mond Chemicals
(A),
MerseysideProj
..No one Morris, Lucy told Greystock Frank 2001, in January Late one afternoon could kill the projseemssatisfied with the analysis so far, but the suggestedchanges piranhas, the company ect. If solid projects like this can't swim past the cofporate will never modernize." MorriswasplantmanagerofDiamondChemicals'MerseysideWorksinLiverpool,England.Hercontroller,FrankGreystock,wasdiscussingacapitalprojectthat of (British Morris wanted to propose to senior management.The project consisted polypropylene propounds) f,9-million expenditure to renovate and rationalize the deferred maintenance iuction line at the Meiseyside plant in order to make up for and to exploit opportunities to achieve ncreased production efficiency' it finanDiamond chemicals wa under pressure ro investors to improve an th accucial performance becauseof both th worldwide economic slowdown aider, Si David mulation of the firm's common sharesby well-known corporate 2000 from around Benjamin. Earnings per share ha fallen to f30.00 at th en of wa ripe to obtain [60:00 at th en of 1999. Morris thus believed that th time for the Merseyside funding from corporate headquarlers or a modernization program with several quesWorkslat least she had believed so until Greystock presentedher tions that ha only recently surfaced'
Diamond Chemicals and Polypropylene industry, was Diamond chemicals, major competitor in the worldwide chemicals wide variety of leading producer of polypiopylene, polymer used in an extremely products to packaging film' carpet fibers' an proOoJt, (ranging fro-^-"ii"ul
rather than to illustrate effective or infor class prepared by Roberl F. Bmner as rt.1-*u. is a lictional company reflecting the issues effective handling of an administrative situation. Diamond Chemicals of Dr' Frank H' McTigue' the literfacing actual {irms. The author wishes to acknowledge the helpful comments Global Scholars Program' copyright ary color ofAnthony Trollope, and the iinancial support of the citicorp A' A11 ights reserved'To order 2001by 2001 by tlr" uniuersity ofVirginia Darden School Foundation,Charlottesville, publication may b-e eproduced'stored sendan e-mtil to
[email protected] part of this copies,sendan ctretrievalsystem,usedinaspreadsheet,ortransmitterlinanyformorbyanymeans-electronic,mechanical, pllotocopying,recording,orothenvise-withoutthepetmissionoftheDardenSchoolFoundation.
Case 20
Diamond Chemicals plc (A): The Merseyside Project
281
manubenefits would be lower energy requirementr as well as a 7 percent greater margin facturing throughput. In addition, the project was expected to improve gross (before depreciation and energy savings) rom 11.5 percent to 12.5 percent.The engineering group at Merseyside was highly confident that the efficiencies would be reahzed' Mirseyside currently produced 250,000 metric tons of polypropylene pellets a year. Currently, th price of polypropylene averaged L54I pe to fo Diamond wa bhemicals' product mix. Th ta rate required in capital-expenditure nalyses been 30 percent. Greystock discovered that any plant facilities to be replaced had basis2 completely depreciated.Ne assetscould be depreciatedon an accelerated necesou"i15 years, he expected if of the assets. he increased hroughput would percent sitate one-time ncreaseof work-in-process nventory equal n value to 3'0 engiof cost of goods.Greystock ncluded n the first year of hi forecastpreliminary on neering coits of f500,000, which ha been spent over th precedingnine months stipuefficiency an design studies of th renovation. Finally, th corporate manual percent lated that overhead costs be reflected in project analyses at the rate of 3'5 times th book value of assetsacquired th project pe year'Greystockhadproducedthediscounted.cash-flow(DCF)Summarygivenin ChemExhibit 2. It suggested hat the capital program would easily hurdle Diamond icals' required return of 10 percent for engineering projects'
Concerns of th
Tiansport Division
propyDiamond Chemicals owned th tank cars with which Merseyside received a cost lene gas from four petroleum refineries England. Th Transport Division, center, oversaw th movement of al raw, intermediate, an finished materials Because throughout th company an wa responsible or managing th tank cars' be the energy savings as percentageof salesand assumed hat the savings would ',Cr"y.*t "t ^racterized Thereafter' without added equai to 1.25 percent of sales the first years and 0.75 percent years 6-1 0' old level, and the savings aggressive gieen" spending, he energy efficiency of the plant would revert to its investmentswas a would be zero. He believed that the decision to make further environmentally oriented to include such beneiits (of separate hoice (and one that should be made much later) and, therefore, that be inapproprlate' presumably later investment decision) in the project being considered oday would 2The company,s capital-sxpenditure manual suggested he use of double-declining-balance (DDB) depreciacode The reason or this tion, even though other more aggressiveproceduresmight be permitted by the tax that could apply differpolicy was to discourage oct"ying for corporate approvals basedon tax provisions the controller's staff would ently fbr dift-erentprolects and div:isions.Prior to senior-management'sapproval, however, were presentan independentanalysis of special ax effects that might apply. Division managers, DDB approach o a 15-year project, the iidcouraged from relying heavily on those effects. ln applying depreciation was calculated formula for accelerateddepreciation was used for the first 10 years, after which that the assetwould deprecion a straight-line basis. This convelsion to straight line was commonly done so ate fully within its economic life. sThe corporate-policy manual stated hat new projects should be able to sustain reasonableproportion of hose expensesand corporate overhead expense.Projects that were so marginal as to be unable to Sustain Thus, all new capital projalso meet the Othercriteria of investment attractivenessshouid not be undertaken' of the initial asset nvestects should reflect an annual pretax chargeamounting to 3.5 percent of the value ment for the ProJect.
Case 20
Diamond Chemicals plc (A): The Merseyside Projecl
volume would revive, and it would be reasonable assume that any lost business return at that time. president' and chose to Greystock had listened to both the director and the vice preliminary analysis of the reflect nt charge or a loss of business at Rotterdam in his Merseyside project. He told Morris: n this nstance' cannibalizationeally sn't cash low; here no checkwritten Anyway,ifthecompanystafisburdeningitscost-reductionprojectswithfictitious cannibalization chargesik this,we'll nevermaintain ur costcompetitiveness' charge rubbish!
Concerns of the Assistant Plant Manager
subordinate, proposed Griffin Tewitt, the assistant plant manager and Morris's direct meeting with an unusual modification to Greystock's analysis during late-afternoon been absorbed with the Greystock and Morris. Over thl past few months, Tewitt had separate and independent part of the proposal to modernize d"velopment of th production line fo ethylene-propylene-copolymer ubber Merseyside by Diamond (EPC). This product, a variety of synthetic rubber, had been pioneered tire manufacturers' chemicals in the early 1960s and was sold in bulk to European the market in synDespite hopes that this oxidation-resistant rubber would dominate in the European chemical thetics, in fact, EPC remained a relatively small product th entire volume at industry. Diamond, th largest supplier of EPC, produced because of the Merseyside. EpC had beenlnly marginally profitable to Diamond compounds by competitofs and the development of competing synthetic-rubber "nt.y over Past five Years. TewitthadproposedarenovationoftheEPCproductionlineatacostoffl EP cost base th world million. Th renovation would give Diamond th lowest andwouldimprovecashflowsbyf25,000adinfinitum.EvenSo,atcurrentprices wa -f,750,000. Tewitt an volumes, th ne presenr value (Npv) of this project th company's executive an th EP product manager ha argued stfenuously to rom the project and committee that the negative*NPV ignoied strategic advantages Nevertheless' he execincreases volume a=nd rices when th recession ended' mainly on economic utive committee ha .e;"ct"d th project, basing it rejection grounds. In a hushed voice, Tewitt said to Morris and Greystock:
Whydon,tyouincludetheEPCprojectaspartofthepolypropylenelinerenovations?The PV of theEPC projpositiveNPV of the poly renovations aneasilysustainhenegative 'ect.Thisisanextremelyimportantprojecttothecompany,apointthatseniormanagement when he ecesdoesn'tseem get. f we nvestnow,we'll beready exploit hemarket exit hebusiness ltosionends. we don't nvestnow,you canexpect hatwe will have getherinthreeyears.Doyoulookforwardtomorelayoffs?Doyouwanttomanagea shrinkingplant.iRecallthatourannualbonusesarepeggedtothesizeofthisoperation. monitored enovation Also rememberhat, the ast20 years, o one rom colporate as projects nce he nvestment ecisionwasmade'
Case 20
Diamond Chemicals
pl
(A): Th
MerseysideProiect fnttr ruur
28
investment
Merseyside -roiect no stood' th analysis Greystock's criteria: f0'018 addition to EPS annual 1. Average l'(Years PaYbackPeriod value f9'0 million N"t Pre'"nt ;.";. percent return 25'9 the attracof rate Internal seriouslY weaken might that further tinkering concerned Morris was tiveness of the Project'
'untt;':jl:tjofr on'n" "u"n'u'n""':''Uq':O''"n" "o*Ou'ut'u"'n'o'*u''on Pl6ot (indexed to low-
,tar",'
Plant Location
CBTG
oiamononem' Diamond
Liverpoot
;;;iil;.
Hamnurs
Builr -.ln
l::l t2':" l:ll
i,?,?'i!*.?""'^ ""15,* :V 1e76 .n saone'Poutet ffi!,if VavsolS'A' t'.text largesiPlanis
I*r.",
cut" writer's nalysis
A.""Tl-9:Tj' "tttt (metric ons)
'"ostproduce0
350,000
1.09
250,000
1.02
120,000
1.07
ioo.ooo
11:.333 o-u6,ooo
1.11
i?3
