Diamond Chemicals

Diamond Chemicals: Financial Analysis

Course:

Financial Management I (MGMT-6020)

Spring 2011

In the Diamond Chemicals case, the discounted cash flow (DCF) model, which is a method of valuing a project based upon the concept of the time value of money, is used. In the DCF model, future cash flows are estimated and discounted to estimate the present values. The DCF model computes the net present value (NPV)-the sum of all incoming and outgoing future cash flows- taken as input cash flows and a discount rate, and gives as output a price. The DCF model has two major shortcomings as the complication can be seen in the Diamond Chemical financial analysis. The discount rate assumption relies on the time of the analysis, which would likely change, by such factors as inflation over time. A straight-line assumption about income increasing over a period of time is another drawback of the DCF model.

In this case, we believe there are a few changes Frank Greystock should make to the proposed Discounted Cash Flow analysis. The first change that should be made is related to preliminary engineering costs. The $500,000 spent in 2001 should not be accounted for as it was spent on research and development for the possible new project. This cost should be considered as a sunk cost and should not be considered in the incremental cash flows because sunk costs are past costs that have already been incurred and cannot be recovered.

There are also cash flows that come as a side effect of the new project. These are classified as erosion. Erosion occurs when the new project reduces the cash flows for the existing projects. Rotterdam’s annual output of 250,000 metric tons would decrease due to the new Merseyside project, which will be a decrease in cash flows elsewhere for Diamond Chemicals. Though in Greystock’s DCF analysis there is no direct cost for erosion, or cannibalism, we can infer this cost based on the old and new outputs in the analysis.

With regard to the...