mond Chemicals Plc (A),e Merseyside Proj ect

Late one afternoon in January 2001, Frank Greystock told Lucy Morris, ..No one

seems satisfied with the analysis so far, but the suggested changes could kill the proj-

ect. If solid projects like this can't swim past the cofporate piranhas, the company

will never modernize."Morr iswasplantmanagerofDiamondChemicals 'MerseysideWorksinLiver-

pool,England.Hercontroller,FrankGreystock,wasdiscussingacapitalprojectthatMorris wanted to propose to senior management. The project consisted of a (British

pounds) f,9-million expenditure to renovate and rationalize the polypropylene pro-

iuction line at the Meiseyside plant in order to make up for deferred maintenance

and to exploit opportunities to achieve increased production efficiency'

Diamond chemicals was under pressure from investors to improve its finan-

cial performance because of both the worldwide economic slowdown and the accu-

mulation of the firm's common shares by a well-known corporate raider, Sir David

Benjamin. Earnings per share had fallen to f30.00 at the end of 2000 from around

[60:00 at the end of 1999. Morris thus believed that the time was ripe to obtain

funding from corporate headquarlers for a modernization program for the Merseyside

Workslat least she had believed so until Greystock presented her with several ques-

tions that had only recently surfaced'

Diamond Chemicals and Polypropylene

Diamond chemicals, a major competitor in the worldwide chemicals industry, was a

leading producer of polypiopylene, a polymer used in an extremely wide variety of

proOoJt, (ranging fro-^-"ii"ul products to packaging film' carpet fibers' and

rt.1-*u. prepared by Roberl F. Bmner as a basis for class discussion rather than to illustrate effective or in-

effective handling of an administrative situation. Diamond Chemicals is a lictional company reflecting the issues

facing actual {irms. The author wishes to acknowledge the helpful comments of Dr' Frank H' McTigue' the liter-

ary color ofAnthony Trollope, and the iinancial support of the citicorp Global Scholars Program' copyright @

2001 by tlr" uniuersity ofVirginia Darden School Foundation, Charlottesville, vA' A11 rights reserved' To order

copies, send an e-mtil to sati@dardenpublishing. com. No part of this publication may b-e reproduced' stored in

ctretrievalsystem,usedinaspreadsheet,ortransmitterlinanyformorbyanymeans-electronic,mechanical,pllotocopying,recording,orothenvise-withoutthepetmissionoftheDardenSchoolFoundation.

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Case 20 Diamond Chemicals plc (A): The Merseyside Project 281

benefits would be a lower energy requirementr as well as a 7 percent greater manu-

facturing throughput. In addition, the project was expected to improve gross margin

(before depreciation and energy savings) from 11.5 percent to 12.5 percent. The engi-

neering group at Merseyside was highly confident that the efficiencies would be reahzed'

Mirseyside currently produced 250,000 metric tons of polypropylene pellets a

year. Currently, the price of polypropylene averaged L54I per ton for Diamond

bhemicals' 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 basis2

ou"i15 years, the expected life of the assets. The increased throughput would neces-

sitate a one-time increase of work-in-process inventory equal in value to 3'0 percent

of cost of goods. Greystock included in the first year of his forecast preliminary engi-

neering coits of f500,000, which had been spent over the preceding nine months on

efficiency and design studies of the renovation. Finally, the corporate manual stipu-

lated 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'-

Greystockhadproducedthediscounted.cash-f low(DCF)SummarygiveninExhibit 2. It suggested that the capital program would easily hurdle Diamond Chem-

icals' required return of 10 percent for engineering projects'

Concerns of the Tiansport Division

Diamond Chemicals owned the tank cars with which Merseyside received propy-

lene 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

',Cr"y.*t "t ^racterized the energy savings as a percentage of sales and assumed that the savings would be

equai to 1.25 percent of sales in the first 5 years and 0.75 percent in years 6-1 0' Thereafter' without added

aggressive "gieen" spending, the energy efficiency of the plant would revert to its old level, and the savings

would be zero. He believed that the decision to make further environmentally oriented investments was a

separate choice (and one that should be made much later) and, therefore, that to include such beneiits (of a

presumably later investment decision) in the project being considered today would be inapproprlate'

2The company,s capital-sxpenditure manual suggested the use of double-declining-balance (DDB) deprecia-

tion, even though other more aggressive procedures might be permitted by the tax code The reason for this

policy was to discourage joct"ying for corporate approvals based on tax provisions that could apply differ-

ently fbr dift-erent prolects and div:isions. Prior to senior-management's approval, the controller's staff would

present an independent analysis of special tax effects that might apply. Division managers, however, were

iidcouraged from relying heavily on those effects. ln applying the DDB approach to a 15-year project, the

formula for accelerated depreciation was used for the first 10 years, after which depreciation was calculated

on a straight-line basis. This convelsion to straight line was commonly done so that the asset would depreci-

ate fully within its economic life.sThe corporate-policy manual stated that new projects should be able to sustain a reasonable proportion of

corporate overhead expense. Projects that were so marginal as to be unable to Sustain those expenses and

also meet the Other criteria of investment attractiveness shouid not be undertaken' Thus, all new capital proj-

ects should reflect an annual pretax charge amounting to 3.5 percent of the value of the initial asset invest-

ment for the ProJect.

r. Polypropylene

rith propylene, afour reflneries inoline. In the first15 combined withn. the polypropy-d in a centrifuge.iic polypropylened attributes for ar shipment to the

best, and, there-\ferseyside plant

nd in Rotterdam,The managers ofI manager of thee company posi-

Lit. The strategic-:ers. seven majori' market region.a comparison of

; 12 months pre-gineer nine Yearsbd review of theellt in polYProPY-deferral of main-operating results

tures to only thecable was becom-antiquated Plant

flow: (1) relocat-nble the process,to achieve highermpounding plant

r- The entire PolY-r- and because ther: would buy fromr permanent. The

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Case 20 Diamond Chemicals plc (A): The Merseyside Projecl

increase its alloca-m could make thiserate from 2005 toicipated growth ofolling stock wouldFe. the cars couldde Britain because

suu_eested that theleneyside's capital

of s hat we're doingcess capacity. Evenrt Division's books.th the philosophy ofhe Transport Divi-ld carry the alloca-

E of excess rolling

ported to separatex(ecutive officer ofnus pegged to the

f,rt

. In a recent meet-

r the full efficienciescmelv competitive.r is in the works.tsrdam towardDamond Chemi-

I rr-ith lower costsfrom the plants ofB recession, com-lhe market would

teieht vears and

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 the vice president' and chose to

reflect nt charge for a loss of business at Rotterdam in his 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,ifthecompanystafisburdeningitscost-reductionprojectswithfictit iouscharges 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 Morris's direct subordinate, proposed

an unusual modification to Greystock's analysis during a late-afternoon meeting with

Greystock and Morris. Over thl past few months, Tewitt had been absorbed with the

d"velopment of a proposal to modernize a separate and independent part of the

Merseyside works, thl 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 syn-

thetics, 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 beenlnly marginally profitable to Diamond because of the

"nt.y by competitofs and the development of competing synthetic-rubber compounds

over the Past five Years.Tewit thadproposedarenovat ionoftheEPCproduct ionl ineatacostof f l

million. The renovation would give Diamond the lowest EPC cost base in the world

andwouldimprovecashf lowsbyf25,000adinf in i tum.EvenSo,atcurrentpr icesand volumes, the net presenr value (Npv) of this project was -f,750,000. Tewitt

and the EPC product manager had argued stfenuously to the company's executive

committee that the negative*NPV ignoied strategic advantages from the project and

increases in volume a=nd prices when the recession ended' Nevertheless' the exec-

utive committee had .e;"ct"d the project, basing its rejection mainly on economic

grounds.In a hushed voice, Tewitt said to Morris and Greystock:

Whydon,tyouincludetheEPCprojectaspartofthepolypropylenelinerenovations?Thepositive NPV of the poly renovations can easily sustain the negative NPV of the EPC proj-

'ect .This isanextremelyimportantproject tothecompany,apoint thatseniormanagement

doesn't seem to get. If we invest now, we'll be ready to exploit the market when the reces-

sion ends. If we don't invest now, you can expect that we will have to exit the business alto-

getherinthreeyears.Doyoulookforwardtomorelayoffs?Doyouwanttomanageashrinkingplant.iRecallthatourannualbonusesarepeggedtothesizeofthisoperation.Also remember that, in the last 20 years, no one from colporate has monitored renovation

projects once the investment decision was made'

|a:JM AseC :OCJnOS

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Case 20 Diamond Chemicals plc (A): The Merseyside Proiect 285

. ^ l l fnt t r investment

-roiect met al t ruur , '

Greystock's analysis now stood' the Merseyside

criteria:

1. Average annual addition to EPS = f0'018

2. PaYbackPeriod : l '(Years

;. N"t Pre'"nt value : f9'0 million";.

Internal rate of return : 25'9 percent

Morris was concerned that further tinkering

tiveness of the Project'

might seriouslYweaken the attrac-

:r : Tnr., . '

i ; : ' .Jerstu:-

6111r.113 l1r ' i : :

l " :est edi t i " ' -

hemicals

-ritrator-s h;;

r, . .J ' iat or mar-

.." iatv or enrl-

"- . . :m of fou:

:,opotal to t'-

..a,-\ categor\ '

r:.e ;ontribu-

1. cl i ter ion

J-.:r.liion of the

:-: .hares at the

i rvs,zooo.

*n ioL free cash

F,-.r engrneenng-

i:-^re cash flows

:::rrcr. proposals t

Ls:, dows had to

L: :t u hich the

:.rr. .-in other

::, r-etficiencY

:re questions sur-

r rI Rotterdam' As

,tar",' ' , "o*Ou'ut'u"'n'o'*u''on on'n" ="u"n'u'n""':''Uq':O''"n"

t'untt;':jl:tjofr

Pl6ot

"tttt (indexed to low-

Builr A.""Tl-9:Tj' '"ost produce0Plant

- -.ln (metric tons)

Location " ' - : : ^:^ 1 '00

350,000 1.09

CBTG A.G. Liverpoot l:: l 250,000 1.02

saone'Poutet s.n ffi!,if 1e76 o-u6,oooVavsol S'A'

t'.text lO largesi Planis

I*r.", cut" writer's analysis

1 981

oiamono cnem' ;;;iil;. t2':" ioo.ooo 1.11Diamond Chem Hamnurs l: l l

120,000 1.07

i,?,?'i!*.?""'^ $""15,* :V 11:.333 i?3

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