Empirical Chemical Case

TO:                       Prof. Cole

DATE:                  Aug. 2016

SUBJECT: Empirical Chemical (EC) Case

KEY ISSUES (WITH SOLUTIONS): There are eight key issues involved in our decision to recommend that EC accepts the project of $7 million expenditure for the modernization of Merseyside.

·       Issue 1: Evaluating Criteria

· EPS impact. Dislike criteria. Can be easily manipulated to fool investors no matter if investment is good or bad.

· Payback. Dislike criteria. Does not take into account the risk, time value of money, and cash flows beyond the cutoff point or payback horizon.

· DCF and IRR. Like criteria. Reflects investors’ interest and takes into account entire project period.

·       Issue 2: Preliminary engineering costs

These costs occurred nine months before the project and cannot be removed. These irrelevant costs are known as sunk costs and should not be part of the analysis.

·       Issue 3: Allocated Overhead Costs

For DCF analysis it is important to consider cash flows that arise only from the project per se, that’s what we call incremental cash flows. For this project, corporate overhead expense should not be considered since the project will not cause any change in corporate expenses.

·       Issue 4: Cannibalization

Sales Director thinks Rotterdam sales will be cannibalized with the new project. With lower production costs, new project can take business away from competitors. We suggest that cannibalization not be accounted for, but if it does, profit loss for Rotterdam should be used as a cash flow for Liverpool.

·       Issue 5: Change in working capital

The WIP inventory needed for the increased throughput represents an investment in net working capital. The case only considered this net working capital at the beginning but not at the end. In DCF analysis a change in net working capital should be recovered toward the end of the project.

·       Issue 6: Inflation

Cash flow in general describes real...