Diamond Chemicals Harvard Case Solution & Analysis

Introduction

Diamond Chemicals, which operates in manufacturing and selling of the polypropylene is considering investing up to GBP 1 Million in the renovation of its old plant in order to improve its efficiency so that profitability can be increased and thus, the value of the shareholder can also be increased. For this purpose, the detailed calculations have been performed using Net Present Value and Internal Rate of Return. Net present value or NPV is the sum of all projected cash flows and discounted in order to estimate the current value of the project. Internal rate of return is the discount rate at which NPV is zero, it can be interpreted that the highest IRR of the project could be considered good for the decision making but for the superior decision making, NPV will be used.

Analysis and Recommendations

There are certain amendments that should be made in the NPV analysis, such as changes in transport division cash flows are relevant and should be account fall in the calculation. GBP 2 million is the cost that is estimated to be incurred in the new rolling stock that support anticipated future growth that is not incorporated into the original estimation. It can be further analyzed that GBP 2 million will be considered as the cash outlay. There is a need of tank cars to accommodate the increased throughput that is associated with this project and ignoring such assumption is not relevant.

Other relevant assumption is the impact of lost sales. For the renovation it is estimated that the factory will be closed for 45 days and in the year, around 25000 tonnes are being sold while the average cost of per tonne is GBP 541. In the financial analysis conducted by Greystocks’s, it is assumed that all customers will be returned to the customer within a period of one year which is thought to be aggressive approach of estimating. If a more conservative approach is taken, then not all customers will return quickly, therefore, this will likely affect sales and should be incorporated into sales. There are other subjective assumptions, such as increased competition and state of the economy as well. Lost sales will result in a reduction of NPV and IRR.

GBP 0.5 Million can be identified as sunk cost that is included in the calculation. Sunk cost is not a relevant cost and should be excluded from the calculation. Sunk cost is also known as past cost that is not prospective or future cash flow.

Corporate manual state overhead costs are reflected at a 3.5 % rate. This renovation project is expected to reduce the overhead cost and should not charge an annual pre tax so it can be suggested that 3.5% should be removed from the NPV analysis.

Use of discount factor also matters as if cash flows are nominal then a discount factor should also be used as a nominal discount factor. On the other hand, if cash flows are in real terms then a discount factor should also be used in real terms. Both of the cash flows and discount factor should be consistent so that estimation of cash flows should be accurate. 10% discount rate which is proposed is the nominal discount rate while cash flows are in real terms so real discount rate which is 7% should be used in the calculations. There is a difference between nominal and real discount rate as the real discount rate does not include inflation, while the nominal discount rate includes the inflation.

Diamond Chemicals Case Solution

Summary or recommendation can be an annual output assumption which should be evaluated. The discount rate should be changed from 10% to 7%, and overhead investment rates should be reduced from 3.5% to zero.Perlim engineering cost which is sunk cost should be removed from the calculations. Lost sales impact should be increased from 1.5 to 1.52.

Conclusion

It can be concluded that by changing each assumption, there will be significant impact of the NPV and IRR. By taking into account assumptions as discussed above will increase from GBP 9 Million to GBP 13.05 Million. On the other hand, IRR has reduced from 25.9% to 24%. As NPV is increased, the project looks more lucrative and attractive if decided between NPV and IRR then NPV is more superior for decision making purpose. At IRR, it is assumed that the amount is reinvested at the rate of IRR. .................

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