Diamond Chemicals Plc (a): the Merseyside Project
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Diamond Chemicals is a leading producer of polypropylene, the polymer used in a variety of products (ranging from medical products to packaging film, carpet fibers and automotive components) and is known for its strength and elasticity. Diamond Chemicals is producing polypropylene at Merseyside (England) and in Rotterdam (Netherlands). Both factories are identical in size, age and plant-design. They were both built in 1967. Merseyside production process is the production process that are old, the best semi-continuous and therefore has a total workforce of more than the plant competitors.
Since its establishment in 1967, Diamond Chemicals failed to jump in on opportunity and enhance their production process; for the way they produced chemicals was old, outdated and cost the plant far more than its competitors. Therefore Lucy Morris is being appointed to her post almost a year ago, proposed a £9 million expenditure plan as a solution. The solution is aimed at developing new methods for the production of polypropylene.
Diamond Chemicals evaluate its capital-expenditure by four different categories. (1) New product market, (2) product or market extension, (3) engineering efficiency or (4) safety for environment. Merseyside Project goes under category (3) which is engineering efficiency. With this project comes some concerns and that is why evaluating capital expenditure proposals can become such a complicated scheme. With Merseyside categorized as an engineering efficiency, it needs to meet a few requirements. The first one is impact on earnings per share (EPS). Whether this measure will have a positive effect or not. The additional EPS in this capital-expenditure will be approximately 0.1005. This means that the impact is positive.
Second is the payback time. Thus, how long time it will take to amortize the initial project outlay by calculating the free cash flow. For engineering efficiency projects, it should be within six years. This project gives a payback time to be approximately 4.5 years. Third is the discounted cash flow, the net present value of the project. This measure should be positive, is the only requirement here. And it is. The calculated NPV is 9.33 (by using 10% as discount rate). And last, but not least the internal rate of return. For engineering efficiency projects, this measure should be higher than 10%. This is found to be around 26.45%. Way higher than the required IRR. They have been in the market for quite a few years, and are one of the largest manufacturers of polypropylene in Europe. By having such schemes, where every criterion must be fulfilled (the estimations).
One of the reasons for having such a complicated scheme can be quality assurance. It will be more difficult to find new projects, but they will be safe. At the other side, people working at the plant will know what the management is looking for, which measures thus. This means that those people will work to improve those given measures until they seem to live up to mark. By having such a complicated scheme, it will be more difficult to improve all these measure without concentrating on other aspects of the project. This will automatically give a better project. There will be difficult to find weak spots in the project.
Concerns regarding Transport Division
As the projected project needs to increase throughput, Transport would also have to increase its allocation of tank cars to Merseyside. What Greystock said that “the Transport division is not paying one pence of actual cash because of what they are doing at Merseyside” is not dissected. He has not taken into consideration of the company departments as a whole because he said” every tub on its own bottom”.
This unilateral view is harmful to Diamond as standing on the point of only one corner will not help to see the whole picture and therefore detrimental to the operation of Diamond. In order to make the allocation out of excess capacity, the Transport Division would accelerate from 2005 to 2003 the need to purchase new rolling stock to support the anticipated growth of the firm in other areas. Greystock should reflect this charge for the use of excess rolling stock in the DCF analysis.
Given that the Transport division depreciated rolling stock using DDB depreciation for the first eight years and straight-line depreciation for the last two years, we calculated the depreciation schedule as follows: It should be added after the item new depreciation item. Morris might also consider to report this kind of problem to the director’s board that as two divisions report to separate executive vice presidents, the employees tend to solve questions on their own behalf inside the division, instead the company as whole. This could be changed by changing the incentive bonus program.
Concerns of the ICG Sales and Marketing Department
Greystock has not taken into consideration of the opportunity cost of the loss of business at Rotterdam in his preliminary analysis of the Merseyside project. It is discussable whether doing so is good for estimation. Although the cannibalization charge is hard to estimate, but totally ignore the cost is not appropriate in evaluating the capital expenditure of the project. Morris should ask the Sales and Marketing Department head to provide more sufficient figure for the estimation of loss of business due to cannibalization problem and take the relevant loss into the analysis.
In fact, the director of Sales is right that Greystock should not be so optimistic about that they can sell the added output and obtain the full efficiencies from the project given the market is quite competitive. Morris should ask the vice president of Marketing to provide supportive figures and logical analysis to show what percentage of the lost business volume could return after the market revives. In addition, sensitivity analysis can be done for the elasticity of price and demand tradeoff.
Concerns of the Assistant Plan Manager
In general Morris should say no to the assistant plant manager, because the project does not look promising. The main reasons for this is the negative NPV, more competitors in the market and increasing development of substitutes. It is also negative that the company has not been able to make significant money on this product, even as they were the first on the market.
The way he presents it, by also putting pressure on the way bonuses are paid, and at the same time the personal feeling of maybe to lay workers of at a later point is something which can cause an argument for not recommending taking this project in under “his own”. The one thing which can be interesting to know more about and also ask the assistant plant manager is what kind of “strategic advantages” he see in this project. Good arguments here can make a difference, but with the information provided the answer will be no.
Concerns of the Treasury Staff
In the calculations inflation has been added as the treasury staff recommended and asked for. Discount rate used in the calculations is 10%, since this is figure is promoted in the latest edition of Diamond Chemicals` capital-budgeting manual. Since the expected long-term inflation is 3% per year, the real rate of return is 7%. This is done to give a more realistic picture of the value of the cash flow from the project. As it is visible in the calculations, the net present value (NPV), payback time and the requirement should add value for the share holders, since it still looks promising.
Is the project attractive?
Merseyside project is attractive in terms of the four criteria mentioned in the case. At first, it has a positive 9.33 million NPV. Secondly, it is an efficient project. With 9 million initial investment, both the payback period 4.5 years and the IRR 26.453% qualifies engineering efficient projects requirements – no more than 6 years payback period and approaches a greater than 10% IRR. Finally the project improves the EPS by 0.1 dollars. So, it is an attractive project and Morris should continue to promote the project for funding.