ADVANCED FINANcial Management
Diamond Chemicals PLC
Cases A and B
* Tank car cost = sunk cost
* Discount rate is used in nominal terms using inflation
* Forecasted cash flows are adjusted for inflation
* Merseyside and Rotterdam projects are mutually exclusive events * The acceptance of one project cannibalizes output at the other work site * We used worst case scenarios for all project comparisons * No capital rationing
* Based our decision between Merseyside and Rotterdam on NPV maximization * For inflation sensitivity we altered the rates by 1%
* Used discounted payback period
Executive Summary: Part A
After reviewing Frank Greystock’s analysis, we have decided that he needs to completely exclude the cost of the allocation of new tank cars. This is due to the fact that this cost will be realized regardless of the acceptance of this project or not. If the project is accepted, this cost will be realized earlier than expected in the year 2003. If the project is rejected, the costs will be realized 2 years later in 2005. Excluding the £2 Million would increase the cash flow in the year 2003, creating a larger NPV. We have also decided that Frank needs to include the forecasted inflation of 3% into his discounted cash flow analysis (EXHIBIT 2 and 3). Doing so would increase both the new sales, as well as the old sales used in comparing the projects effects, resulting in a higher NPV and IRR.
When looking at the transport division’s request to include the cost of the tank cars in Greystock’s initial outlay, we approve of Frank’s disagreement but with different reasoning. The cost should not be included in the initial outlay because of the fact that the cost is not realized initially, but rather in the year 2003.Greystock said that he believes that the Transport Division should pay for the cost of the tank cars because the cost occurs in their individual division, considering the philosophy of “every tub on its own bottom.” We disagree with this because the goal of the project is to increase earnings per share (EPS). EPS is achieved company wide, so therefore we feel that the cost should be incurred over the company as a whole, not Justas an individual division. We do agree with Frank’s decision to exclude the tank car cost however, citing that the allocation of these cars is a sunk cost due to the cost being experienced regardless of the acceptance of the project or not. Therefore, we do not need to include the cost of the cars in our discounted cash flows.
We realize that the cannibalization of Rotterdam does not produce a gain for Diamond Chemicals today. The current economic conditions prevent the company from converting the excess output into sales. The acceptance of this project increases the output at Merseyside, but by doing so forces Rotterdam to decrease production to accommodate the economic demand. However, when the economy comes out of recession and the demand increases, Rotterdam can increase production back up to their capacity of 250,000 tons. This excess demand can then be sold; pleasing the sales department.
We feel that the addition of the rubber project to the Merseyside project proposed by the assistant plant manager, Griffin Tewitt, should be ignored despite the positive outlook the future holds for rubber demand. The rubber project’s NPV is negative, and because we don’t know the affects that the addition of the rubber project will have on the Merseyside project, we cannot accept the rubber project.
The Treasury Staff thinks Greystock should adjust the discount rate to account for inflation. We believe this idea is correct and inflation does need to be accounted for, but we believe it should be realized by adjusting new and old sales throughout the life of the project. By realizing inflation this way we would leave the discount rate at 10%. If we were to adjust the discount rate as well we would...
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