Ajax Petroleum

Memo

Ajax Petroleum is considering investing a Solvent Decarbonizing Unit (SDU) with an initial cost of $30 million. The function of an SDU is to clean and purify residual oil to produce feedstock for the catalytic cracking unit “cat cracker”. The cat cracker then converts this feedstock into gasoline. The purpose of this memo is to analyze whether this project will exceed the company’s ^[a]required return on investment of 20%. These are the key factors to consider:^[b]

• Net selling price spread between residual oil and gasoline ^[c]
• Raw material cost of residual oil
• Allocation of “Cracker” costs
• SDU Operating Costs
• Market conditions for residual and gasoline

Net selling price spread between residual oil and gasoline

The table above illustrates incremental sales for gasoline over residual oil sales. The current market price for gasoline is 39 and has shown ^[e]to be fairly stable. $26.5 and $21 are averages for residual oil prices for years 1-5, ranging from $18 to $35 per barrel, and 6-20, ranging from $17 to $25 per barrel, respectively.

Cost of Residual Oil

To properly value the ROI of this project, it is important to determine if the residual oil that is put into the SDU should be treated as raw material costs or a by-product from the ^[f]distillation process that has no cost associated with it. There are three characteristics to consider when deciding if residual oil should be treated as a raw material cost or a ^[g]by-product:^[h]

1. The material is not the desired output of the process, but rather something that happens to be created in the process.
2. It is low in sales value relative to the main product.
3. It is produced in relatively small quantities.

Gasoline, not residual oil, ^[i]is clearly a desirable product ^[j]that Ajax Petroleum is aiming to produce. Furthermore, the price per barrel is consistently lower in value than the price per barrel of gasoline and the quantity of residual oil produced is small compared to gasoline production. Finally, when organizations are deciding to either sell a product or process further, costs incurred before the decision point should not be considered. These are sunk costs and cannot be recuperated regardless. Fixed and variable costs associated with the SDU are discussed in the SDU Operating Costs ^[k]section.

Allocation cost of the Cracker

As part of the SDU’s fixed operating cost, the analysis should include the incremental capacity of the cat cracker because the SDU uses ⅓ of the cat cracker capacity. Although the increase in utilization does not change the initial investment of the cracker, it will decrease the useful life of the machine. Thus, in order to fully capture all costs for the SDU, a potential 33% of cat cracker’s capacity should be added to the analysis.^[l]

The table above shows the calculation of the allocated share of the annual fixed operating cost that should be charged to the SDU. At 60% capacity, the cracker has a fixed operating costs at $4.5 million per year, ^[m]so an additional 33% capacity is computed by taking ⅓ of 100% capacity, or $2,325,000 annually.^[n]

SDU Operating Costs

The table above shows the calculation for the total operating costs of the SDU annually. The variable costs are computed by taking the fuel price of $2.90 times the 9,000 barrels produced per day times 365 days for a total variable cost of $9,526,500 annually. The variable costs added with the fixed costs and depreciation expense total the operating costs for the SDU of $14,176,500. The depreciation expense for the SDU is a noncash item so it is added back to the total free cash flow in the analysis.