The Diamond Chemical PLC
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The Diamond Chemical PLC as the producer of polypropylene has two production plants which are in Merseyside and Rotterdam. Both factories have similar size and have same production output but their system is already outdated since it is established in 1967 and therefore the costs to produce the polypropylene escalate as the plants are not running efficiently anymore thus its cost is higher than the competitor. To maintain the competitive advantage the Diamond Chemical PLC develops the project to reduce the cost and increase the production capacity of the plant in Merseyside and Rotterdam.
The project is mutually exclusive means that only one project that can be accepted by the executive vice president of the intermediate Chemicals Group (ICG) James Fawn. Lucy Morris is a plant manager in Merseyside. She proposed to reduce the cost and increase the production capacity through (1) relocating and modernizing tank-car unloading areas which would enable the process flow to be streamlined, (2) refurbishing the polymerization tank to achieve higher pressures and thus greater throughput and (3) renovating the compounding plant to increase extrusion through obtain energy saving. The overall strategies of Morris are to redesign the plant and renewing the existing asset so the plant will produce just like when the plant is new and the cost of initial investment is 9 million pound.
It will quicken the process of unloading raw material and increase the energy saving. The second plant which is in Rotterdam and Elizabeth Eustace as the plant manager proposed different strategy to reduce the cost of production. Her strategy is by replacing the polymerization from batch process into continuous flow and adopting new sophisticated technology to the factory. This strategy will accelerate the flow of the material to the processing unit thus reduce the time and the new sophisticated technology from Japan will produce significant improvement in cost and output.
To have stable input of the raw material she proposed to purchase the pipeline from one refinery 5 kilometer away from the factory. Her proposed strategy will cost 8 million pounds spread over three years. This paper will focus on the financial goal which is to invest in projects that generate the highest benefit for the Diamond Chemical PLC. To decide whether or not a project is worth investing in the company, herein will be discussed the NPV, IRR, Payback Period and some strategic consideration. And it will answer the key issues which is the most appropriate project for current condition and in the future for Diamond Chemical PLC. ANALYSIS
Relation between Merseyside Project and Rotterdam Project
Mutually exclusive projects are projects that serve the same purpose for which reason only one project will give the required output whereas the output of the second project will become abundant. For this reason one has to choose which project to realize because implementing both will not bring any additional benefits. In the case of Diamond Chemicals PLC the Rotterdam and Merseyside plant both propose projects that could increase the polypropylene output of the company. It is expected that each project can increase the output by 7%. However the companies’ strategic analysis staff suggests that an output increase of 14% would not make sense. Therefore only one project needs to be chosen which makes both projects mutually exclusive.
The 2 Projects based on Diamond PLC’s Investment Criteria
Diamond PLC is using 4 criteria to value these 2 projects. They are EPS growth, payback period, NPV, and IRR. Regarding EPS growth, it is can be easily manipulated by some accounting policies. This criteria also can subjectively eliminates longer-term projects that may yield a low or even negative cash flows in few years beginning of the projects. Finally, this criteria also able to penalize small projects that make a relatively insignificant contribution to the company’s EPS. Regarding the payback period criteria, it ignores the time of value of money and ignores cash flows occurring after the payback horizon. In the end, we decide to just use NPV and IRR. These measures can fully account the value of the projects. From the Case A, there are some concerns given by some parties into Merseyside Project. After that, Frank Greystock made some adjustment and get new numbers for his NPV and IRR. With Erosion consideration, the new NPV is £7.43 million and the new IRR is 22.7%, while no Erosion is £14.06 million and 31.3% respectively.
Greystock eliminates the preliminary engineering costs of £0.5 million and overhead allocation of 3.5% which was included in the calculation before. He also takes consideration of the cannibalization toward Rotterdam Works if Merseyside Project chosen (full erosion). Unfortunately, by our own calculation, we get slightly different result. The new NPV and IRR with Full Erosion consideration is £7.44 million and 23.27%. While without erosion consideration, it is £14.07 million and 32.19%. (see Appendix 2) From the Case B,Elizabeth Eustace is including the value of right-of-way.Because the right-of-way is already purchased. It is said that right now the right-of-way has market value £6 million. But, the exercise of option to sell the right-of-way now is not included in incremental account. Therefore, the £3.5 million outlay today should be removed from the cash flows of the Rotterdam Project. The new NPV of Rotterdam project (see Appendix 3) is presented in table below.
NPV = £14.90 m
IRR = 22.2%
NPV = £14.07 m
IRR = 32.19%
NPV = £10.01 m
IRR = 18.7%
NPV = £7.44 m
IRR = 23.27%
After the revision has been made, it can be seen that there is conflicting result between the NPV and IRR. If we look only at the NPV, then Rotterdam Project is the winner, but reflecting to IRR result, Merseyside Project is the winner. For giving more consideration to the decision-maker, sensitivity analysis is also needed to be done. Below is the sensitivity analysis comparison between two projects.
Other option is related to technology usage. The initial state of Merseyside project is without any new technology commitment. Thus, later it can invest in Japanese or even the German technology, but also can choose not using any. From these three options, it will give more benefit if the company choose to use the new technology, whether it is from Japan or Germany. The Japan technology has already proved to have positive NPV and it can be assumed that German technology also will yield positive NPV. To sum up, Merseyside project has three options. One is to use Japanese technology from beginning to end, or wait for the commercialization of German technology and use it, or use Japanese technology first then switch to use German technology even though this last option is going to cost a lot of money. For Rotterdam Project, they are committing to use Japanese technology from the get-go, but it also possible that they want to switch into German technology later. But from economic prospective, it is uneconomical to switch five years later when the cash flow after using Japanese technology becomes positive. SWOT Analysis Merseyside
•Receive positive cash flows immediately
•Higher cash flows in the beginning
•Relatively short payback period
•Can wait to see if German technology will be better than Japanese technology Weakness
•Production process is old & not
continuous at times
•Higher labor costs
•Increased output/Lower costs
•Higher market share
•45 day facility closure will cause
customers to purchase from
•Will have to compete to regain lost
•Obsolescence of technology
SWOT Analysis Rotterdam
Polymerization process becomes continuous
Flexible payment schedule (over 4 yr pd)
Japanese technology proven successful in Japan
Propylene gas pipeline option – decreased need for railroad tank car transportation
Lack of flexibility option
Committed to project
If better technology is developed can not integrate it
Use of right of way
Future sale of right of way
Loss of right of way
Lost cash flows from not implementing the
Managers Behavior: Looking at 2 Project Managers Behavior
Elizabeth Eustace, responsible for the Rotterdam plant, advocates the project more enthusiastically. She says that the long-term benefits will come with the learning curve effects which have been exploited in the USA and Japan for long time and should now give a European company a competitive advantage. Additionally the sourcing of raw materials needs to be adjusted in order to provide a fast and secure supply. For this reason a pipeline needs to be built. Overall Elizabeth Eustace is more future oriented and risk-taking thus being beneficial for her to convince people. Lucy Morris on the other argues more logical and down to earth. Her attempt is to just increase the efficiency of the current technology the plant uses.
This will result in the same output increase but not require completely new machinery. Her approach is rather conservative than Elizabeth Eustace’s. The differences in style might affect the decision negatively because usually a more future-oriented and new approach is seen as innovative and hence desirable. However even though Lucy Morris can be seen as conservative her approach has real advantages. By only increasing the efficiency the company can achieve and increased output but still has the option to purchase even better technology in five years if developed by the Germans. This way the company keeps a certain level of flexibility.
Both projects have an almost similar NPV with 14.90 (Rotterdam) and 14.07 (Merseyside). From this point of few the Rotterdam project would be slightly favorable. However taking other considerations into account we decided to aim for the Merseyside project. On the one hand the IRR of the Merseyside project is higher meaning that funds are used more efficiently. Secondly there is no need to invest in the construction of a pipeline and land for which reason the company will further focus on its core competences and not deal with additional risks (or perhaps benefits). Furthermore the pay-back-period of the project is faster which means that the investment can be completely in a shorter time. Lastly a major argument for choosing the Merseyside project is the flexibility it comes along with.
The company does not have to commit to the Japanese technology as in the Rotterdam case but remain with the old machinery. Therefore the company can see in five years how the actual development of demand is and if further investments would pay off. In addition to that they can benefit from a possible successful commercialization of the German technology if they choose to upgrade the plant. That way the additional money needed to fund the Merseyside project will pay off in a large flexibility which makes it worth it.