CORPORATE FINANCE

SHUBHAM SARVAIYA
UPMA MEENA
SONAL GUPTA
SUDIPTA SANFUI
TANVI NARENDRA PEDNEKAR

0349/51
0353/51
0358/51
0366/51
0374/51

OND CHEMICALS THE MERSEYSIDE PROJ

Case Facts

Diamond Chemical is a leading producer of polypropylene and a major

competitor in worldwide chemicals industry
The company is under pressure from investors for improvement of
financial performance
Morris, plant manager of Diamond Chemicals Merseyside is proposing
a 9 million project for renovation and rationalization of
polypropylene production line at Merseyside plant
The project will lower energy requirements and increase production
efficiency

Q1. What changes, if any, should Lucy Morris ask Frank Greystock
to make in his discounted cash flow (DCF) analysis? Why? What
should Morris be prepared to say to the Transport Division,
Director of Sales, her assistant palnt manager and the analyst from
the Treasury Staff?
Initial Greystock analysis

Suggested Changes

7%

Output Improvement

0%

Discount Rate

10%

Infation
Preliminary Engg Cost

0.0 million

Transportation Cost

Loss Sales &

Cannibalization

0.5 million

NPV
9

0.0 million

IRR
25.9
%

Gross Margin
Imporovement

11.5% to 12.5%

Change Discount Rate

Add Transportation Cost
Remove Preliminary Engineering Cost

3.3

1. Change Discount rate

Include Cannibalization of Sales
Andrew Gowan - A Treasury analyst is sceptical about the discount
rate consideration Include
of 10%. Loss
Cashofflows
and discount rate need to be
customer
consistent in their assumptions about inflation whereas in the
calculation 3% long term inflation expectation is ignored. Hence,
the discount rate should be 7% (=10%-3%) i.e. with real target
return of 7% after inflation adjustment. This will impact NPV by
3.3 million upwards.
Two things can be done here: i.e. keep the discount 10% and adjust
3% inflation in cash flow or keep cash flows same and change
discount rate to 7%
Recommendation: Change discount rate to 7%

-0.2

2. Add Transportation Cost

Purchase of new rolling stock for transportation department
costing 2 million should be included in NPV calculation. The
reason behind is that the transportation department is not a
separate company rather a cost centre of Merseyside plant, and
because of the increased output they need to increase the
allocation of tank cars hence spend the extra amount in 2003
instead of 2005. Rolling stock has depreciable life of 10 years
hence change in NPV will be -0.2 million.
Recommendation: Include PV of investment of 2 million in 2003
instead of 2005

0.3

3. Remove Preliminary Engineering Cost

Greystock included preliminary engineering cost of 0.5 million
which has been spent on efficiency and design studies of
renovation. This is a sunk cost as already spent and cannot be
recovered hence should not be included in NPV calculation. Change
in NPV will be 0.3 million.
Recommendation: Remove Preliminary Engineering Cost of 0.3
million

-1.0

4. Include Cannibalization of Sales

Greystocks analysis assumes the fact that added volume can be
sold in the market without causing change in any other parameter.
Whereas as per Marketing department polypropylene market is
extremely competitive and the industry is currently facing
downturn. Hence to sell the extra output they probably have to
shift capacity away from Rotterdam toward Merseyside. Due to
cost advantage in Merseyside, it is still a considerable option but
cannibalization should be taken into account.

Taking this into consideration, we assume that added 17,500 MT

capacity will cannibalize 1.05% sales of Rotterdam, hence hurting
NPV by -1.0 million
12

25%

10

20%

8
NPV (Millions)
NPV

6
4
2

15%
10%
IRR
5%

IRR

0
0%
2.5000000000000001E-3
Cannibalization of Rotterdam's Gross Profit

-1.5

Recommendation: Include cannibalization of sales

5. Include Loss of customers
The project requires 45 days of shutdown, as Rotterdam plant is
operating near capacity Merseysides customers will buy from
customers. We are assuming 5% drop in sales in 2001, 2.5% in
2002. We are assuming innovation of new technology will help to
acquire previous customers 2003 onwards.
Change in NPV: -1.5 million.
Recommendation: Include loss of customers for 2001 & 2002
6. EPC project Include or not?
Griffin, assistant plant manager proposed renovation of EPC
production line at a cost of
1 million. The project has negative NPV hence not getting
approved, he suggested to merge with polypropylene project. He
claimed it will be profitable after recession ends.
We dont recommend to include it as it is a separate project, and
each project should be self-sustainable. It seems he is pushing for
his personal gain which has no relation with current project.
Recommendation: Dont include EPC project

NPV
9.9

Q2. How attractive is the

After Suggested
Merseyside project?
By what
criteria?
After all changes taken into account,
the NPV of the project is 9.9 million

IRR
22.2
%

and the IRR 22.2% is also greater than the required rate of return.
Hence using both the IRR and the NPV criteria, the Diamond
Chemical Merseyside project is quite attractive.

Q3. Should Morris continue to promote the project for

funding?

According to the case, the Merseyside project will increase output

and save energy. Hence it is in engineering efficiency category.
A project shoud meet following investment criteria as specified by
the company:
1. Impact on EPS : Average annual addition to EPS: 0.017
[Positive]
2. Payback period: 4.26 years Less than 6 years
3. Discounted Cash Flow : NPV 9.9 million hence free cash
flows is positive
4. Internal Rate of return: 22.2% - Much higher than the minimum
required IRR of 10%
As the project satisfies all four investment criteria Morris should
continue to promote the project for funding.