Diamond Chemicals: The Merseyside Project

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Executive Summary

The contents of this paper give an overview of the issues associated with the proposed capital program for the Merseyside project, solutions for those issues and recommendations and conclusion based on the updated Discounted Cash Flow (DCF) analysis. From the study, it was found that after addressing the issues raised by internal and external stakeholders, the project performance parameters still meet all project consideration criteria. If the Merseyside production line renovation project is pursued:

• The project will witness a NPV of 12.75M GBP across the project cycle
• The earnings per share will increase by 0.017 GBP
• The initial investment will be recovered in 4.06 years with an IRR of 22.2%

The study conducted addresses the issues raised by treasury staff, sales and marketing department of ICG, assistant plant manager, transport division, and a few errors with the initial DCF analysis. From the study, it can be concluded that even after addressing valid concerns of the stakeholders the attractiveness of the Merseyside project is not compromised. We recommend that Diamond chemicals should pursue the Merseyside project as in this time of worldwide economic slowdown and when the company is witnessing a fall in earnings per share, this project will result in energy savings, increase in output, and increase in earnings per share.

Statement of Problem

The objective of this study is to evaluate the economic potential of the Merseyside project after incorporating in the capital program valid implications of concerns raised by Diamond’s stakeholders. The study evaluates the following concerns:

1. The Treasury staff has advised that the treatment of preliminary engineering costs and discount rate in Greystock’s initial analysis is incorrect.
2. Assistant Plant Manager thinks that the Merseyside project should include the EPC production line renovation project.
3. The director of ICG sales and Marketing Department is skeptic that the increased output will result in cannibalization of the Rotterdam plant.
4. The controller of the Transport Division has suggested that the cost of Tank Cars required in 2003, two years earlier than planned, to support growth at Merseyside and other areas should be included as investment in the Merseyside project.

Further, the study aims at rectifying any errors in assumptions made by Frank Greystock, Diamond’s controller, while preparing the initial DCF analysis.

Background

Diamond Chemicals, one of the leading producers of Polypropylene and a major player in chemical industry, is under pressure from investors to improve its financial performance. In the midst of worldwide economic slowdown, Diamond chemicals witnessed a 50% fall in its earnings per share in the year 2000. Lucy Morris, manager of Diamond’s Merseyside Polypropylene plant, believes that the company will benefit economically by undertaking the Merseyside production line renovation project and plans to propose it to corporate headquarters for funding. The project involves a capital investment of 9M GBP and has the following benefits: Increased throughput of 7%, Increase in gross margin from 11.5% to 12.5%, and Energy savings at 1.25% of sales for years 1-5 and 0.75% for year 6-10. On the flip side, the project will require the production to stop for 45 days and may result in permanent loss of customers. Frank Greystock, Diamond’s controller has performed initial DCF analysis to test the economic potential of the project (Attached in the Appendix section) and even though the project meets all the company criteria of project selection, Frank and Morris are afraid that the concerns raised by stakeholders could kill the economic potential of the project. The stakeholders of the project are as follows: Company Headquarters, Transport Division, Assistant Plant Manager, Marketing and Sales department, Lucy Morris (Plant Manager) and Frank Greystock (Diamond’s Controller).

Methodology

In our initial assessment of the discounted cash flow we sought out to address the concerns of each stakeholder that raised an issue or recommendation. We decided to include the suggestions from the stakeholders on the basis of accuracy, its impact on the project performance parameters and the generic business sense. We also conducted a thorough review of the discounted cash flow analysis for any potential issues.  Our approach in evaluating the initial analysis and the suggestions from stakeholders was formed from learning’s of cost management, NPV calculations, Payback Period calculations and depreciation calculations. We addressed the concerns of stakeholders in the following manner:

• Assistant Plant Manager’s Concern: We decided to not include the EPC project as it seemed not just unethical but also since the EPC project will not be economically beneficial.
• Treasury Staff’s Concern: The hurdle rate used in Greystock’s analysis is a nominal rate and includes effect of inflation. Since the cash flows are real we decided to use the real discount rate of 7%. Further, the preliminary engineering costs are those that have been already spent. We decided to treat these costs as sunk costs and excluded them from the analysis.
• Marketing Department’s Concern: We believe that good marketing will offset the possibility of cannibalization. Especially, when Diamond chemicals can afford competitive pricing due to added efficiency, good marketing efforts can eat the market share of other competitors. Further, the output from the plant can be controlled on the basis of forecast of sales, which marketing department should have to avoid oversupply. In a scenario where extra output is sold the project will still increase the earnings per share due to increase in gross margin.
• Transport Department’s Concern: We believe that the project should support the added demand for transport because the project is in support of the company and project managers should merge separate divisions together. While funding issues should be resolved internally surrounding what department is funding the trucks, the project is being conducted at the corporate level and should account for the transportation needs. Though sponsoring the trucks will decrease the benefit that can be solely attributed to the project but it will benefit the company at an overall level. We therefore added an investment of 1.63 Million GBP, the present value of 2 Million GBP in 2003 to our initial investment outlay. We chose to use the excess capacity of the transport division till 2003. The project will sponsor the purchase of the rolling stocks in 2003 and hence accounts for resulting depreciation and overhead cost. Over the life of the assets the transport division can control the functioning of the trucks. The transport division will have no issues with such arrangement since it prevents them the planned investment in 2005.
• Errors in initial Cash flow analysis: We noticed that the lost output of 45 days from construction was calculated using the increased value of the output. Since the production is 250,000 metric tons before renovation the lost output should be calculated using this value. Further, we found that the calculation of onetime investment on work in process inventory is incorrect. The investment is realized in the second year of the project when an actual annual increase by 17,500 metric tons is observed. The inventory cost will be 3% of the increase in the cost of goods. Since the investment is one-time, this cost should not be included in subsequent years.

The Cash flow analysis was updated taking into account the implications of the concerns of stakeholders and the project performance parameters: NPV, Payback Period , IRR and Earning per share were recalculated to assess if the project still stands economically attractive.

Results

The key project performance parameters were calculated on the basis of the updated Discounted Cash Flow. Detailed calculations are attached in the appendix. Further, the below table shows a summary of the project performance parameters compared to the initial analysis and company threshold.