Diamond Chemicals

...

and business.

Cannibalization of Rotterdam plant sales: As justified by VP-Marketing, lower costs at Merseyside would take business from competitors and rather it would not affect Rotterdam sales. Hence it can be decided that there would be no cannibalization that need to be factored in analysis.

Inclusion of EPC Project: EPC Project has negative NPV which might once again force executive committee to reject the inclusion. Also, since the renovation proposed for EPC project does not consider the competition from synthetic-rubber compounds, it does not guarantee positive results of renovation. Considering this as a case of selling not-so-useful product along with a very-useful product, it is best to not include this expansion proposal.

Sunk Cost: The preliminary cost of engineering of £0.5M in the cash flow is classified as “Sunk Cost” of the project. And as a norm Sunk Cost should not be considered in the cash-flow analysis.

WIP Inventory: The production capacity gradually increases to maximum capacity after factoring the opportunity losses. Hence it is reasonable to consider inventory charge of 3% of cost of goods for all years until maximum production capacity is reached and zero for subsequent years. Furthermore, since the production in first year is less than initial production of 250000 metric tons, WIP would not be required and hence it is considered zero in the analysis.

Additionally, following factors are considered for analysis as suggested in analysis by Greystock:

o Throughput is considered to increase by 7% over the old output of 250,000 metric tons.

o Gross margin gross margin would be 12.5% with additional lower energy requirement.

o Tax rate considered capital analysis is 30%.

o New assets would have a DDB depreciation for first 10 years and straight-line depreciation for the remaining 5 years.

o Overhead rate of 3.5% of initial asset investment to stay in line with the corporate manual.

Results

Decision Components Greystock Analysis Suggested Analysis

Net Present Value £9M £9.4M

Internal Rate of Return 25.9% 19.2%

Payback Period 3.6 years 5.79 years

Avg. Annual addition to EPS £0.018 £0.015

Net Present Value: The net present value of the proposed analysis is £9.4M. It indicates a very good overall return on the project

Internal Rate of Return: The overall internal rate of return is around 19.2% and shows a healthy outcome of the project based on the benchmarks given in the case. So, net present value will be 0 at this rate of 19.2% for the given Cash flow stream.

Payback Period: The payback period is 5 years and 8 months. It implies that the project will start giving back profits above the break even in the mentioned time.

Earnings per share(EPS) and Number of Shares: An improvement in EPS by ~£0.02 annually which instills a positive perspective of the project success.

Conclusions and Recommendations

This project is an engineering efficiency project and meets performance criteria as shown below:

o Impact on earnings per share: The Average Annual Addition to EPS is positive (£0.015)

o Payback: The payback period for this project is less than 6 years (5.79 years)

o Net Present Value(NPV): The NPV for this project is positive (£9.4M)

o Internal Return Rate(IRR): The IRR for this project is greater than 10% (19.2%)

After careful analysis of the case and evaluating Greystock’s DCF analysis, we recommend that analysis should incorporate a discount rate of 7% with an initial investment of £10.63M considering opportunity loss and WIP inventory costs. Furthermore, the analysis should not account for EPC projects, sunk costs and cannibalization costs.

Therefore, the Merseyside renovation project proposed by Morris should be taken forward since in the long run it would be profitable to the company.

Appendix

References

1. Cost and Value Management in Projects, (Venkatraman and Pinto) 978-0-470-06913-4

2. Diamond Chemicals PLC(A): The Merseyside Project, Darden Business Publishing, University of Virginia, UV2493, Rev. Apr. 30, 2015.