Analysis Dimond Chemicals Plc

Diamond Chemicals PLC(A): The Merseyside Project

1. Identify the relevant cash flows for each of the following items.  In particular, what is the current treatment of each?

a) Sunk costs

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Sunk costs mean the monies already spent on the project. As shown from Exhibit 2, we can see Preliminary Engineering Costs is GBP 0.5 million, which indicates 0.5 million has already spent on engineering. Therefore, 0.5 million is the sunk costs.

b) Cash flows obtained by cannibalizing another activity within the firm

Cannibalization represents market cannibalization which refers to a situation where a new product reduces sales and demands of existing product and thus reduce overall sales of the company. In this case, the plant at Merseyside might be able to get the business from other companies with lower cost.

Additionally, the market will retrieve later and thus they don’t have to struggle with gaining new business.

In conclusion, the charge of cannibalization is unreasonable. We do not have to calculate the cash flows of cannibalization and include it in analysis.

c) Exploitation of excess transportation capacity

As it is indicated in the first paragraph of Concerns of the Transport Division part. There should be GBP 2 million for the excess transportation capacity.

d) Corporate overhead allocations

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As we can see from the Exhibit 2, the overhead cost is GBP 0.32 million.

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Additionally, based on note 4 “all new capital projects needed to reflect an annual pretax charge amounting to 3.5% of the value of the initial asset investment for the project”. Then we can safely conclude that the overhead allocation will be 0.32 million per year.

e) Cash flows of unrelated projects

1million for EPC project. Since they are unrelated projects, actually we don’t have to calculate the cash flows and included in this project analysis.

f) Inflation.

After taking consideration of inflation of 3%, the actual discount rate should be 7% instead of 10% nominally.

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?

According to what has shown in question1, some changes have to be made in DCF Analysis:

1. Adding GBP 2 million in the budget for transportation cost, since the original budget did not include the transportation cost. Then get the 2 million back in 2005. Because it should be burdened by transportation division.
2. Making changes for discount rate to 7% considering inflation rate of 3%. For 10% hurdle rate is only nominal and did not take inflation rate into account.
3. Excluding cannibalization cost in analysis for the charge of cannibalization is unreasonable.

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.

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