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
- new product or market,
- product or market extension,
- engineering efficiency,
- 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. % 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.
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 the years of 2001 and 2002 hurt the FCF for the two years. I decreased the two numbers by 10%. From the years 2002-2015 I decreased sale by 5%.
I calculated the different numbers and took off 5% for the remaining years FCF. Even with the 10% and 5% decrease from the loss sales and increased inventory, the numbers still looked pretty attractive for this project. If you were too look on Greystock’s DCF analysis I would like to point out where I made my changes. In the new sales row, starting with the number 126. 63 and 144. 72, I took away 10%. For the remaining years, 144. 72 in year 3 all the way to year 15, I took away 5%. Next I will like to address some of the concerns that the Transport Division, Director of Sales, Assistant Plant Manager, and the Treasury Staff had.
As I mentioned above, the NPV and IRR both met requirements by NPV being positive and IRR being above 10%. Along with those two, the projects payback period and average annual addition to EPS met their requirements. The payback period was 3. 6 years and the addition to EPS was a positive number. Remember that with this project the investment is only tied up for less than 4 years. The money put out will be returned and can be used to perhaps front another project. The NPV and IRR are very attractive numbers to this project.
I hope that by providing this information that you can see that you should continue to promote the project for funding. TO: James Fawn FROM: DATE: September 30, 2009 SUBJECT: Recommendation of Projects As you already know, Diamond Chemicals is in a debate over which project the company will choose to fund. The two projects are the Merseyside Project and the Rotterdam Projects. Memos have been sent back and forth with information regarding each project and both projects sound very interesting. Being that the company is stuck between these projects shows that they are mutually exclusive projects.
That means that the company can only choose one of these projects. The costs of trying to fund the two would be unbearable for the company to sustain. It is my hope to provide you with some more information and try to make this decision a little less strenuous. Following a brief analysis of the two projects I will make a recommendation on which project is best for the company. Diamond Chemical’s corporate policy is to evaluate projects on four sets of criteria. The four are a positive NPV, IRR above 10%, payback period under 6 years, and positive growth in earnings per share.
In both projects, they have a positive NPV. The only difference between the two projects NPV’s is that Rotterdam Project’s NPV is a little bit higher. Both projects have an IRR over 10%, but Merseyside’s IRR is 8% higher. This could be a leading decision maker because the higher the IRR the more desirable it is to undertake that project. A higher IRR leads to stronger growth potential. Nowhere in Rotterdam’s proposal did they mention a payback period or a positive growth in earnings per share. The payback period might not be set because they seem to be confused on the amount needed.
They state 8 million over three years but later in the case it says the pipeline could cost up to 6 million dollars. That’s a lot more then Eustace expected. With Merseyside the 9 million dollar expenditure would be paid back in 3. 6 years. With the investment being paid back in 3. 6 years it will not tie up any money. The company will know when it is to be returned and they will be capable of potentially reinvesting that money. Also Rotterdam is experimenting with a new technology, the costs of that and the effectiveness of the system might account for the differences in rankings.
I believe the company should stay focused on the corporate policy and follow projects that adhere to their criteria. Next I would like to talk about the managerial flexibility associated with the Merseyside Projects. With the Rotterdam Projects they are taking the new technology and adapting it right into the business. It is brand new technology and they believe it could cut cost and improve output. The only thing with that is, the system is brand new and has the chance of being unsuccessful. It might give them a head start in reducing costs but it is not a guarantee.
Merseyside Project shows great managerial flexibility and yes it can be quantified. It states in the case that although they are not firmly committed to the idea of the new technology right now, they retain the flexibility to allow the technology in the future. By seeing that it shows that they want to do the “wait and see” approach before they implement the new technology. In this case you, Mr. Fawn, stated that even if you were to implement the Merseyside Project today, that you could always install the technology later at Merseyside. Even Merseyside’s management is very flexible with the idea of installing the technology later.
Management wants to wait and see which I believe would also be a better approach. I also believe there are great differences between the way both Elizabeth Eustace and Lucy Morris have advocated their projects. First off, Lucy Morris’ project adheres to corporate policy regarding the 4 criterion on investments. Secondly, I believe Morris’s project is more constructed and gives an accurate understanding of what is needed and how much. With her given a 3. 6 year pack back date, the company is able to plan future investments knowing that in 3. 6 years they will have that money back.
Compared to Eustace, Morris shows exactly where the money is going and how much is needed. There is not any confusion like Eustace has with the pipeline. She states that the pipeline would cost 3. 5 million and that is including in her 8 million dollar estimate. A consultant told her that to lay a comparable pipeline would cost approximately 6 million. Her proposal also seems to rely on some land speculation and the chairman of the executive committee stated that the business is chemicals not land speculation. Also a major difference in the two advocating their projects was the idea of new technology.
Eustace wanted it now, whereas Morris wanted to wait and see how the technology worked before it was installed. Eustace believed that the new technology would give them a head start in cutting costs and increasing output. Even though it might lead to that, there is always a chance of failure. That is why I believe the wait and see approach is better. One of Morris’s greatest points was that the technology could be added in the future and was not as necessary to have right now. The last point I wanted to make about the two projects was that the Rotterdam Project involves too much risk.
In the case it stated that the equipment would be very expensive to dismantle. Her project is an irrevocable commitment and that there would be no going back once the new controls were installed. I believe that this will be the leading factor in the decision process. The company does not know when they will be receiving their investment back and also if in fact that the project will work. There is too much risk behind the Rotterdam Project and especially with the recession that the economy is in, any screw up can cause severe damage to the company.
After reviewing both proposals I believe that you should choose the Merseyside Project to propose to the CEO and the Board of Directors. My reasoning behind this decision came from several factors. These factors include the Risk, the IRR, and the payback period.
The Rotterdam Project involved a lot of risk that could potentially damage the company tremendously. It would be a great cost to implement the new technology and the pipelines. It states in the case that it is very expensive to dismantle. That means that once the decision has been made to install the controls there is no turning back. I feel that Merseyside Project is flexible around the idea of the new technology but they feel that it is not the right time. It’s a huge risk and I feel the Merseyside Project is a better fit.
The internal rate of return was also another deciding factor to me. A higher internal rate of return in a project leads to a higher potential growth rate. Merseyside’s Internal Rate of Return was a 25. 9 % while Rotterdam’s was at 17. 9. There is an 8% percent difference between the two projects IRR.
In the Merseyside Project proposal they give a set date of the return of the investment. It is said to be paid back in 3. 6 years. In the Rotterdam’s proposal I was unable to find a payback date. This could be a deciding factor because if the company does not know when they will receive the money back they can become very tied up from other investments. Since the company knows that in less than 4 years they can receive the investment back from the Merseyside Project, it gives them the ability to be able to propose new plans or invest in another future project. These were only a few of the reasons why I selected the Merseyside Project and I hope my thoughts and information will help you reach your final decision.
