Diamond Chemicals PLC (A) and (B)

Synopsis and Objectives

These two cases present the capital investment decisions under consideration by executives of a large chemicals firm in January 2001. The A case (case 20) presents a go/no-go project evaluation regarding improvements to a polypropylene production plant. The B case (case 21) reviews the same project but from one level higher, where the executive faces an either/or investment decision between two mutually exclusive projects. The objective of the two cases is to expose students to a wide range of capital budgeting issues:

A case: go/no-go decision

1.The identification of relevant cash flows; in particular, the treatment of:
a. sunk costs
b. cash flows obtained by cannibalizing another activity within the firm
c. exploitation of excess transportation capacity
d. corporate overhead allocations
e. cash flows of unrelated projects
f. inflation.
2.The critical assessment of a capital-investment evaluation system.
3.The treatment of conflicts of interest and other ethical dilemmas that may arise in investment decisions.

B case: either/or decision

1. The relevance of cash flows from assets that may be separable from the core project.
2.The classic crossover problem, in which project rankings disagree on the basis of net present value (NPV) and internal rate of return (IRR). 3.The assessment of real option value latent in managerial flexibility to change operating technologies. 4.The identification of some classic games or types of human behavior that can be counterproductive in the resource-allocation process.

Suggested Questions for Advance Study

Two Excel spreadsheet files support student analysis of these cases:

CaseSpreadsheet File
Diamond Chemicals PLC. (A)Case_20.xls
Diamond Chemicals PLC. (B)Case_21.xls

Making those files available in advance to students is highly recommended. (Instructor analysis may rely on TN_20.xls, which should not be shared with students.)

A case

1.What changes, if any, should Lucy Morris ask Frank Greystock to make in his discounted cash flow (DCF) analysis? Why? What should Morris be prepared to say to the Transport Division, the Director of Sales, her assistant plant manager, and the analyst from the Treasury Staff? 2.How attractive is the Merseyside project? By what criteria? 3.Should Morris continue to promote the project for funding?

B case

As described below, if the B case is taught on a stand-alone basis, the instructor should distribute the memorandum in Exhibit TN1, which presents the DCF analysis for the Merseyside project, corrected for the issues discussed in the A case.

1.Why are the Merseyside and Rotterdam projects mutually exclusive? 2.How do the two projects compare on the basis of Diamond Chemicals’ investment
criteria? What might account for the differences in rankings? 3.Is it possible to quantify the value of managerial flexibility associated with the Merseyside project? How, if at all, does this flexibility affect the economic attractiveness of the project? 4.What are the differences in the ways Elizabeth Eustace and Lucy Morris have advocated their respective projects? How might those differences in style have affected the outcome of the decision? 5.Which project should James Fawn propose to the chief executive officer and the board of directors?

Teaching Outline

The two cases are meant to be taught—one each—in sequential class sessions. The instructor could, however, teach the A case alone in a straightforward manner, and the B case alone by distributing Greystock’s revised discounted cash flow (DCF) analysis (included here as Exhibit TN1) along with the B case.

Plan for the A case

1.How does Diamond Chemicals evaluate its capital-expenditure proposals? Why such a complicated scheme? The purpose of this opening is to focus students’ thinking on the hurdles that the Merseyside project must clear. It also affords an opportunity to discuss the relative merits of different investment criteria. 2.What is the Transport Division’s suggestion? Does it have any merit? Here the class must grapple with the potential charge for the use of excess capacity in another division. 3.What is the director of sales’ suggestion? Does it have any merit? The focus here should be the cannibalization issue.

4. Why did the assistant plant manager offer his suggested change? Does it have any merit? This question raises the issue of extraneous cash flows.
5.What did the analyst from the Treasury Staff mean by his comment about inflation? Do you agree with it? At this stage of the discussion, students should review the need for internally consistent assumptions about inflation. 6.How should Greystock modify his DCF analysis?

This question turns to a summary of the adjustments needed to produce an acceptable DCF analysis. 7.What is the Merseyside project worth to Diamond Chemicals? Producing, in class, a revised DCF analysis helps to provide students with closure on the discussion.

Plan for the B case

1.Do you endorse Eustace’s analysis of the project at Rotterdam? How would you improve on it? This open-ended question is intended to stimulate a critique of Eustace’s analysis. The key point of objection is her inclusion of the right-of-way in the analysis. A brief discussion should establish that the option of the right-of-way should be exercised regardless of whether the project at the Rotterdam plant is undertaken. Therefore, the cash flows associated with the right-of-way should be separated from the rest of the Rotterdam project cash flows. It is a simple matter to recast the DCF analysis without the cash flows. The result is that the NPV of the Rotterdam project just slightly exceeds the NPV of the Merseyside project (adjusted to correct for the changes suggested in the A case). 2.After eliminating the right-of-way cash flows at Rotterdam, how do the Merseyside and Rotterdam projects compare financially and along other dimensions?

This surfaces the relatively more credible NPV figures on both projects, and exposes the inconsistent ranking of projects by NPV and IRR. 3.Why don’t the various investment criteria rank the two projects identically? The purpose here is to focus on the crossover problem and its cause, which is the massive differences in the time profiles of cash flow. 4.What should one do when IRR and NPV disagree in ranking mutually exclusive projects? The answer is that one should focus on the ranking by NPV, because it embodies a more reasonable reinvestment-rate assumption than IRR and because, in theory, NPV is the amount by which the market value of equity will change if the project is undertaken. Students will need to chew this over a bit; the instructor might be prepared with some comments on this point. 5.What do you make of Fawn’s concern about “flexibility”? Can we deal with that analytically and, if so, what is its effect on the value of the Merseyside project? What about on the Rotterdam project? Here the students must deal with the value of the option to change technologies. 6.Should Fawn be swayed by Eustace’s rhetoric?

Eustace’s behavior displays a number of classic games used by people attempting to influence the resource-allocation process. Students should see that such games tend to obstruct rather than improve the process. 7.Which project should Fawn approve? How should he justify his decision to the board of directors, who have already been exposed to Eustace’s ideas? The instructor can close the discussion with a vote and some summary comments on the wide range of issues that might have driven the decision another way in a different setting.

Supplemental Technical Notes

At the end of this teaching note are three supplemental notes the instructor may choose to distribute to students.

Supplemental Note TN1: “Relevant Cash Flows,” could be useful to students if distributed in advance of the discussion of the A case.

Supplemental Note TN2: “Valuing Managerial Flexibility and Commitment,” could be useful if distributed in advance of the discussion of the B case.

Supplemental Note TN3: “Reflections on the Real World of Capital Budgeting,” is useful as a wrap-up note for distribution after discussions of both cases. Collateral Readings for the B Case

The application of option-pricing theory to decisions involving real asset investments may be new to students. Thus, supplementing their study of the B case with some of the following readings might be useful:

Brealey, Richard A., Myers, Stewart C., and Allen, Franklin. “Options.” (Part 6) Principles of Corporate Finance. 8th edition (New York: McGraw–Hill Higher Education, 2006). Kester, Carl. “Today’s Options for Tomorrow’s Growth.” Harvard Business Review (March–April 1984): 153–160. Margrabe, William. “The Value of an Option to Exchange One Asset for Another.” Journal of Finance 33 (March 1978): 177–186. Trigeorgis, Lenos, and Scott P. Mason. “Valuing Managerial Flexibility.” Midland Corporate Finance Journal (Spring 1987): 14–21.

Analysis of the A Case

Critique of capital-investment analysis at Diamond Chemicals

The A case presents information regarding Diamond Chemicals’ investment criteria and thus affords opportunities for the students to think critically about the incentives and the side effects of the four hurdles.

EPS growth: This objective is dubious. Earnings per share can be easily manipulated by changes in accounting policies, and the figure ignores the investment necessary to produce earnings growth. Moreover, this objective penalizes longer-term projects that may yield a low (or even a negative) contribution to earnings in the near term. Most textbooks present the considerable volume of academic evidence that the market is not fooled by cosmetic changes in EPS but, instead, the market values cash flows. Finally, the method of implementing this criterion may penalize small projects that make a relatively insignificant contribution to the corporation’s EPS.

Payback: The classic flaws of payback are that it ignores the time value of money and ignores cash flows occurring after the payback horizon. One possible reason that firms use this measure is that they feel financially constrained in their ability to finance new projects and wish to undertake only those projects that do not impose an unacceptable drag on the firm’s finances. One effect of the payback criterion is to focus managers’ attention on near-term performance, possibly to the detriment of longer-term investing. NPV and IRR: These measures most closely reflect the interests of investors and fully account for the entire life of a project. Unfortunately, they are also somewhat more difficult to use than the other two measures, and may not always agree, as shown in the B case analysis.

One virtue of Diamond Chemicals’ evaluation approach is the system of varying investment hurdles. Generally, the required rates of return rise with the risk of the projects, which is consistent with the general risk/return framework of finance and is representative of systems presently being adopted at major corporations.

Adjustments to DCF analysis

Greystock’s preliminary DCF analysis of the Merseyside project should be corrected for at least two violations of the principles of relevant costs and could be adjusted in other ways, depending on one’s judgment. The main issues to be resolved and the possible responses to each are as follows:

Engineering study: Because the funds are already spent, they should not be included in the cash-flow analysis. The principle here is: Do not include sunk costs. The text of the case did not highlight this issue, but sharp students will note it.

Corporate overhead allocation: These charges are not incremental flows of cash but, rather, accounting allocations. Undertaking the Merseyside project will not necessarily trigger more headquarters expense (indeed, many students will say that it is unlikely to trigger more expense). At issue here is the principle of discounting only incremental cash flows. Again, the text does not highlight this issue, but sharp students will raise it.

Cannibalization of the Rotterdam plant: Students must confront the “scope of analysis” issue and take into account the investors’ perspective. Unless managers adopt the perspective of the owners of the corporation, they may make suboptimal investment decisions. Particularly interesting here is the ambiguity about whether Rotterdam will inevitably be cannibalized. Evidently, the director of sales thinks it will, whereas the marketing vice president thinks it will not if sales can be taken away from Saone-Poulet and/or Vaysol S.A. (the competitors with the next lowest costs). Different classes of students will have different judgments about this issue, but the comments in the case about the severity of the current recession are likely to suggest to students that cannibalization is more probable than not. If cannibalization is expected to occur, then Rotterdam’s decline in after-tax gross profits must be reflected in the cash flows of the Merseyside project.

Use of excess capacity in tank cars: Undertaking the Merseyside project will trigger no purchase of tank cars today, so some students will argue that the proposed shadow charge for tank-car capacity is inappropriate to include in the analysis. The counterargument is that Merseyside will trigger an earlier expenditure than it would have otherwise. The proper adjustment here is to reflect the change in timing of expected cash flows. A second issue to consider is whose interests are at stake. Greystock seems to suggest that the project should be evaluated from the narrow perspective of the Merseyside Works or the Intermediate Chemicals Group, but a basic principle of capital budgeting is that projects should be evaluated from the standpoint of investors in the entire company. Thus, accounting for secondary effects induced by undertaking a project is appropriate no matter how far afield those effects are from the business unit in question.

The final issue regarding the tank cars has to do with the interdependence of excess capacity and the cannibalization issue. If the class has decided that Merseyside will erode the volume of Rotterdam, some students may be tempted to argue that the spare capacity absorbed by Merseyside will be offset by an increase in spare capacity from the decline in volume at Rotterdam. But the A case explicitly states that the rolling stock is not usable outside Britain, because of differences in track gauge.

Changes in inventory: Students often neglect to reflect in their expenditure analyses the changes in working capital resulting from a project. Greystock has shown an increase in raw materials and work in process (WIP) inventory driven by the increased throughput at the plant. He has ignored the potential recapture of that inventory, however, at the end of the project life. The buildup of inventory does not simply vanish at the end of year 15. Cash in the amount of the inventory buildup is thus shown in Exhibits TN1 and TN2 as being returned during the 15th year, the last year of the project. Inventory adjustments must also reflect the reduced working capital requirement at Rotterdam brought about by cannibalization. Those adjustments are reflected as necessary in Exhibits TN1 and TN2.

Adjustment for inflation: Greystock’s analysis in the A case indeed mismatches cash flows and discount rates. Students should be encouraged to discuss the need for internally consistent assumptions about inflation in both cash flows and discount rate. The modification is straightforward: students should inflate cash flows at 3% and keep the current discount rate of 10%.1 Extraneous cash flows and ethics

Griffin Tewitt’s proposal to include the EPC (ethylene-propylene-copolymer rubber) project is characteristic of the kinds of adverse games that operating managers can play with capital budgeting. For another example, Joseph Bower recounts how one manager built almost an entire plant on the basis of small investment authorizations that were within a manager’s own power to approve.2 The manager was caught when he submitted an investment proposal for a chimney (the cost of which exceeded his personal authorization limit).

Greystock’s analysis should not be modified to include the EPC project for two reasons:

1.To do so is to violate the basic axiom of relevant cash flows: One should include only those flows of cash that are incremental to the project being valued. As the case states, the EPC project is “separate and independent” from the polypropylene-line renovation; its flows simply do not belong in this valuation analysis. 2.To do so is at the least surreptitious and practically amounts to lying about the nature of the project. Senior executives have already rejected the project. To include it in the polypropylene project is to willfully undercut one’s own leaders, a failure of one’s responsibility as an agent. The conflict of interest underlying this principal-agent breakdown is clear in Tewitt’s own comments to maximize plant size, to maximize personal bonuses, and to avoid layoffs because they are painful to make. He advocates this step despite the implication that the shareholders will be worse off from this investment. Finally, the potential personal risks to Morris are disproportionately greater than any benefits she might receive. Failures of one’s duties as an agent tend not to be well received in large, bureaucratic organizations.

Summary of revisions and their impact

Contained in Exhibit TN1 is a memo from Greystock and Morris to Fawn, the key decision maker, in which changes have been made to reflect adjustments based on these five issues. Specifically, the costs of the engineering study and overhead allocation have been dropped from the cash flows. The forecast is given for cases of no erosion and full erosion of business at the sibling plant. The cash-flow effect from the change in timing of new tank cars is reflected, as are the changes in inventory. The cash flows are discounted at the nominal rate of 10%, and inflation of 3% is incorporated into the models. In sum, the project offers a NPV of (British pounds) £7.29 million and an IRR of 22.5% (or, if no adjustment were made for erosion, £13.92 million and 31.2%). If the Merseyside project were to be evaluated now on a stand-alone, go/no-go basis, it should be accepted.

The revised estimates in Exhibit TN1 afford a focal point for the students with which to continue the analysis in the B case. Ideally, the instructor would hand out copies of Exhibit TN1 with little or no comment other than to say, “This is how Frank Greystock finally decided to model the project.” The instructor should take care not to hand out the memo as a “solution” to the case, because that might dampen any emphasis made earlier in the class about the large gray area for judgment in capital-expenditure analysis. In other words, Exhibit TN1 should not be presented as the “right” answer to the A case. An added caution is that once distributed, Exhibit TN1 may enter the body of solutions that students at some schools pass along to succeeding classes. Thus, distribution of this exhibit may impair the quality of discussion the next time the case is taught.

An alternative approach is for the instructor to allow the students to revise their own analyses of the A case, consistent with the class discussions, and then to use those analyses as a basis for discussion of the B case. This approach encourages variability in student analyses.

Analysis of the B Case

Critiquing Elizabeth Eustace’s analysis: the right-of-way

As with the A case, students should be encouraged to scrutinize the DCF analysis and offer suggestions for possible improvement. In most respects, Eustace’s analysis seems appropriate, although as in the case with Merseyside, this teaching note recommends that nominal cash flows and nominal discount rates be used. In addition, a close reading of the nature of the investment in the right-of-way suggests that the right-of-way should be purchased, regardless of whether the Rotterdam project is undertaken. Diamond holds an in-the-money option to purchase for £3.5 million the right-of-way, which has a current market value of £6 million. This option is to expire in six months. Even if the Rotterdam project is not undertaken, Diamond should exercise the option and sell the right-of-way at a profit, despite the fact that, in the B case, a director of the company is quoted as asserting that land speculation is not Diamond’s business. If there were any speculation, it occurred when Diamond bought the option in the first place; now it is time to harvest a lucky profit. In short, the exercise of the option is not incremental to the project; the £3.5 million outlay today, and the £35 million terminal value in 2006 should be removed from the cash flows of the Rotterdam project.3

In my experience teaching this case, many students will object to Eustace’s inclusion of the right-of-way in the analysis for another reason: The lump-sum terminal value, which significantly influences the NPV of the project, is uncertain. The consultant’s unsubstantiated estimate of a terminal value of £35 million 15 years into the future is easy to challenge. While it is appropriate to scrutinize “key value drivers,” the instructor should take care not to let students dispense with the right-of-way simply because of its size or difficulty to value. If the problem is credibility, then the answer is to get better information. It remains that the key intellectual test of whether to include a flow of cash in a DCF analysis is whether that flow is incremental to the project.

Exhibit TN2 adjusts the DCF valuation of the Rotterdam project by excluding the cash flows associated with the right-of-way, and by using nominal cash flows and discount rates. The result is an NPV for the Rotterdam project that is considerably lower than initially projected. Also, comparing the IRRs and NPVs of Rotterdam and Merseyside under the assumption of full erosion yields inconsistent rankings. Table TN1 shows the situation facing James Fawn in the B case:

Table TN1.

Rotterdam Project
(without right-of-way)

Merseyside
Project

Assumes NO EROSION at the sibling plant

NPV = £14.90 m
IRR = 22.2%
(see Exhibit TN2)

NPV = £13.92 m
IRR = 31.2%
(see Exhibit TN1-B)

Assumes FULL EROSION at the sibling plant

NPV = £10.01 m
IRR = 18.7%
(see Exhibit TN2)

NPV = £7.29 m
IRR = 22.5%
(see Exhibit TN1-A)

The analysis suggests that on an NPV basis, the Rotterdam project dominates Merseyside in both the full and non-erosion scenarios. In terms of IRR, however, Merseyside dominates Rotterdam. Clearly, NPV and IRR disagree in their rankings. Generally, one’s preference for either project depends on the discount rate one assumes, as shown in the table in Exhibit TN3 and in the graphs given in Exhibits TN4 and TN5.

The disagreement in rankings offers two important learning opportunities: (1) why the differences arise, and (2) what to do about the situation. In essence, this ranking problem arises because of the highly different time profiles of the two projects’ free cash flows—these are compared graphically in Exhibit TN6. Rotterdam’s cash flows are large later on; Merseyside’s are comparatively large in the near term. Varying the discount rate affects the attractiveness of the two projects differently. Both projects have positive NPVs, and in a “go/no-go” decision setting, both should be accepted. Apparently, Diamond Chemicals can use 7% more capacity in polypropylene production, but not 14% more. Thus, only one of the two projects may be accepted, no matter how good the other project looks independently. The textbook solution to this ranking problem is to take the project with the highest NPV. First, NPV assumes the firm reinvests cash at a rate equal to the discount rate (10%), whereas IRR assumes higher reinvestment rates, which may not be replicable. Second, NPV has a straightforward interpretation: It is the amount by which the market value of the firm will change if the project is undertaken. If we are taking the investors’ point of view, such a statistic is extremely relevant.

On the basis of NPV calculated on the two projects’ cash flows, James Fawn would probably find the selection too close to call. But perhaps the NPV analysis ignores hidden real options.

The impact of real options

This consideration is appropriate to explore with students who have been exposed to option-pricing theory and the concept of real options. I like to emphasize to students that the value of a project consists of the DCF value of determinate cash flows plus the value of options the project may contain—rather like valuing a convertible bond in which we value the bond and option pieces separately— and then sum. Conceivably, there are many options latent in both projects. Since the plants in Rotterdam and Merseyside are identical and since the choice between them is mutually exclusive, I prefer to assume away most of the latent options by saying that they don’t help us differentiate between the two investment alternatives. However, the B case highlights options associated with technological change that may help us differentiate between the two. Table TN2 summarizes the technology choice options latent in the two proposals:

Table TN2.

Rotterdam

Merseyside

New technology commitment at initiation of project

Japanese process controls

No initial new technology commitment

Option(s) present

Option to switch from Japanese to German technologies

1. Call option on the Japanese technology
2. Option to switch from Japanese to German technologies
3. Option to delay

The question here is whether the values of the real options are significant enough to influence the managerial decision in this case. The learning point for students here is to see that the NPV analyses ignore the creation (or destruction) of options; they focus only on the flows of cash. An appropriate approach is to frame the investment decision as a comparison between the NPVs of the two projects’ incremental cash flows plus the values of the call options on process-control technology at each of the two plants. In other words, the simple comparison of NPVs ignores an important component of value.

Teaching strategies for the real options issue

Discussion of the real options issue should be tailored carefully to the capabilities of the class.

Novices: With degree students who have had little or no prior exposure to option theory, the options could be treated as qualitative considerations. Here, the approach would be to help students see that the two projects have very different stances toward the new technologies. Then the instructor could ask, “In your opinion, does Merseyside’s ‘wait-and-see’ approach have any merit over Rotterdam’s commitment to one technology today?” This type of question can prompt students to reflect on the potential value of flexibility.

Students familiar with option-pricing theory: Those who can appreciate the challenges in estimating option values might benefit from a more detailed presentation of the real option aspect. Here, the instructor can choose between at least two approaches, depending on the teaching objectives for the day.

Intuitive presentation: To gain some degree of closure on the real option issue at the intuitive level, the instructor must help the students reason through the types of options embedded in each project, assess whether they are in- or out-of-the-money, and assess the risk of the underlying asset. The discussion that follows argues that the Rotterdam project contains an option to switch that is deeply out-of-the-money, and unlikely to be exercised. Merseyside contains (1) a call option on the Japanese technology, (2) an option to switch from Japanese to German technologies, and (3) an option to continue to delay further without making any investment at all. The Japanese technology option is probably in-the-money. The German option is less clear, but one could reason that, at worst, it is probably not far out-of-the-money. In short, the Merseyside options are probably more valuable than the Rotterdam options.

Since the NPVs are close, the relative option values may be enough to tip the financial evaluation in Merseyside’s favor. Numeric presentation: The actual estimation of the technology option values associated with each project is the most time-consuming approach, and should be supplemented with transparencies or handouts. In my experience, students left on their own rarely address all the required issues in the numeric estimation of the projects’ options. The teacher will need to add some structure to the unfolding of this aspect of the discussion. The structure of this presentation is similar to the intuitive approach, but employs assumptions given in the case and an option-pricing model to arrive at numeric estimates. The sections that follow provide a foundation for this presentation.

Numeric estimates of option value at Merseyside and Rotterdam

The Merseyside project contains rights to invest later in the Japanese or the German control systems, as well as the right to do nothing. This is a trinomial problem, the formal solution of which goes well beyond the mastery of most MBA finance students. But one simplifying assumption can reduce the situation to a more tractable solution: one can be optimistic that either the German or the Japanese technology will so dominate the “do-nothing” alternative that the option value of continuing to wait indefinitely is quite small. The evidence for this optimistic assumption is that the NPV of the Japanese technology is positive; the option on the Japanese technology is already in-the-money. If the German technology is successfully commercialized, one can assume that it will have a positive NPV, too. From this perspective, investing in either of the new technologies is likely to dominate doing nothing.

This reduces the choice to two alternatives: German or Japanese technology. Some students will suggest that Merseyside retain two call options, one on each technology—but this overstates the option value at Merseyside, since one would logically not exercise both call options. Instead, Merseyside really contains the option to call on one of the new technologies, and then to switch to the other. Given what we know about the uncertain commercialization of the German technology, the logical inference is that Merseyside contains a call on the Japanese technology, with an option to switch to the German technology once the viability of the German technology becomes known.

The Rotterdam project takes a very different posture toward the new technology. It commits to the Japanese technology now, but retains the flexibility to switch to the German technology later. Some students will resist the notion that Rotterdam would ever be re-engineered to the German technology, as suggested by the statements in the B case. Their intuition is not unreasonable. Looking forward from the date of the case, it is uneconomical to install the Japanese technology and use it for only five years. By then, executives will face positive cash flows and a relatively high NPV by not switching, since the investment in the Japanese technology will have been a sunk cost. It would be unlikely for the new German technology to be attractive enough to replace what is already operating.

The rights on new technology at both Merseyside and Rotterdam include switching options. William Margrabe has modeled the option to switch as a European option to exchange one asset for another.4 The analysis here follows his presentation:

Value of option to switch = PGN{d1} − PJN{d2}

PG = exercise price of the German technology (£3.85 million5) PJ = exercise price of the Japanese technology (£3.856 million for Merseyside, and £25.99 million7 for Rotterdam) VG = standard deviation of the German-technology returns (0.08), B case footnote 3 VJ = standard deviation of the Japanese-technology returns (0.08), B case footnote 3 ρ = correlation of NPVG and NPVJ (0.80), B case footnote 3 V2 = VJ2 + VG2 − 2VGVJρ [= 0.0064 + 0.0064 − (2  0.08  0.08  0.80) = 0.00256]8 V = expected standard deviation of switching returns = 0.0506 Rf = 0%9

T = term to maturity (5 years)

Inserting those parameters into the Black-Scholes option-pricing model gives:

Merseyside option to switch:£0.174 million
Rotterdam option to switch:£0.000 million

Merseyside’s option to switch is positive but relatively small and because of the simplifying10 assumptions, it should be regarded as a conservative estimate. The surprisingly low option value reflects the high covariance between the returns on the Japanese and German technologies.

Rotterdam’s option to switch is virtually worthless. The huge NPV forgone (£25.99 million, the “lost” cash flows from the Japanese system in years 6–15) renders the switching option deeply out-of-the-money. Hence, the flexibility to change technology at Rotterdam is worth little.

Stated differently, whenever you suspect that a “crossover problem” might exist, use NPV for decision-making.

Another prominent issue under the panoply of system design is choice of discount rate. Diamond Chemicals used a risk-adjusted system by functional type of project. Finance theory would applaud this approach as far as it goes. One must be prepared to adapt the system to unusual proposals, however, such as Rotterdam’s, which could be viewed as a combination of plant maintenance and real estate arbitrage. This instance might profit from decomposing the bundle and valuing the two pieces at their respective appropriate risk-adjusted discount rates.

Ultimately, no capital-expenditure evaluation system can fully anticipate the variety of assets and projects to be valued; where the educated analyst adds value is in tailoring the system to the characteristics of the asset being valued. Of course, the analyst and the company run a risk every time the system is tailored: Changes in the rules send signals to managers, and one wants to avoid inadvertently sending the wrong signals. Moreover, a system that is tailored for every project may be seen as being completely arbitrary and able to be manipulated. Finally, decision makers will filter the output of such a system in their own ways. For many senior corporate executives, the track record of the executive sponsoring the proposal is about as influential as NPV.

The practical implication of this example is that NPV is a necessary, but not sufficient, condition for project approval. The human-behavioral side of resource allocation potentially overshadows all attempts at rigorous quantitative analysis. This reminder leads to the third and final barrier.

3. Dealing with political “games”: In “Diamond Chemicals PLC (B),” Elizabeth Eustace has framed the political landscape in ways that may prevent the proper economic decisions from being made. Eustace’s behavior included the following: Supplemental Note TN3 (continued)

Seeking approval or support of a budget request from more than one supervisor Supporting the request with voluminous data (the 90-page proposal), but with the data arranged in such a way that their significance is not clear Justifying the analysis in terms of subjective and lofty benefits (for example, technological “learning”) Raising and rejecting competing alternatives at two extremes (do nothing, make marginal changes) Other classic games are:

Selling a new program modestly, thereby concealing its real magnitude Concealing a politically unattractive program within an attractive program Playing competing committees or managers against each other

The reality is that games such as those permeate the capital-investment environment in most corporations and are believed to have a significant influence on decisions.3

What is to be done? The naive conclusion from all of this is that DCF-based systems are of little practical use. Knowledgeable analysts can draw a different conclusion: DCF is easy to misuse and abuse, but in a world of economic risk, strategic uncertainty, and politics, it can be enormously helpful in focusing managers’ thinking on the economic consequences of their actions. In sum, where the budgeting analyst adds value is by making the process of capital-expenditure analysis work rigorously, fairly, and honestly—not an easy task, but certainly worthy work.