Case Study in Corporate Finance

Solution presented by Jatin Jain

The controller at Diamond Chemicals’ Merseyside Works wants a project consisting of a 9 mn pounds outlay to be passed that would achieve increased production capacity.

Though the project shows a highly positive NPV and meets all the investments criteria, there are some issues:i. The production line would have to be shut down for 45 days

during which customers would buy from competitors.ii. The project would require the parent company’s Transport

Division to invest 2 mn pounds which the controller refuses to add in her own project’s outlay.

iii. The marketing department is skeptical about sales figures due to the ongoing recession.

iv. The assistant plant manager wants the controller to include an EPC project as a part of the overall project.

v. A Treasury analyst says the discount rate used is incorrect. Additionally, the treatment of engineering costs is incorrect.

Issue: A Treasury analyst says the discount rate used is incorrect. Additionally, the treatment of engineering costs is incorrect.

The discount rate currently used in evaluating the project is 10%. However, it’s the nominal rate but the cash flows are real. Hence, the discount rate used should be adjusted for inflation, which is 3%.

Hence, the new discount rate used is 7%.

Preliminary engineering costs of 0.5 mn have been spend on the efficiency and design studies of the renovation and are thus a sunk cost.

Hence, these costs should not be included in the analysis.

Issue: The assistant plant manager wants the controller to include an EPC project as a part of the overall project.

The plant manager wants the EPC project to be included because of its potential strategic advantages.

This is a classic corporate malpractice wherein an unrelated project is obscured and pushed along an attractive one.

Anyways, the plant manager’s views need to be taken with a pinch of salt considering that the EPC market has contracted in the past few years due to new substitutes.

The project, thus, should not be undertaken. Rather, Merseyside Works should start planning to create new opportunities to prevent layoffs.

Issue: The production line would have to be shut down for 45 days during which customers would buy from competitors.

Though this is true, there is reason to believe that the customers will come back due to the cost efficiency of Diamond Chemicals as shown below:

Diamond Chemicals’ cost competitiveness will only increase after the completion of the project and it will thrive in the highly competitive market.

Plant Location Age Plant Annual Output Production Cost(metric tons) (indexed to low-

cost producer)CBTG A.G. Saarburn 1981 3,50,000 1Diamond Chem. Liverpool 1967 2,50,000 1.09Diamond Chem. Rotterdam 1967 2,50,000 1.09Hosche A.G. Hamburg 1977 3,00,000 1.02Montecassino Genoa 1961 1,20,000 1.11Saone-Poulet Marseille 1972 1,75,000 1.07Vaysol Antwerp 1976 2,20,000 1.06Next 10 largest plants 4,50,000 1.19

Issue: The marketing department is skeptical about sales figures due to the plant shutdown and the ongoing recession.

The concerns of the marketing department are well-established and need to be addressed.

Due to the shutdown for 45 days, there would be customer losses for some time as not all customers will be back soon and adjustment needs to be made for that. I have accounted for this loss to be the same as the expense due to lost output during the 45 days.

Regarding sales, it would be the task of the marketing department to drive the sales. We can be optimistic on that front as the market will revive even though the recession may persist for long.

Issue: The project would require the parent company’s Transport Division to invest 2 mn pounds which the controller refuses to add in her own project’s outlay.

The Transport Division’s concerns are also well-established and this outlay should be included in the total investment for the project, making it 11 mn pounds.

Original Assumptions Suggested Assumptions Annual Output (metric tons) 250000 Annual Output (metric tons) 250000Output gain/Original output 7% Output gain/Original output 7%Price/ton (pounds sterling) 541 Price/ton (pounds sterling) 541Inflation rate (prices and costs) 0% Inflation rate (prices and costs) 0%Gross margin (ex. Depr.) 12.50% Gross margin (ex. Depr.) 12.50%Old gross margin 11.50% Old gross margin 11.50%Tax rate 30% Tax rate 30%Investment outlay (in mn) 9 Investment outlay (in mn) 11

Discount rate 10% Discount rate 7%Depreciable life (yrs) 15 Depreciable life (yrs) 15Overhead/Invesment 3.50% Overhead/Invesment 3.50%Salvage value 0 Salvage value 0WIP inventory/COGS 3% WIP inventory/COGS 3%Months downtime, construction 1.5 Months downtime, construction 1.5After-tax scrap proceeds 0 After-tax scrap proceeds 0Loss due to construction(in mn) 0.76 Loss due to construction (in nm) 1.52Preliminary engineering costs 0.5 Preliminary engineering costs 0.5

Original FCF calculation Suggested FCF calculationYear FCF Year FCF

0 -9 0 -111 1.4 1 1.142 2.66 2 2.663 3.09 3 3.094 3.06 4 3.065 3.02 5 3.026 2.49 6 2.497 2.47 7 2.478 2.45 8 2.459 2.43 9 2.43

10 2.41 10 2.4111 1.68 11 1.6812 1.68 12 1.6813 1.68 13 1.6814 1.68 14 1.6815 1.68 15 1.68

NPV 8.99 NPV 10.07IRR 25.92% IRR 20.09%

Due to change in hurdle rate, NPV has gone up even though IRR has reduced

The project should be undertaken due to the following reasons:

It meets all investment criteria and adds to the shareholder value.

It is likely to introduce efficiency and result in the long run gain to the organization.

With the new technology the organization is likely to benefit from the returns to scale as well.