Diamond Chemicals Case Study

Topics: Net present value, Internal rate of return, Discounted cash flow Pages: 8 (2919 words) Published: November 24, 2010
Diamond Chemicals: Case 21-22

TO: Lucy Morris
DATE: September 30, 2009
SUBJECT: Merseyside Project

In this memo I will be making a recommendation for or against the Merseyside Project. With the help of a few questions that guide my memo, I will be able to determine whether or not to continue funding for the Merseyside Project. This memo will include an exhibit that will show an analysis of the Merseyside Project including the NPV and the IRR. In the DCF analysis that was provided in the case I have made a few changes to it and that will be presented later in my memo. First I will like to talk about how Diamond Chemicals evaluate its capital expenditure proposals.

Before submitting a project for approval, the leader of the project must determine what category the project falls in. They have four possibilities and they are (1) new product or market, (2) product or market extension, (3) engineering efficiency, and (4) safety or environment. The Merseyside Project fell under category 3 which was engineering efficiency. With this project comes some concerns and that is why evaluating capital expenditure proposals can become such a complicated scheme. With Merseyside categorized as an engineering efficiency, it needs to meet a few requirements. •Impact on Earnings per Share: This number must be a positive for all engineering efficiency projects. This number “calculates the average EPS contribution of the project over its entire economic life. “(Bruner,284) In Greystock’s analysis it was positive and the number was at 0.018. •Payback: The maximum payback period for engineering efficiency projects stands at 6 years. Along with the Impact of Earnings per Share meeting the criteria, the payback period also does. Greystock’s analysis has the payback period at 3.6 years. •Discounted Cash Flow: To determine this number you use the Present Value of the Future Cash flows. Once you determine those numbers you add them to determine the NPV of free cash flows. In engineering efficiency projects the number has to be positive. In Greystock’s analysis the NPV is positive and is at 9.0 million. •Internal Rate of Return (IRR): In engineering efficiency, projects had to be greater than 10%. Greystock’s internal rate of return is at 25.9% which is well above the minimum 10%.

Although all the criteria were met and this seems to be a very attractive project, there are a few concerns that might need to be addressed that could negatively affect this project. One of my major concerns was the recession that the economy was in and the competitiveness in the polypropylene market. I believe that this could lead to a big loss of sales, a big increase in inventory, and overall a loss in profit. Exhibit A, below, will show Greystock’s analysis for the NPV and the IRR of the Merseyside Project. Exhibit B, directly next to it, will show some changes that I made that will show the impact the economy and an increase in competiveness.

Exhibit A:Exhibit B
Year#'s Per YearFCFPVYear#'s Per YearFCFPV
-99 -99
200111.4$1.27 200111.26$1.15
200222.66$2.20 200222.39$1.98
200333.09$2.32 200332.94$2.21
200443.06$2.09 200442.91$1.99
200553.02$1.88 200552.87$1.78
200662.49$1.41 200662.37$1.34
200772.47$1.27 200772.35$1.21
200882.45$1.14 200882.33$1.09
200992.43$1.03 200992.31$0.98
2010102.41$0.93 2010102.29$0.88
2011111.68$0.59 2011111.6$0.56
2012121.68$0.54 2012121.6$0.51
2013131.68$0.49 2013131.6$0.46
2014141.68$0.44 2014141.6$0.42
2015151.68$0.40 2015151.6$0.38
NPV= 9 IRR= 26%NPV= 7.94IRR= 24%
As you can see the numbers in the two exhibits are different. I felt that there needed to be some changes in Greystock’s original DCF analysis. For the years 2001 and 2002, I felt there was going to be a 10% decrease of sales. That 10% decrease of sales for...
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