Diamond Chemicals PLC(A): The Merseyside Project

1. Identify the relevant cash flows; in particular, the current treatment of

the following:
a) Sunk costs
Preliminary engineering costs of 0.5mn have been spend on the efficiency and
design studies of the renovation and are thus a sunk cost. This cost should not be
included in analysis.
b) Cash flows obtained by cannibalizing another activity within the firm
The increase in throughput from Merseyside can increase profits by even stealing
the competitor sales and not necessarily cannibalize Rotterdam plant. This should
not be included in analysis.
c) Exploitation of excess transportation capacity
$2M investment in new rolling stock to be included in DCF analysis.
d) Corporate overhead allocations
since the relevant amount of overhead costs for the new investment are the
incremental amount, it should be retained in DCF analysis. Inflation should be
applied on these overhead costs as well.
e) Cash flows of unrelated projects
The Merseyside project is evaluated for engineering efficiency, not expansion. It
should be excluded in DCF analysis and considered as a separate project.
f) Inflation
The 10% initial discount rate proposed by Greystock is a nominal rate and lacks
consideration for inflation. As the inflation rate is 3%, the real rate is 7%.
Either keep discount rate 10% and include 3% inflation rate or keep discount rate
7% with no inflation.
2. What changes, if any, should Lucy Morris ask Frank Greystock to make
in his discounted cash flow (DCF) Analysis in regards to the cash flows in
question 1? Why?
Lucy should ask Frank to make following changes in his DCF analysis:
-

Changing discount rate to 7% keeping inflation rate 0%

Removing cannibalization cost
Including transportation cost
And include overhead allocations

3. What should Morris be prepared to say to the Transport Division, the

Director of Sales, her assistant plant manager, and the analyst from the
Treasury Staff? Provide a separate response for each person.
Transport division: Tanker cars are necessary to accommodate increased
throughput. Though current capacity of transportation can be further exploited; but
project will include the financial cost caused by accelerated purchasing tank cars
The director of sale: Since the market is highly competitive; there will be no
cannibalizing cost in this market. As per the primary and secondary research of
market we can say that sales are highly price sensitive. The lower price, the higher
sales. Diamond can either keep its price same: the extra output will be bought by
customers who were purchasing the product with higher price from competitors;
and if Diamond lowers its sale price: it can try to gain market share from
saone_poulet or Vayaol S.A. who sell the product at a lower price compared with
Diamond. If the micro economy become better, the total demand in this market
would be growing, then the extra output can be easily sold out.

Treasure staff: To apply 0% inflation rate and 7% discount rate instead of 10%
consistent rate.

4. How attractive is the Merseyside project? By what criteria?

It is attractive since the NPV is positive while improving the companys
competitiveness.
5. Should Morris continue to promote the project for funding?

Yes. As micro economy will revive in sometime, there will be growing demand for the produce due
to emerging economies in Asia and Latin America. Increasing production capacity will prove
profitable in long run.
Also, all the plant equipments have already depreciated and investing in new facilities will not only
improve production line but can give tax benefits as well.