Introduction
The goal of this report is to analyze and evaluate the capital budgeting decision of Ms. Morris and suggestion to the senior management of Diamond Chemicals PLC if sufficient capital should be allocated for the proposed £12 million expenditure to modernize and rationalize the polypropylene production line at the Merseyside Plant. The project has been proposed to improve the product output of Diamond Chemicals’ Merseyside factory. However, recently, different departments have mentioned problems such as capital expenditure, marketing cannibalization, discount rate etc. Diamond Chemicals needs to take all these suggestions into consideration. Based on that they have to decide if they should carry out this project or not. Assumptions:
Preliminary engineering costs:
We have decided not to include this figure because we assume that its cost has already been paid out. Therefore its investment will not be necessary and if the project does not go through that money will not be reusable.
Treasury staff:
The treasury staff is partly wrong. He says we should use a discount rate of 7%. This would be true if the discount rate was the real interest rate, however for the discounting we are supposed to use the normal rate. Since we have to add 3% inflation rate in our model. Our discount rate becomes: Nominal = Real + inflation Nominal discount rate = 7%+3% = 10%
So our discount rate stays at 10% and our inflation rate goes to 3%.
Plant assistant manager:
We should add £1M to the initial cost of the project as well as an additional 25,000£ in every cash flow starting from the first year. This project seems to be important on the long term but the impacts on the short term must be studied in order to identify if this project is interesting on the short/medium term.
Sales manager:
If we suppose maximum cannibalization, this will represent the fact that the company won’t be able to sell the extra production. Therefore we subtract the extra amount of production as the maximum cannibalization. This would be the worst-case scenario.
Transportation:
We would have to advance the purchase of trucks from 2012 to 2010. This is linked to another project therefore the 2million will be paid in 2010 and subtracted back in 2012, this also has to be done with the depreciation.
Evaluation Capital Expenditure
Before submitting a project for approval, the leader of the project must determine what category the project falls in. There are four possibilities which are: (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. After determine of the project, Diamond Chemicals evaluate the capital-expenditure proposals by following factors Impact on earnings per share – For an engineering-efficiency project, the contribution to net income from contemplated projects had t e positive This criterion was calculated as the average annual earnings per share (EPS) contribution of the project over its entire economic life, using the number of outstanding shares at the most recent fiscal year-end (FYE) as the basis for the calculation.
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. Maximum payback period is 6 years. Discounted cash flow – it is the net present value of future cash flow of the project, and the net present value of the cash flow has to be positive. Internal rate of return – it is the discount rate at which the PV of future cash flow just equal to the initial payment. IRR of the proposal is required to over 10%.
Due to capital-expenditure proposal need to invest large amount of money and long period of time for the benefit to show out. Even capital-expenditure can provide lots of benefit to the company, but it will also lead to a great loss to the company if there is a miss forecasting of the proposal. To avoid unnecessary risk of causing the failure of the proposal, company will evaluate the capital-expenditure proposal with a complicated scheme to ensure the risk is reduce to the lowest level.
Changes in DCF
Transport Division
It is a good idea to purchase trucks. Greystock disagree with that cause by his misunderstanding. When we try to reflect this in to the discount cash flow, it has an obliviously decrease in payback period. And the NPV, IRR have an increasing too. It must be benefit for our project.
Director of Sales
Our target wants to maximize the profit of the company. We should find a way to sell out all the products. It is sad to us if we must cut the extra production. According to our testing, maximum cannibalization will make the NPV, IRR and EPS decrease nearly half of current expectation. We don’t want to see that.
Assistant plant manager
We agree it may be a good choice in the long term (more than 20 years). But, we are doing the 15 years forecasting now. And it will be more difficult to predict the longer future. Therefore, we can’t see the benefits of your suggestion. However, we will put this as our backup choice.
Analyst from the treasury staff
Andrew Gowan has done a good job. It is important to calculate the long term inflation expectation of 3 percent per year. Greystock’s calculation mix nominal and real rates because of his misunderstanding. Now we would like to use a real rate of return is 7%. (Calculate by discount rate of 10% and inflation rate of 3%).
Assessment of the project
The Merseyside project is quite attractive. The basic project itself satisfies all the 4 criteria (NPV, IRR, Payback period and EPS).First of all, according to our calculation; it has a positive NPV of 11.096. Then the Internal rate of return is 25%, which is much higher than the required 10%.Besides, the payback period is 3.69 years which is within 7 years as the requirement. Furthermore, the average annual addition to EPS is 0.024 pound. When we take other projects into consideration with the basic project (the treasury staff’s project, the transport division project, the sales manager’s project and the assistant plant manager’s project), different stories come out (see appendix 2).
Although these statistics vary a lot, even the worst situation, that is, after add all the three extra projects to the basic project, the mixed one will still satisfy there of the four criteria (Only the payback period is longer than required). Therefore, we think that Morris should continue to promote the project for funding and the optimal situation is to conduct the basic project plus the transport division project, for this provides the best result for the film.
