Diamond Chemicals PLC (A)
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Diamond Chemicals is a large worldwide chemicals producer with two factories in Liverpool England and Rotterdam Holland. Both of their plants were built in 1967 with annual output of 250,000 metric tons polypropylene. Compare with low-cost producer, the production cost per ton is 1.09 which is a little bit high than competitors (see Exhibition 1). With the decline EPS from £60 in 1999 to £30 in 2000 and worldwide economic slowdown, the controller of plant manager of Merseyside (Liverpool), Frank Greystock, bring a improvement project in order to make plant more efficiency, more output and save more energy.
Frank proposed an expenditure of £9 million to renovate and rationalize the polypropylene production line at Merseyside plant. This project would be in the engineering-efficiency category with 17,500 tons production increasing and following investment criteria: 1) Average annual addition to EPS = £0.018. 2) Payback period =3.6 years. 3) NPV=£9 million. 4) IRR=25.9%.
This project will take 45 days to shut down Merseyside plant and their customers have to buy from competitors since Rotterdam’s plant was operating near capacity. After improvement, the output will increase 7% and gross margin will increase from 11.5% to 12.5% with a low energy requirement. But there are four major issues from inside and outside Merseyside plant:
Currently the transport division could make this allocation out of excess capacity, but doing so would accelerate from 2005 to 2003 the need to purchase new rolling stock to support the growth.
The director of sales argues that the industry is in a downturn and it looks like an oversupply is in the works. That means they have to shift capacity away from Rotterdam toward Merseyside. It is not really a gain for whole company. Marketing vice president is less skeptical and believes the market would revive and need more products at that time.
The assistant plan manager suggests adding more EPC improvement project (cost £1 million) to sustain the negative NPV of EPC project. Otherwise this EPC project may have to exit in three years.
The treasury staff thinks this impounds a long-term inflation expectation of 3 percent per year.
ANALYSIS AND RECOMMENDATION:
Morris drafted a Discount Cash Flow analysis for this project with above data (see Exhibition 2); however it might be revised according to current external environment and internal factors. EXHIBITION 3 presents a new discount cash flow analysis for the Merseyside project if we consider following factors. Following is the analysis for four major issues list above.
The transport division needs to purchase a new tank car two years earlier than original plan (from 2005 to 2003). Because this project accelerates the purchasing of tank cars, it is necessary to involve the depreciation shift to an earlier date. So two year depreciation should be included in DCF. In another words, the total depreciation = New depreciation of plant + New depreciation of tank cars (from 2004) – original depreciation of new tank cars (from 2006). [_refer line 19-21 of Exhibition 3_]
Here the tank car needs to purchase in 2003 instead of 2005. Compare with original financial statement (without this project), 2003 will lose more 2 million and 2005 will add more 2 million. In order to make the data more accurate, the cash flow in 2003 will be deducted 2 million pound because of purchasing, and added this purchasing (2 million pound) back to our cash flow in 2005. [_refer line 31 of Exhibition 3_]
This project will cannibalize another plant (Rotterdam plant). The industry is in a downturn and it looks like an oversupply is in the works, so the Merseyside project will probably have to shift capacity away from Rotterdam toward Merseyside in order to move the added volume. It also shows from Exhibition 3 that from 2002, the increase output (17,500 tons) of Merseyside may cause lost of Rotterdam output. So the incremental gross profit need to be deducted by the lost of Rotterdam output. [_refer line 12-15 of Exhibition 3_] But as all known, it is hard to predict. Maybe the industry may go up after several years (as marketing vice president said). At that time, the increase of output will benefit the company. Here we draft this project DCF with a conservative assumption to see whether this project is value to invest.
The EPC project, originated by assistant plant manager, should be a separate project in the Merseyside’s capital budgeting. Although the EPC production is a part of output from Merseyside plant, this project we are talking about is to renovate and rationalize the polypropylene production line. There is no dependency between them. We understand this EPC project might be very important for the company. But it is needed to propose another separate capital budgeting for approval.
As Gowan said, “The Treasury staff thinks this impounds a long-term inflation expectation of 3 percent per year”. To keep the gross margin, the company may need increase sales 3% per year. As we all known, in most cases, the cost of goods sold will increase accordingly with inflation. If the company continues keeping original sales, it means the revenue will decline. So in DCF table, we add 3% increase for both before and after Merseyside project. The impact items from the table are: new sales [_line 4 of exhibition 3_], old sales [_line 9 of exhibition 3_], and overhead [_line 23 of exhibition 3_].
Moreover, there is a potential risk that the plant will be closed for 45 days. All the customers would buy from competitors since Rotterdam plant was operating near capacity. Greystock believe the loss of customers will not be permanent. But actually, it is hard to forecast that the customer will come back to buy your product because the industry is in a downturn with an oversupply in the works. So the company may lose some of customer if they feel it is good from competitors.
Also this project will reduce the cost of goods and save more energy in the future. From the history data [_refer exhibition 1_], the newer plant generate lower production cost per ton. Once the industry recovery sometime in the future, the new plant will have more competitive strength with lower cost of goods and higher output.
From EXHIBITION 3, we re-calculate the cash flow for the Merseyside project with the assumption on new depreciation of transport, cannibalization of other plant, and 3% inflation per year. The results of key finical factors are:
Net present value = £5.22 million
Internal rate of return = 20.31%
Payback period = 4.51 years
Average annual addition to EPS = £0.020
From above data, the Merseyside project met all four investment criteria. The project is worth for Diamond Chemicals.
EXHIBIT 1 COMPARATIVE INFORMATION ON THE SEVEN LARGEST POLYPROPYLENE PLANTS IN EUROPE