Background & Problem Statement
Diamond chemicals is a leading propylene producer and a major player in the chemicals industry worldwide. However the share of the company had fallen from £60 at the end of 1999 to £30 in 2000 on account of worldwide economic slowdown and poor financial performance. Given the prevalent scenario, it was time to obtain funds from corporate headquarters for a modernization program for Merseyside project. This project will not only renovate and rationalize a production line but also make up for deferred maintenance and increase production efficiency. Lucy Morris is the Plant Manager at Merseyside and by nature she is a high achiever and a Notre dame MBA.
Frank Greystock is the Controller, President of Diamond Chemicals. To make a compelling case, Frank and Lucy try to make a financial model to calculate the NPV, IRR and Payback period for this project but are challenged on several aspects. To pursue their endeavor, they need to correct the model as per the feedback from the shareholders and management. Thus the problem statement is to suggest corrections to the existing model and thus calculate the NPV, IRR and payback period which would not be challenged further and the project could be approved. Methodology and Results
In addition to the baseline model presented in Exhibit 2 of the case study, four cash flow models were built considering the following criteria:
* Cannibalization: This model was directly taken from the case study and was used as a starting point for reference. This model presents the information that Greystock included on the analysis that was submitted to Morris. Cannibalization of demand: This model reflects a reduced output at Rotterdam. The cannibalization aspect is obtained by shifting the added volume from the plant in Holland (Rotterdam) to the plant England (Merseyside) regardless of the fact that both plants operate under the same company.
* Excess transport needed: This model accounts for a £2 million for the purchase of rolling stock to support the anticipated growth of the firm. The funds would be used to purchase tank cars to be used at Merseyside. * Including EPC project: This model includes the recommendation provided by Griffin Tewitt, assistant plant manager at Merseyside. This model reflects the detrimental effects of including a project that adds no value, to the original model. By itself, the EPC project does not stand a chance of approval, thus the only effect that it has, by bundling with the polypropylene project, is to increase the paylack period, lower NPV and reduce the IRR of the overall project. * Recommended model which consists all the right variables’ values: This model contains all the adjusted variable with the recommendations that our team would follow, if placed in the position of Morris. This accounts for The Results from these were as follows:
| Baseline| Cannibalized| Excess Transport| EPC| Recommended| IRR| 25.9%| 21%| 22%| 21.43%| 31.47%|
NPV (MM)| £ 8.95 | £ 5.75 | £ 6.16 | £ 5.00 | £ 13.37 | PBP (Yrs)| 3.61| 4.09| 3.95| 4.08| 3.20|
Thus we can see for the recommended model as the NPV is £ 13.4 Million and the investment required it £ 9 Million, it is a lucrative project.
The recommended model above considers a 3% inflation which varies from 1.2 – 5.1% in UK. Considering this variation the following graph shows how the NPV and IRR would change with inflation
The company charges a 3.5% for overhead investments. However, as the project is expected to reduce overhead costs, increase efficiency, output and reduce the power consumption, this overhead investment fee should be waived. If this waiver is implemented, the NPV increases to £15.0 Million. The Purchase Cost of Rolling Stock is currently considered as £ 2 Million. This would be used for transportation needs arising due to the anticipated excessive demand.
However this investment would be made regardless of the project and hence only a part of the investment should be considered for the modeling purposes. What proportion of the investment would be used specifically for this project will determine the value of the Purchase Cost of Rolling Stock that would be definitely lesser than £2 Million. Currently, the model is based on the assumption that the production will run on full capacity and the sales team will be able to sell all of the throughput. This assumption should be tested and, if not valid, the variation should be accounted in the model.
Conclusions and Recommendations
* Using the recommended model as a basis for comparison, against the original model, Merseyside is a promising project because the NPV is £ 13.4 Million and the investment cost is £ 9 Million with a payback period of 3.2 years and IRR of 31.47%. . * Greystock’s model did not account for inflation. The inflation rate of 3% should be considered in the final analysis. This changes the NPV from £9.7 Million to £13.4 Million, a £3.7 Million difference. * The sunk costs £0.5 Million should not be considered
* In case the overhead investment cost can be waived as the project itself aims at reducing overhead investments; the NPV would be £ 15.0 Million * The Purchase Cost of Rolling Stock is considered £ 2 Million which can be lowered considering the actual increase in transportation * The Customer retention can vary and depending on the anticipated demand the NPV, IRR and Payback period might change References:
i. Darden Business Publishing: Diamond Chemicals PLC (A): The Merseyside Project ii. http://www.bankofengland.co.uk/publications/Pages/inflationreport/infrep.aspx iii. Class 1 & 2 Presentations from Operations Cost and Risk Management