Recommendations and Actions for Management:
Diamond Chemicals are the leading producers and a major competitor in worldwide industry of chemicals. Morris has recommended a project to renovate and rationalize a production line and to increase the production efficiency and making up for the deferred maintenance with estimated $9 million investment in the project. There are several objections raised on the project, and the analysis by Grey stock contains some errors, which are required to be fixed to evaluate the project correctly.
The first issue to consider is the correction of hurdle rate.The discount rate and the cash flows need to be consistent in their assumptions about the inflation.The 10% hurdle rate is a nominal rate which is proposed by Grey stock.The real rate is 7% and the inflation rate is 3%. It is recommended that if discount rate is same, the inflation effect should be included in the cash flows or should change the discount rate to 7% and do not incorporate the inflation in cash flows. The management should change the hurdle rate to 7%, which will result in a higher NPV for Diamond Chemicals increased by $3.3 million.
Another recommendation would be to exclude annual pre-tax cost of 3.5% from the project, due to the project itself expected to reduce the cost therefore, it should not be added in the project.The management should exclude the cost, as by excluding the pre-tax cost it will improve the NPV by 2 million pounds.
It is recommended to remove the 0.5 million sunk cost that is included in the project, as sunk costs are retrospective costs, which are already spent and cannot be recovered, and they should not affect the decisions that are presently made according to the principle with-without. The costs that are related to the future are relevant for the investment decisions.
The management should remove the sunk cost, which will raise the NPV by 0.3 million after the hurdle rate and pre-tax cost adjustment.
Transportation investment is important for Diamond Chemicals, and it should be considered in the project as an expense or outflow.Transport division is also the part of Diamond Chemicals and without it, achieving the overall organization goal is not possible. However, the tanker cars are necessary due to the increased throughput associated with the project; otherwise it would be hard to accommodate the increase.
The management should include the transport investment with the 10 year depreciation. The changes will result in a decrease in NPV by 1.2 million pounds after the hurdle rate correction and after excluding sunk costs.
The total NPV after the following changes will be 13.4 million, which is more attractive than the NPV before the following recommendations and can have serious effect on decisions......................
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