Here is a case study that has no definate answer, however, you do need
to give a logical explanation for a possible solution to the problem
and be able to defend it.
Thanks,
Jimmy5
Diamond Chemicals PLC (A):
The Merseyside Project
Late one afternoon in January, Frank Greystock told Lucy Morris, ?No
one seems satisfied with the analysis so far, but the suggested
changes could kill the project. If sold projects like this can?t swim
past the corporate piranhas, the company will never modernize.?
Morris was plant manager of Diamond Chemicals? Merseyside Works in
Liverpool, England. Her controller, Frank Greystock, was discussing a
capital project that she wanted to propose to senior management. The
project consisted of a &9 million expenditure to renovate and
rationalize the polypropylene production line at the Merseyside Plant
in order to make up for deferred maintenance and exploit opportunities
to achieve increased production efficiency.
Diamond Chemicals was under pressure from investors to improve its
financial performance because of both the worldwide economic slowdown
and the accumulation of the firm?s common shares by a well-known
corporate raider, Sir David Benjamin. Earnings per share had fallen
to &30 at the end of 2000 from around &60 at the end of 1999. Morris
thus believed that the time was ripe to obtain funding from corporate
headquarters for a modernization program for the Merseyside Works?at
least she had believed so until Greystock presented her with several
questions that had only recently surfaced.
DIAMOND CHEMICALS AND POLYPROPYLENE
Diamond Chemicals, a major competitor in the worldwide chemicals
industry, was a leading producer of polypropylene, a polymer used in
an extremely wide variety of products (ranging from medical products
to packaging film, carpet fibers and automobile components) and known
for its strength and malleability. Polypropylene was essentially
priced as a commodity.
The production of polypropylene pellets at Merseyside began with
propylene, a refined gas received in tank cars. Propylene was
purchased from four refineries in England that produced it in the
course of refining crude oil into gasoline. In the first stage of the
production process, polymerization, the propylene gas was combined
with the diluent (or solvent) in a large pressure tank and was then
concentrated in a centrifuge.
The second stage of the production process compounded the basic
polypropylene with stabilizers, modifiers, fillers, and pigments to
achieve the desired attributes for a particular customer. The
finished plastic was extruded into pellets for shipment to the
customer.
The Merseyside production process was old, semicontinuous at best
and, therefore higher in labor content than competitors? newer plants.
The Merseyside plant was constructed in 1967.
Diamond Chemicals produced polypropylene at Merseyside and in
Rotterdam, Holland. The two plants were of identical scale, age, and
design. The managers of both plants reported to James Fawn, executive
vice president and manager of the Intermediate Chemicals Group (ICG)
of Diamond Chemicals. The company positioned itself as a supplier to
customers in Europe and the Middle East. The strategic-analysis staff
estimated that, in addition to numerous small producers, seven major
competitors manufactured polypropylene in Diamond Chemicals? market
region. Their plants operated at various cost levels. Exhibit 1
presents a comparison of plant sizes and indexed costs.
THE PROPOSED CAPITAL PROGRAM
Morris had assumed responsibility for the Merseyside Works only 12
months previously, following a rapid rise from an entry position of
shift engineer nine years before. When she assumed responsibility,
she undertook a detailed review of the operations and discovered
significant opportunities for improvement in polypropylene production.
Some of these opportunities stemmed from the deferral of maintenance
over the preceding five years. In an effort to enhance the operating
results of the Works, the previous manager had limited capital
expenditures to only the most essential. Now, what had been routine
and deferrable was becoming essential. Other opportunities stemmed
from correcting the antiquated plant design in ways that would save
energy and improve the process flow: (1) relocating and modernizing
tank-car unloading areas, which would enable the process flow to be
streamlined; (2) refurbishing the polymerization tank to achieve
higher pressures and thus greater throughput; and (3) renovating the
compounding plant to increase extrusion throughput and obtain energy
savings.
Morris proposed the expenditure of &9 million on this program. The
entire polymerization line would need to be shut down for 45 days,
however, and because the Rotterdam plant was operating near capacity,
Merseyside?s customers would buy from competitors. Greystock believed
the loss of customers would not be permanent. The benefits would be a
lower energy requirement as well as a 7 percent greater manufacturing
throughput. In addition, the project was projected to improve gross
margin (before depreciation and energy savings) from 11.5 percent to
12.5 percent. The engineering group at Merseyside was highly
confident that the efficiencies would be realized.
Merseyside currently produced 250,000 metric tons of polypropylene
pellets a year. Currently, the price of polypropylene averaged &541
per ton for Diamond Chemicals? product mix. The tax rate required in
capital-expenditure analyses was 30 percent. Greystock discovered
that any plant facilities to be replaced had been completely
depreciated. New assets could be depreciated on an accelerated basis
over 15 years, the expected life of the assets. The increased
throughput would necessitate a one-time increase of work-in-process
inventory equal in value to 3 percent to cost of goods. Greystock
included in the first year of his forecast ?preliminary engineering
costs? of &500,000, which had been spent over the preceding nine
months of efficiency and design studies of the renovation. Finally,
the corporate manual stipulated that overhead costs be reflected in
project analyses at the rate of 3.5 percent times the book value of
assets acquired in the project, per year.
Greystock had produced the discounted-cash-flow summary given in
Exhibit 2. It suggested that the capital program would easily hurdle
Diamond Chemicals? required return of 10 percent of engineering
projects.
CONCERNS OF THE TRANSPORT DIVISION
Diamond Chemicals owned the tank cars with which Merseyside received
propylene gas from four petroleum refineries in England. The
Transport Division, a cost center, oversaw the movement of all raw,
intermediate, and finished materials throughout the company and was
responsible for managing the tank cars. Because of the project?s
increased throughput, Transport would have to increase its allocation
of tank cars to Merseyside. Currently, the Transport Division could
make this allocation out of excess capacity, although doing so would
accelerate from 2005 to 2003 the need to purchase new rolling stock to
support anticipated growth of the firm in other areas. The purchase
would cost &2 million. The rolling stock would have a depreciable
life of 10 years, but with proper maintenance, the cars could operate
much longer. The rolling stock could not be used outside of Britain
because of differences in track gauge.
A memorandum from the controller of the Transport Division suggested
that the cost of these tank cars should be included in the initial
outlay Merseyside?s capital program.
But Greystock disagreed. He told Morris
The Transport Division isn?t paying one pence of actual cash because
of what we?re doing at Merseyside. In fact, we?re doing the company a
favor in using its excess capacity. Even if an allocation has to be
made somewhere, it should go on the Transport Division?s books. The
way we?ve always evaluated projects in this company has been with the
philosophy of ?every tub on its own bottom??every division has to fend
for itself. The Transport Division isn?t part of our own Intermediate
Chemicals Group, so they should carry the allocation of rolling stock.
Accordingly, Greystock had not reflected any charge for the use of
excess rolling stock in his preliminary DCF analysis, given in Exhibit
2.
The Transport Division and Intermediate Chemicals Group reported to
separate executive vice presidents, who reported to the chairman and
chief executive officer of the company. The executive VPs received an
annual incentive bonus pegged to the performance of their division
CONCERNS OF THE ICG SALES
AND MARKETING DEPARTMENT
Greystock?s analysis had let to questions from the director of Sales.
In a recent meeting, the director told Greystock.
Your analysis assumes that we can sell the added output and thus
obtain the full efficiencies from the project, but as you know, the
market for polypropylene is extremely competitive. Right now, the
industry is in a downturn and it looks like an oversupply is in the
works. This means that we will probably have to shift capacity away
from Rotterdam toward Merseyside in order to move the added volume.
Is this really a gain for Diamond Chemicals? Why spend money just so
one plant can cannibalize another?
The vice president of Marketing was less skeptical. He said that
with lower costs at Merseyside, Diamond Chemicals might be able to
take business from the plants of competitors such as Saone-Poulet or
Vaysol. In the current severe recession, competitors would fight hard
to keep customers, but sooner or later, the market would revive, and
it would be reasonable to assume that any lost business volume would
return at that time.
Greystock had listened to both the director and vice president and
chose to reflect no charge for the loss of business at Rotterdam in hi
preliminary analysis of the Merseyside project. He told Morris.
Cannibalization really isn?t a cash flow; there is no check written in
this instance. Anyway, if the company starts burdening its
cost-reduction projects with fictitious charges like this, we?ll never
maintain our cost competitiveness. A cannibalization charge is
rubbish!
CONCERNS OF THE ASSISTANT PLANT MANAGER
Griffin Tewitt, the assistant plant manager and direct subordinate of
Morris, proposed an unusual modification to Greystock?s analysis
during a late-afternoon meeting with Greystock and Morris. Over the
past few months, Tewitt had been absorbed with the development of a
proposal to modernize a separate and independent part of the
Merseyside Works, the production line for ethylene-propylene-copolymer
rubber (EPC). This product, a variety of synthetic rubber, had been
pioneered by Diamond Chemicals in the early 1960s and was sold in bulk
to European tire manufacturers. Despite hopes that this
oxidation-resistant rubber would dominate the market in synthetics, in
fact, EPC remained a relatively small product in the European chemical
industry, Diamond, the largest supplier of EPC, produced the entire
volume at Merseyside, EPC had been only marginally profitable to
Diamond because of entry by competitors and the development of
competing synthetic-rubber compounds over the past five years.
Tewitt had proposed a renovation of the EPC production line for a
cost of &1 million. The renovation would give Diamond the lowest EPC
cost base in the world and improve cash flows by &25,000 ad infinitum.
Even so, at current prices and volumes, the net present value (NPV)
of this project was --&750,000. Tewitt and the EPC product manager
had argued strenuously to the executive committee of the company that
the negative NPV ignored strategic advantages from the project and
increases in volume and prices when the recession ended.
Nevertheless, the executive committee had rejected the project, mainly
on economic grounds.
In a hushed voice, Tewitt said to Morris and Greystock.
Why don?t you include the EPC project as part of the polypropylene
line renovations? The positive NPV of the poly renovations can easily
sustain the negative NPV of the EPC project. This is an extremely
important project to the company, a point that senior management
doesn?t seem to get. If we invest now, we?ll be ready to exploit the
market when the recession ends. If we don?t invest now, you can
expect that we will have to exit the business altogether in three
years. Do you look forward to more layoffs? Do you want to manage a
shrinking plant? Recall that our annual bonuses are pegged to the
size of this operation. Also remember that, in the last 20 years, no
one from corporate has monitored renovation projects once the
investment decision was made.
CONCERNS OF THE TREASURY STAFF
After a meeting on a different matter, Frank Greystock described his
dilemmas to Andrew Gowan, who worked as an analyst on Diamond
Chemicals? Treasury staff. Gowan scanned Greystock?s analysis, and
pointed out that
Cash flows and discount rate need to be consistent in their
assumptions about inflation. The 10 percent hurdle rate you?re using
is a nominal target of return. The Treasury staff thinks this
impounds a long-term inflation expectation of 3 percent per year.
Thus, Diamond Chemicals? real (i.e., zero-inflation) target rate of
return is 7 percent.
The conversation was interrupted before Greystock could gain a full
understanding of Gowan?s comment. For the time being, Greystock
decided to continue to use a discount rate of 10 percent, because it
was the figure promoted in the latest edition of Diamond Chemicals?
capital-budgeting manual.
EVALUATING CAPITAL-EXPENDITURE PROPOSALS AT
DIAMOND CHEMICALS
In submitting a project for senior-management approval, the
project-initiators had to identify it as belonging to one of four
possible categories: (1) new product or market, (2) product or market
extension, (3) engineering efficiency, or (4) safety or environment.
The first three categories of proposals were subject to a system of
four performance ?hurdles,? of which at least three had to be met for
the proposal to be considered. The Merseyside project would be in the
engineering efficiency category.
1. Impact on earnings per share. For engineering-efficiency projects,
the contribution to net income from contemplated projects had to be
positive. This criterion was calculated as the average annual EPS
contribution of the project over its entire economic life, using the
number of outstanding shares at the most recent fiscal year-end as the
basis for the calculation. (At FYE 2000, Diamond Chemicals had
92,891, 240 shares outstanding.)
2. Payback. This criterion was defined as the number of years
necessary for free cash flow of the project to amortize the initial
project outlay completely. For engineering-efficiency projects, the
maximum payback period was six years.
3. Discounted cash flow. DCF was defined as the present value of
future cash flows of the project (at the hurdle rate of 10 percent for
engineering-efficiency proposals), less the initial investment outlay.
This net present value of free cash flows had to be positive.
4. Internal rate of return. IRR was defined as being that discount
rate at which the present value of future free cash flows just equaled
the initial outlay?in other words, the rate at which the NPV was 0.
The IRR of engineering-efficiency projects had to be greater than 10
percent.
CONCLUSION
Morris wanted to review Greystock?s analysis in detail and settle the
questions surrounding the tank cars and potential loss of business
volume at Rotterdam. As Greystock?s analysis now stood, the
Merseyside project met all four investment criteria:
1. Average annual addition to EPS = &0.018
2. Payback period = 3.6 years
3. Net present value = &9.0 million
4. Internal rate of return = 25.9 percent
Morris was concerned that further tinkering might seriousley weaken
the attractivness of the project. |
