at US$5 million at the end of 2013. The emission permits are issued by the PRC

Government to entitle a business to discharge pollutants with administrative permission. Itanticipates to commence construction of the plants in mid-2014 and to begin production in

2016.

The company intends to use the net proceeds of US$251 million raised from the global

offering for financing the Anhui Bio-MEG Project and the rest mainly comes from

borrowing.

The Discount Rate

In a capital budgeting exercise, a financial manager usually uses a discount rate to calculate

the net present value of a project. The discount rate represents the current market assessment

of the risks specific to a particular activity, regarding the time value of money and individual

risks of the underlying assets which have not been incorporated in the cash flows estimates.

The discount rate is the weighted average cost of capital based on market comparable

observable values. It takes into account both the debt and the equity. The cost of equity is

derived from observable market data and the cost of debt is based on the prevailing market

interest rate given a credit risk class.


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Capital Budgeting Exercise

In mid-June 2012, it appointed an international consultant specialized in petrochemicals to

carry out a feasibility study on the Anhui Bio-MEG Project on behalf of the company. The

consultancy fee was agreed on US$120,000. The consultant submitted the feasibility report in

December 2012 when Mr. Danilo Bianchi, Chief Financial Officer of PET Chemicals, is

considering doing the capital budgeting exercise on the Anhui Bio-MEG Project. He collects

the following financial information based on the feasibility report and the company’s own

estimates (all the cash flows are nominal cash flows on the specified year):

The life of the project is estimated to be 15 years from 2016 to 2030.

The project will produce 220 kMT of bio-MEG per year for 15 years starting from 2016

to 2030. (Notice: kMT = thousand metric tons)

The price of MEG is currently at US$1,120 per metric ton and the current production

cost is at US$450 per metric ton. The other expenses (excluding depreciation and

amortization) are estimated to be 10% of the sales revenue of bio-MEG.

The capital expenditures are estimated as follows. The buildings are depreciated on a

straight line basis for 20 years. The machines are depreciated on a straight line basis for

10 years. The accounting salvage value is estimated as 10% of the original cost. The

buildings and machines will be put into use in 2016. (See Appendix 2 for the accounting

treatment.)

US$ million 2013 2014 2015 TotalBuildings $73.2 $81 $109.8 $264

Machines $48.8 $54 $73.2 $176

Total $122 $135 $183 $440

It acquired the US$10 million exclusive license to use the pretreatment proprietary

technology in the two bio-ethanol plants in early 2012. (See Appendix 2 for the

accounting treatment.)

It plans to purchase the dehydrogenation proprietary license at US$8 million from the

affiliate at the end of 2013. (See Appendix 7 for the accounting treatment.) It plans to buy the emission permits at US$5 million at the end of 2013. (See Appendix 2

for the accounting treatment.)

Lingshan Group has already got hold of the land use rights of a piece of land with a

market value of US$40 million. It will contribute it for the construction of the Anhui

plants. The cost method will be used for accounting for the land use rights if applicable.

(See Appendix 2 for the accounting treatment.)

The by-products arising from the production of bio-MEG, such as diethylene glycol,

triethylene glycol and lignin, are expected to be produced with an annual nominal

capacity of 100 kMT, starting from 2016. These by-products (including the lignin used


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for the cogeneration plant) will be sold in the local Chinese market at a net income of

US$50 per metric ton at the current price in 2012.

The initial working capital of US$100 million will be required starting in 2015. It is

expected to increase with the inflation rate. It can be released at the end of the project.

At the end of the project, all the facilities (land use rights, buildings, machines, licenses,

emission rights) will be transferred to the Lingshan Group at an agreed price of US$160

million based on a contract between PET Chemicals and the Lingshan Group.

The corporate tax rate is 25%. (See Appendix 2.)

The annual inflation rate is expected to be 3% in the all coming years.

The discount rates for different activities estimated through market data are as follows:

Discount Rate

WACC for PET production 20.0%

WACC for Bio-MEG production 17.6%

WACC for engineering activity 14.1%

WACC for PET Chemicals 19.6%

Average WACC for major competitors of

PET Chemicals

18.8%

Conclusion

The company expects that the Anhui Bio-MEG Project will provide it with access to a

significant portion of the upstream petrochemical MEG market with a relatively low capitalexpenditure. It plans to locate plants in Anhui of Mainland China, a key agricultural area with

a large supply of inexpensive biomass resources, consisting mainly of wheat straw and

cornstalk. It expects that the lower costs of biomass resources as compared to

petroleum-based raw materials will result in a positive return on its investment, even without

considering the premium that it expects brand-owners will be willing to pay to have access to

bio-MEG rather than petroleum-based MEG.

It believes that due to the exclusives rights to use the new technologies and proprietaryhydrogenation technology for the production of polyester raw materials from biomass, the

company is in a good position to take advantage of the opportunity created by the growing

global demand for sustainable polyester products, particularly in Asia, not only in relation to

its Anhui bio-MEG project, but also as a key part of its Engineering division’s growth

strategy. It intends to be a pioneer in this market and to capitalize on its Engineering

division’s expertise in bio-MEG plant engineering and design and its historical presence in

Asia to be a leading participant in the sustainable polyester industry.

The high growth Asian polyester fiber industry, in particular the Mainland Chinese polyester


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textiles and liquefied natural gas (LNG) markets, represents an important growth opportunity

for the company. It plans to expand its presence in the region as a technology and engineering

player, through its Engineering division’s presence in the region and its Anhui bio-MEG

project in Mainland China.


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Requirement

Suppose that now is in December 2012 (year 0) and you are the financial manager appointed

by Mr. Danilo Bianchi to do the capital budgeting exercise and prepare a report to be

submitted to the Board of Directors of PET Chemicals for discussion. In the report, you

should discuss the following issues.

(1) State whether the following cash flows are relevant or irrelevant in the capital budgeting

exercise and explain why. If it is relevant, state whether it is a cash inflow or cash

outflow.

(a) the capital expenditures of US$440 million;

(b) the sales revenue, production costs and other expenses generated in the Anhui

Bio-MEG Project;(c) the depreciation of buildings and machines and the amortization of licenses on

proprietary technologies;

(d) the US$10 million exclusive license to use the pretreatment proprietary technology

in the two bio-ethanol plants;

(e) the purchase of the dehydrogenation proprietary license at US$8 million;

(f) the purchase of emission permits at US$5 million (as an expense);

(g)

the value of the land use rights of US$40 million;

(h)

the consultancy fee of US$120,000;(i)

the value of the by-products sold in the local Chinese market;

(j) the initial working capital of US$100 million; and

(k) the selling price of facilities of $160 million to the Lingshan group at the end of the

project.

(2) Explain why interest expenses are not included as relevant cash outflows in cash flow

estimation.

(3) Among all the discount rates provided above, which is the appropriate one for evaluating

the Anhui Bio-MEG Project? Explain why.

(4) Use the nominal basis to carry out the capital budgeting exercise. You can use a table to

calculate and show all the relevant cash flows, the net cash flows and the net present

value. Based on the net present value rule, should the company accept the project?

(5) The capital budgeting exercise in part (4) is just the base case. Carry out the following

scenario analysis:


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US$ Worst case Best case

Nominal capacity for production of bio-MEG 200,000 metric ton 240,000 metric ton

Current price of bio-MEG per metric ton $1,020 $1,220

Current production cost per metric ton $480 $420

Other expenses as a percentage of sales revenue 12% 8%

Discount rate 20% 15%

(6) Identify three risk factors that may affect the Anhui Bio-MEG Project.

Submission of Group Case Study Report

Your group is required to submit a hardcopy of the report to the instructor on the specified

due date with the following structure:

Font: Times New Roman

Font size: 12

Margin: 2.54 cm on each side

Spacing: single line

Format of Report:

Cover Page (one page): give details of the course and the list of group members with full

names and student ID numbers Executive Summary (one to two pages): give a summary of the report so that the

instructor can understand the main content in 10 minutes

Main Body (no more than 10 pages)

Appendices (if applicable, no more than 10 pages): supporting documents, tables,

figures, exhibits, etc.


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Appendix 1: The MEG Market

MEG

Monoethylene glygol (MEG) is normally produced from naphtha, gas oil or liquefied

petroleum gas. In addition, MEG can be produced from biomass. However, chemical

companies in Mainland China are currently developing newer catalysts that are expected to

enable polyester-grade MEG to be made from cola, using dimethyl oxalate and

methanol-to-olefins processes. The cost of production of MEG in Mainland China is

estimated to be US$600-800 per metric ton and depends on feedstock and processing costs,

but with market prices at over US$1,100 per metric ton, most technologies are economically

viable compared to importing material from Asia, the Middle East or North America.

The cost of producing MEG from biomass depends on the cost of biomass. First generationbiomass (i.e. food) is expensive because of the high alternative food use value and would

drive production costs to the upper end of the traditional range. However, if the cost of

biomass can be contained (including yield and logistics) in a range of US$200-250 per metric

ton by employing second generation biomass technologies, bio-MEG production costs could

fall 20-30% below the lower end of the traditional range, being approximately US$420-480

per metric ton.

MEG PricingThe price of MEG is determined by supply and demand, and the cost of ethylene, which in

turn is largely driven by oil and natural gas prices.

In the Americas, the MEG contract price for major polyester buyers is related to Asian market

pricing. In Asia, some major companies make a public nomination each month for their

contract volumes so customers may open letters of credit. The actual net market price is then

determined by the average monthly Asia spot price, plus a premium or minus a discount. The

historical spread for conventional MEG is calculated from spot market prices for both

ethylene and MEG, using a formula based on the MEG price and subtracting 0.6 times the

ethylene price. Integrated ethylene/MEG producers have a higher margin since they have no

logistics costs associated with ethylene sourcing. There is a forecast of a US$300-400 per

metric ton spread for conventional chemical MEG which is supplemented by a bio-MEG

premium, which was as high as US$500 per metric ton in 2012, but it is likely to plateau as

more capacity is installed. From 2013 to 2017, a bio-MEG premium of approximately

US$200-300 per metric ton is estimated over the spread for conventional chemical MEG.


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MEG Supply and Demand

Global MEG capacity is forecast to increase at a cumulative average growth rate of 15.6% in

2012-2017, from 28 mMT to 57.8 mMT, while demand is forecast to increase at a cumulative

average growth rate of 7% during the same period, primarily driven by growth in the Asian

polyester fiber market and demand for PET and film.

In 2012, MEG capacity in North America was 4 mMT, whereas demand was estimated at 3

mMT. Capacity and demand are forecast to grow to almost 6.8 mMT and 3.2 mMT

respectively by 2017.

Capacity in South America was only 415 kMT in 2012, whereas demand was approximately

380 kMT, with two other producers in South America (one in Brazil and the other in

Venezuela). It is forecast that capacity and demand for MEG will grow to 1 mMT and 0.6mMT, respectively, by 2017, as domestic polyester production is expected to substitute

imported PET, fibers and textiles.

Bio-PET and Bio-MEG

The limitations of the Earth’s resources, the environmental impact of oil-based plastics

production and increasing consumer concerns about packaging waste are driving the rapid

growth in demand for sustainable polyester, not only among food and beverage brand owners,

but also among other brand owners using polyester in fiber and tire-cord applications.Diagram 12 shows the historical and forecast global demand for bio-MEG.

Diagram 11: Global Demand for Bio-MEG

Source: Polyester Analysis Ltd.


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Appendix 2: Tax Depreciation and Amortization Methods of Assets in Mainland China

Wear and tear allowances are granted on fixed assets and other capital assets used in the

production of income. The fixed assets and other capital assets are based on the original cost.

Only the straight-line method of depreciation is allowed. In applying the straight-line

depreciation method, a company should assume a salvage value of not less than 10% of the

original cost (assumed to be 10% of the original cost in this case). Depreciation in fixed

assets should be computed starting from the month following that in which the fixed assets

are put in use. The useful lives of premises, buildings and structures are 20 years. The useful

lives for machinery and other production equipment are 10 years.

Land use rights are classified as intangible assets with indefinite useful lives and the

accounting can be the fair value model or the cost model. Under the fair value model, landuse rights are subject to an annual impairment test to assess whether its fair value declines at

the financial year end. The impairment loss is then recorded in the income statement. Under

the cost model, the original purchase price of the land use rights is recorded as the cost of the

asset and no amortization is recognized. Assume that the company uses the cost model in this

case.

Licenses on proprietary technology and emission rights are classified as intangible assets with

definite useful lives and such intangible assets are amortized on a straight line basis for 10years. Intangible assets should be based on the original cost and zero salvage value.

The corporate tax rate is 25%.

Documents

FINA2303 PET Chemicals Case Study on Capital Budgeting