Post on 18-Dec-2014
description
Diamond Chemicals
Team #7: APEX
Members:Christina FisherJason SchollJohn Silmon Josh KingJeff McGinnJeff Mochal
2
Case introduction
Main Characters:
Lucy Morris: Plant Manager, Merseyside; high achiever; Notre Dame MBA
Frank Greystock: Controller; President, Diamond Chemicals WAG club
Plot Summary:
Major competitor in worldwide chemicals industry & a leading producer of polypropylene
Morris is recommending a £9 million project;
– Renovate and rationalize a production line at Merseyside
– To make up for deferred maintenance and increase production efficiency
Several objections to the project have been raised at corporate, and the initial analysis from Greystock contains errors that need to be fixed
3
Initial Greystock Analysis
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
£12.7
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Key Variables Assumption
Annual Output (metric tons) 250,000
Output Improvement 7%
Discount Rate 10%
Inflation Rate 0%
GM% Improvement +100 bps (from 11.5% 12.5%)
Overhead Investment 3.5%/per year
Prelim Engineering Cost £0.5M
Transportation Investment £0.0M
Lost Sales Impact £18.1M
NPV
IRR 25.9%
What changes should Lucy Morris ask Frank Greystock to make in his DCF analysis? What is the justification for each of these changes?
4
Recommended adjustments
Cash flow and discount rate consistency
Annual pretax charge for overhead
Engineering sunk costs
Transportation investment
Lost sales impact
5
Recommendation #1
Cash flow and discount rate consistency
As Gowen points out – cash flows and discount rate need to be consistent in their assumptions about inflation
10% initial rate proposed by Greystock is a nominal rate – real rate is 7%, Inflation rate is 3%
Two options: Keep the discount rate at 10% and include a 3% inflation rate in cash flows; OR keep cash flows the same (with no inflation factor) and change discount rate to 7%
Recommendation: Change discount rate to 7%
6
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
£12.7
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Change to NPV
7
Recommendation #2
Annual pretax charge for overhead
Corporate manual states overhead costs be reflected at 3.5% rate
This project is expected to reduce overhead costs and should not be required to charge an annual pretax
Recommendation – Remove 3.5% pretax
8
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
£12.7
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Change to NPV
9
Recommendation #3
Engineering sunk costs
£0.5M sunk cost for renovation efficiency is included in the analysis
Sunk costs are retrospective costs that have already been spent and cannot be recovered, according to the with-without principle, not relevant to present decisions
Only prospective (or future) costs are relevant to an investment decision
Recommendation – Remove £0.5M sunk cost
10
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
£12.7
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Change to NPV
11
Recommendation #4
Transportation investment
£2M cost for purchasing new rolling stock to support anticipated future growth was not included in the DCF analysis
Cost should be considered a cash outflow and expense
The tanker cars are necessary to accommodate the increased throughput that is associated with this project
Transport Division and Merseyside – *One Company*
Recommendation – Include £2M transportation investment and the 10 year depreciation
12
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
£12.7
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Change to NPV
13
Recommendation #5
Lost sales impact
Greystock’s DCF Analysis concludes that all customers will return within one year
Conservative approach concludes not all customers will return so quickly and this will impact sales and should be included in the analysis
– Potential factors include the overall state of the economy and improving competitor efficiencies
Reduces both the NPV and IRR but the project remains attractive
Recommendation – Include customer losses
14
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Change to NPV
£12.7
15
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
Greystock’s Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Summary of adjustments to NPV
£12.7
16
Recommended Changes
£9.0
£3.3
£2.0£0.3
(£1.2)(£0.7)
£12.7
Greystock's Initial DCF Analysis
Cash flow & Discount Rate
consistency
Annual pretax charge for overhead
Engineering Sunk costs
Transportation Investment
Customer Impact in Year 2
Recommended NPV
Conclusion
Key Variables Initial Assumption Changes
Annual Output (metric tons) 250,000 250,000
Output Improvement 7% 7%
Discount Rate 10% 7%
Inflation Rate 0% 0%
GM% Improvement 8.7% 8.7%
Overhead Investment 3.5%/per year 0%
Prelim Engineering Cost £0.5M £0.0M
Transportation Investment £0.0M £2.0M
Lost Sales Impact £18.1M (£27.1M)
IRR 25.3%