Diamond Chemicals PLC (A): The Merseyside Project Harvard Case Solution & Analysis

Introduction

            The investors of Diamond Chemicals were pressurizing the company to improve the performance of the company. Therefore, in order to boost the profits as well as the performance of the company, Frank Greystock analyzed a project of capital investment at Merseyside works in England. The initial investment for this project was 9 million pounds and Frank Greystock had performed the DCF analysis for this project. However, no one seemed to be satisfied with the analysis of the project.

The purpose of this project was to create opportunities related to increased production efficiencies by exploiting the deferred maintenance by making up for it. Furthermore, it had also been proposed by him that this project is going to improve the production output of Diamond Chemicals Merseyside factory. However, different issues have been raised by the members of different departments such as issues related to discount rates, marketing cannibalization and capital expenditures. Therefore, it needs to be evaluated and decided that whether diamond chemicals should go ahead with this project or not after incorporating all the assumptions.

Problem Diagnosis

            This case provides us with a go or not to go decision situation and a decision needs to be made based upon the net present value, internal rate of return, the payback period and the average earnings per share for the Mersey side project. The objective of this case is to identify all the relevant cash flows associated with this project and address all the concerns of the people of all the departments of the company.

Overall, based on the fact that the output is going to increase by 7% and the gross margin of the company would also increase by 1% at a level of 12.5%. Based on this, the requirements for energy usage would also be low. However, there were many concerns that need to be addresses. First of all, the transport division would be making the allocation for this project out of excess capacity.

However, in order to do this new rolling stock will have to be purchased to fuel the growth. Furthermore, the director of sales argues that this industry is facing economic downturn and this would result in oversupply of the production and as a result the management will have to shift the capacity from the Rotterdam site to Merseyside. This is not a positive factor however, the marketing vice president believes that the demand would increase once the market revives.

Moreover, the assistant plant manager of the company suggests including the EPC project as part of the Merseyside project so that the negative net present value of EPC could be sustained. If this is not incorporated then the EPC project is going to exit in three years’ time. Lastly, the treasury staff believes that the hurdle rate for the calculation is a nominal inflation adjusted hurdle rate and the real discount rate to be used should be 7%.

Analysis

            The discounted cash flow calculations had been drafted by Morris and the calculations could be seen in exhibit 2 of the excel spreadsheet. However, the net present value calculations and all the other metric calculations does not seem to be correct because most of the concerns have not been addressed therefore, a new discounted cash flow analysis has been performed in the excel spreadsheet for the Merseyside project. The concerns of the transport division, the ICG sales and marketing department, assistant plant manager and the treasury staff dew other issues have been addressed as follows.

Addressing Concerns of Transport Division

            The transport division will have to increase its allocation of the tank cars for the Merseyside project. A new car will have to be purchased by the transport division two years earlier than the original year planned, which would be from 2003 to 2005. The purchase of the tank cars is accelerated therefore, the depreciation shift will also have to be calculated and it would be applied to an earlier date.

Therefore, the depreciation for these new cars has also been incorporated in the discounted cash flow analysis. This is also linked to a new project therefore, the cost of 2 million pound will be paid in 2003 and it would be recovered in 2005. The same would be done with the depreciation as depreciation is a non-cash expense.................

Case Analysis

Diamond Chemicals PLC (or DCL) is a successful firm, which has its core strength in commercial law. It is an example of a case study analysis. A case study analysis is the examination of a business case to gain insights into its strengths and weaknesses.

The inability to find contract specialists that meet their requirements is a major impediment to success. The Merseyside Project is a case study analysis that provides a solution to this problem.

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The Merseyside Project Valuation

Let us define intrinsic value, the amount of intrinsic value and valuation. Intrinsic value is the value of the asset or any other valuable thing that does not change even if there is a change in the price of the asset. Therefore, it is the value of the investment.

Once you know the intrinsic value of a particular asset, then you can calculate the value of the same asset at different times. However, it is not a bad idea to have a valuation of a company at regular intervals. Valuation provides you with the money value of an asset which was paid in full in one period and has been reduced by a certain amount in another period. This calculation assumes that the discounted future value of an asset will decrease to a fixed amount, thus, providing a fixed return for the asset at the moment when it is to be sold.

It can be observed that the potentials of assets are constantly changing due to constant changes in economic conditions. Therefore, before considering a valuation of an asset, a company needs to identify the possible movements in the market price of the asset. Any reduction in the value of an asset should be considered before calculating the valuation of an asset.

A Diamond Chemicals PLC valuation is done using certain concepts and tools to determine the values of an asset. These concepts include:

The cost of capital is a crucial part of the valuation. Basically, the valuation has a fixed cost which will represent the costs of the asset and its future costs. Cost of capital is the cost of all the fixed assets before they are purchased and the capital cost of each asset after the transaction is complete.

The cost of sales is a sum of the costs of purchasing and selling a particular asset. The gross profit or net profit, if the sale is above the cost of capital, is the cost of capital and thus, the gross profit or the gross sales of the asset is calculated.

Finally, the appraisal of the assets is an important tool in determining prospective prices for each asset. These appraisals should be done for all the assets owned by the company for the purpose of valuation.

The appraisal of an asset is the average amount a buyer will pay for the asset, taking into account the value of all the assets owned by the company at the time of the appraisal. The appraisals are based on the following formulas: current market value of an asset, intrinsic value of the asset, average cost of capital and most important, the pricing patterns in the market.

A valuation of a company is the amount a buyer will pay for an asset when purchasing all the assets owned by the company at the time of the valuation. The final amount would be calculated by the following formula: a - b + c where a is the weighted average cost of capital, b is the percentage of the total assets owned by the company and it is the percentage of the total assets sold during the period. The percentages can be changed to meet the market value.

In Diamond Chemicals PLC valuation, the price for all the assets being bought and sold is determined based on the formula mentioned above. A Discounted Cash Flow model is used by a team of financial analysts to help determine the amount of cash flow expected for a particular asset.

The final DCF is used to determine the discounted cash flows expected from one asset to another. Diamond Chemicals PLC valuation then makes use of information provided by the analysts in calculating the value of an asset.

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