1. Diamond Chemicals Team #7: APEX Members: Christina Fisher Jason Scholl John Silmon Josh King Jeff McGinn Jeff Mochal
2. Case introduction Main Characters: Lucy Morris: Plant Manager, Merseyside; high achiever; Notre Dame MBA Frank Greystock: Controller; President, Diamond Chemicals WAG club Plot Summary: Major competitor in worldwide chemicals industry & a leading producer of polypropylene Morris is recommending a £9 million project; Renovate and rationalize a production line at Merseyside To make up for deferred maintenance and increase production efficiency Several objections to the project have been raised at corporate, and the initial analysis from Greystock contains errors that need to be fixed 1
3. Initial Greystock Analysis £0.3 £2.0 £3.3 (£1.2) (£0.7) NPV £12.7 £9.0 Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact Recommended DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV IRR 25.9% consistency overhead 2 What changes should Lucy Morris ask Frank Greystock to make in his DCF analysis? What is the justification for each of these changes?
4. Recommended adjustments Cash flow and discount rate consistency Annual pretax charge for overhead Engineering sunk costs Transportation investment Lost sales impact 3
5. Recommendation #1 Cash flow and discount rate consistency As Gowen points out – cash flows and discount rate need to be consistent in their assumptions about inflation 10% initial rate proposed by Greystock is a nominal rate – real rate is 7%, Inflation rate is 3% Two options: Keep the discount rate at 10% and include a 3% inflation rate in cash flows; OR keep cash flows the same (with no inflation factor) and change discount rate to 7% Recommendation: Change discount rate to 7% 4
6. £0.3 £2.0 £3.3 (£1.2) (£0.7) £12.7 £9.0 Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact Recommended DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV consistency overhead Change to NPV 5
7. Recommendation #2 Annual pretax charge for overhead Corporate manual states overhead costs be reflected at 3.5% rate This project is expected to reduce overhead costs and should not be required to charge an annual pretax Recommendation – Remove 3.5% pretax 6
8. £0.3 £2.0 £3.3 (£1.2) (£0.7) £12.7 £9.0 Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact Recommended DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV consistency overhead Change to NPV 7
9. Recommendation #3 Engineering sunk costs £0.5M sunk cost for renovation efficiency is included in the analysis Sunk costs are retrospective costs that have already been spent and cannot be recovered, according to the with-without principle, not relevant to present decisions Only prospective (or future) costs are relevant to an investment decision Recommendation – Remove £0.5M sunk cost 8
10. £0.3 £2.0 £3.3 (£1.2) (£0.7) £12.7 £9.0 Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact Recommended DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV consistency overhead Change to NPV 9
11. Recommendation #4 Transportation investment £2M cost for purchasing new rolling stock to support anticipated future growth was not included in the DCF analysis Cost should be considered a cash outflow and expense The tanker cars are necessary to accommodate the increased throughput that is associated with this project Transport Division and Merseyside – *One Company* Recommendation – Include £2M transportation investment and the 10 year depreciation 10
12. £0.3 £2.0 £3.3 (£1.2) (£0.7) £12.7 £9.0 Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact Recommended DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV consistency overhead Change to NPV 11
13. Recommendation #5 Lost sales impact Greystock’s DCF Analysis concludes that all customers will return within one year Conservative approach concludes not all customers will return so quickly and this will impact sales and should be included in the analysis Potential factors include the overall state of the economy and improving competitor efficiencies Reduces both the NPV and IRR but the project remains attractive Recommendation – Include customer losses 12
14. £0.3 £2.0 £3.3 (£1.2) (£0.7) £12.7 £9.0 Recommended Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV consistency overhead Change to NPV 13
15. £0.3 £2.0 £3.3 (£1.2) (£0.7) £12.7 £9.0 Recommended Greystock’s Initial Cash flow & Annual pretax Engineering Sunk Transportation Customer Impact DCF Analysis Discount Rate charge for costs Investment in Year 2 NPV consistency overhead Summary of adjustments to NPV 14
