The case relates to the proposed renovation and rationalization of the polypropylene production plant at the Merseyside plant in England. The initial cost of the project is 9 million pounds with the aim of modernizing the plant as well as making it more viable to counter the declining earnings and ensuring that the plant is cost effective. The main matters that Morris tried to handle are the presence scarce capital cost. Hence with the Morris’s proposal of renovating the plant was to save on energy as well as enhance the process flow. The project proposal will take 45 days to completion which implies a shutdown of the plant with a capital cost of 9 million pounds investment initial cost. Frank Greystock who is the controller of the project anticipated that the hurdle rate for the proposed investment on the basis of some assumption will be 10% holding other factors constant.
Exhibit 2 depicts the discounted cash flow assessment by Greystock for the Merseyside plant investment project. The assumption made is that the discounting rate will remain at 10% and tax rate at 30%. The initial capital investment is estimated at 9 million pounds with no salvage values with asset accelerated depreciation rate with a lifespan of 15 years (Damodaran, 2010). The 15 years assessment depicts fair steady free cash flows projected with all the cash flows being positive. This outcome depicts a positive net present value of NPV of 15 pounds with an internal rate of return (IRR) of 26.5% which is deeming healthy for the project. Based on the analysis, the following concerns were raised and recommendation provide with regards to proposed investment of plant renovation.
Concerning the discounted cash flow assessment and on the basis of some matters raised in the case with reference to the projected discounted cash flows, my evaluation is as follows
The Greystock precisely tackled the transport segments matters since, there is redundant capacity in these segments and hence there no real cash flow linked to utilization of this capacity for the proposed renovation and upgrade of the plant (Ehrhardt, 2008).
The director of sales had a genuine concern that relates to cannibalization of the revenue from the plant. As a result, to solve this matter, Greystock must take into consideration incremental revenue in the analysis of the discounted cash flows, not merely for Merseyside project but as well relating to the cannibalized revenue of the plant to provide a very precise projection.
The marketing division concern relates to the yield with great market portion as well as sales from the competitors but the matter of stern competition was raised. Greystock is right with the decision of not putting more attention to this matter, since there is nothing of the future that might be correctly evaluated (James, 2015). He might just forecast the discounted cash flow on the existing assumptions and sales.
The proposal of the assistant plant manager to renovate the EPC plant as part of the entire proposal was on the basis of strategic benefits that the project will provide to the company. As much as there is a negative net present value, the EPC production line was balanced for bigger revenue and the price at the time the recession ends (Shi, 2001). Nevertheless, we are оf the opinion that this must be entailed in the proposed capital investment since there is a strong incentives of the community engaged which will lead to over go-getting perception of the expansion of EPC prospect, and furthermore, the negative net present value might get rid of the entire net present value of the renovation proposal as well as it might make it undesirable for the company since, the cost of the project will be more than the expected positive returns.
The discounted rate employed in the discounted flow for the project is 10%. The treasury personnel raised a matter concerning the nominal rate and for it to be useful, it must be real since there is a constituent of the inflation effect of 3% in the discounted cash flow assessment. Nevertheless, in the assessment, the cash flow should as well be nominal implying that it turns to be the case for the proposed project. In this regards, the net present value and the internal rate of return workings is precise on the basis of the 10% discounting rate. On the contrast, even if the company uses the real rate of return, there shall be same return on the net present value and hence no real advantage of changing the discounting rate.
We consider that the deprecation method in the discounted cash flow must not be the accelerated depreciation methods since the business propose to use the double declining balance approach for the project the aggressive deprecation is ideal for the tax saving but the method of deprecation the asset is the straight line method which depreciates the assets In entirety and depict a more practical outlook (William Petty, 2015). This may provide reassurance outlook to the senior management and they will not be persuaded to accept project merely for the sake of achieving such tax advantage. Another matter is that the discounted cash flows analysis integrates the initial cost of engineering as expenditure. This need not be the case and it must be considered as the sunk cost.
With regard to the recommendation above, it is evident that the proposed project still depicts a positive net present with an internal rate of return of rate of 26.5% which more than the 10% discounting rate and hence, the project should be accepted.
The Net present value, Payback period and the internal rate of return of the proposed project renovation
Year Now 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
1. Estimate of Incremental Gross Profit
New Output (tons) 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500 267,500
Lost Output–Construction -31,250
lost sales -7,088 -8,025 -4,013 -2,675
New Sales (Millions) 127.81 149.06 153.53 162.88 167.77 172.8 177.98 183.32 188.82 194.49 200.32 206.33 212.52 218.9
New Gross Margin 13.80% 13.80% 13.80% 13.80% 13.80% 13.30% 13.30% 13.30% 13.30% 13.30% 12.50% 12.50% 12.50% 12.50% 12.50%
New Gross Profit 17.57 20.5 21.11 0 22.4 22.23 22.9 23.58 24.29 25.02 24.31 25.04 25.79 26.57 27.36
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