tn20 diamond chemicals plc a and b

8/10/2019 TN20 Diamond Chemicals PLC a and B

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f. inflation.

2. The critical assessment of a capital#investment evaluation system.

>. The treatment of conflicts of interest and other ethical dilemmas that may arise ininvestment decisions.

# case: eit$e /o decision

1. The relevance of cash flows from assets that may be separable from the core pro$ect.

2. The classic crossover problem& in which pro$ect ran)ings disagree on the basis of net present value N68! and internal rate of return ?++!.

>. The assessment of real option value latent in managerial flexibility to changeoperating technologies.

@. The identification of some classic games or types of human behavior that can becounterproductive in the resource#allocation process.

Suggested %uestions fo Advance Study

Two xcel spreadsheet files support student analysis of these cases'

3ase 5preadsheet ,ile-iamond 3hemicals 6 3. A! 3aseB20.xls-iamond 3hemicals 6 3. %! 3aseB21.xls

/a)ing those files available in advance to students is highly recommended. ?nstructor analysis may rely on TNB20.xls& which should not be shared with students.!

A case

1. Chat changes& if any& should ucy /orris as) ,ran) 4reystoc) to ma)e in hisdiscounted cash flow -3,! analysisD ChyD Chat should /orris be prepared tosay to the Transport -ivision& the -irector of 5ales& her assistant plant manager&and the analyst from the Treasury 5taffD

This teaching note and the associated cases were written by 6rofessor +obert ,. %runer& drawing on the generalexperience of -r. ,ran) . /cTigue& a consultant in the chemical industry. The author than)s en ades for anumber of valuable analytic insights. Any errors remain the author s. -iamond 3hemical is a fictional company&reflecting the issues facing actual firms. The development of cases was supported financially by the 3iticorp4lobal 5cholars 6rogram. 3opyright E 2001 by the 7niversity of 8irginia -arden 5chool ,oundation&3harlottesville& 8A. To order copies, send an e-mail to dardencases9virginia.edu. No part of this publicationmay be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means

electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden Foundation.


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2. ow attractive is the /erseyside pro$ectD %y what criteriaD

>. 5hould /orris continue to promote the pro$ect for fundingD

This teaching note and the associated cases were written by 6rofessor +obert ,. %runer& drawing on the generalexperience of -r. ,ran) . /cTigue& a consultant in the chemical industry. The author than)s en ades for anumber of valuable analytic insights. Any errors remain the author s. -iamond 3hemical is a fictional company&reflecting the issues facing actual firms. The development of cases was supported financially by the 3iticorp4lobal 5cholars 6rogram. 3opyright E 2001 by the 7niversity of 8irginia -arden 5chool ,oundation&3harlottesville& 8A. To order copies, send an e-mail to dardencases9virginia.edu. No part of this publicationmay be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means

electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden Foundation.


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# case

As described below& if the % case is taught on a stand#alone basis& the instructor shoulddistribute the memorandum in E&$ibit 'N1 & which presents the -3, analysis for the /erseyside

pro$ect& corrected for the issues discussed in the A case.

1. Chy are the /erseyside and +otterdam pro$ects mutually exclusiveD

2. ow do the two pro$ects compare on the basis of -iamond 3hemicals investmentcriteriaD Chat might account for the differences in ran)ingsD

>. ?s it possible to Fuantify the value of managerial flexibility associated with the /erseyside pro$ectD ow& if at all& does this flexibility affect the economic attractiveness of the pro$ectD

@. Chat are the differences in the ways li*abeth ustace and ucy /orris have advocatedtheir respective pro$ectsD ow might those differences in style have affected the outcomeof the decisionD

:. Chich pro$ect should James ,awn propose to the chief executive officer and the board of directorsD

'eac$ing Out"ine

The two cases are meant to be taughtGone eachGin seFuential class sessions. Theinstructor could& however& teach the A case alone in a straightforward manner& and the % casealone by distributing 4reystoc) s revised discounted cash flow -3,! analysis included here asE&$ibit 'N1 ! along with the % case.

("an fo t$e A case

1. ow does Diamond !hemicals evaluate its capital-e"penditure proposals# $hy such acomplicated scheme#

The purpose of this opening is to focus students thin)ing on the hurdles that the/erseyside pro$ect must clear. ?t also affords an opportunity to discuss the relative meritsof different investment criteria.

2. $hat is the Transport Division%s suggestion# Does it have any merit#

ere the class must grapple with the potential charge for the use of excess capacity inanother division.

>. $hat is the director of sales% suggestion# Does it have any merit#

The focus here should be the cannibali*ation issue.

@. $hy did the assistant plant manager offer his suggested change# Does it have any merit#

This Fuestion raises the issue of extraneous cash flows.


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:. $hat did the analyst from the Treasury Staff mean by his comment about inflation# Do you agree with it#

At this stage of the discussion& students should review the need for internally consistentassumptions about inflation.

H. ow should &reystoc' modify his D!F analysis#

This Fuestion turns to a summary of the ad$ustments needed to produce an acceptable-3, analysis.

I. $hat is the (erseyside pro)ect worth to Diamond !hemicals#

6roducing& in class& a revised -3, analysis helps to provide students with closure on thediscussion.

("an fo t$e # case

1. Do you endorse *ustace%s analysis of the pro)ect at +otterdam# ow would you improveon it#This open#ended Fuestion is intended to stimulate a critiFue of ustace s analysis. The )ey

point of ob$ection is her inclusion of the right#of#way in the analysis. A brief discussionshould establish that the option of the right#of#way should be exercised regardless of whether the pro$ect at the +otterdam plant is underta)en. Therefore& the cash flowsassociated with the right#of#way should be separated from the rest of the +otterdam

pro$ect cash flows. ?t is a simple matter to recast the -3, analysis without the cash flows.The result is that the N68 of the +otterdam pro$ect $ust slightly exceeds the N68 of the/erseyside pro$ect ad$usted to correct for the changes suggested in the A case!.

2. fter eliminating the right-of-way cash flows at +otterdam, how do the (erseyside and

+otterdam pro)ects compare financially and along other dimensions#This surfaces the relatively more credible N68 figures on both pro$ects& and exposes theinconsistent ran)ing of pro$ects by N68 and ?++.

>. $hy don%t the various investment criteria ran' the two pro)ects identically#

The purpose here is to focus on the crossover problem and its cause& which is the massivedifferences in the time profiles of cash flow.

@. $hat should one do when ++ and N / disagree in ran'ing mutually e"clusive pro)ects#

The answer is that one should focus on the ran)ing by N68& because it embodies a morereasonable reinvestment#rate assumption than ?++ and because& in theory& N68 is the

amount by which the mar)et value of eFuity will change if the pro$ect is underta)en.5tudents will need to chew this over a bit( the instructor might be prepared with somecomments on this point.

:. $hat do you ma'e of Fawn%s concern about 0fle"ibility1# !an we deal with that analytically and, if so, what is its effect on the value of the (erseyside pro)ect# $hat about on the +otterdam pro)ect#

ere the students must deal with the value of the option to change technologies.


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H. Should Fawn be swayed by *ustace%s rhetoric#

ustace s behavior displays a number of classic games used by people attempting toinfluence the resource#allocation process. 5tudents should see that such games tend toobstruct rather than improve the process.

I. $hich pro)ect should Fawn approve# ow should he )ustify his decision to the board of directors, who have already been e"posed to *ustace%s ideas#

The instructor can close the discussion with a vote and some summary comments on thewide range of issues that might have driven the decision another way in a different setting.

Supp"e!enta" 'ec$nica" Notes

At the end of this teaching note are three supplemental notes the instructor may choose todistribute to students.

Supp"e!enta" Note 'N1 ' ;+elevant 3ash ,lows&< could be useful to students if distributed in advance of the discussion of the A case.

Supp"e!enta" Note 'N2 ' ;8aluing /anagerial ,lexibility and 3ommitment&< could beuseful if distributed in advance of the discussion of the % case.

Supp"e!enta" Note 'N) ' ;+eflections on the +eal Corld of 3apital %udgeting&< is usefulas a wrap#up note for distribution after discussions of both cases.


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Co""ate a" *eadings fo t$e # Case

The application of option#pricing theory to decisions involving real asset investments may be new to students. Thus& supplementing their study of the % case with some of the followingreadings might be useful'

%realey& +ichard A.& /yers& 5tewart 3.& and Allen& ,ran)lin. ; ptions.< 6art H! rinciples of !orporate Finance . =th edition New Kor)' /c4rawL ill igher

ducation& 200H!.

ester& 3arl. ;Today s ptions for Tomorrow s 4rowth.< arvard 2usiness +eview /archLApril 1M=@!' 1:>L1H0.

/argrabe& Cilliam. ;The 8alue of an ption to xchange ne Asset for Another.< 3ournal of Finance >> /arch 1MI=!' 1IIL1=H.

Trigeorgis& enos& and 5cott 6. /ason. ;8aluing /anagerial ,lexibility.< (idland

!orporate Finance 3ournal 5pring 1M=I!' 1@L21.

Ana"ysis of t$e A Case

C iti+ue of capita"-invest!ent ana"ysis at Dia!ond C$e!ica"s

The A case presents information regarding -iamond 3hemicals investment criteria andthus affords opportunities for the students to thin) critically about the incentives and the sideeffects of the four hurdles.

* S growth ' This ob$ective is dubious. arnings per share can be easilymanipulated by changes in accounting policies& and the figure ignores theinvestment necessary to produce earnings growth. /oreover& this ob$ective

penali*es longer#term pro$ects that may yield a low or even a negative!contribution to earnings in the near term. /ost textboo)s present the considerablevolume of academic evidence that the mar)et is not fooled by cosmetic changes in

65 but& instead& the mar)et values cash flows. ,inally& the method of

implementing this criterion may penali*e small pro$ects that ma)e a relativelyinsignificant contribution to the corporation%s 65.

aybac' ' The classic flaws of paybac) are that it ignores the time value of moneyand ignores cash flows occurring after the paybac) hori*on. ne possible reasonthat firms use this measure is that they feel financially constrained in their ability tofinance new pro$ects and wish to underta)e only those pro$ects that do not impose

Case A:-iscussionFuestion 1


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an unacceptable drag on the firm s finances. ne effect of the paybac) criterion isto focus managers attention on near#term performance& possibly to the detrimentof longer#term investing.

N / and ++ ' These measures most closely reflect the interests of investors andfully account for the entire life of a pro$ect. 7nfortunately& they are also somewhatmore difficult to use than the other two measures& and may not always agree& asshown in the % case analysis.

ne virtue of -iamond 3hemicals evaluation approach is the system of varyinginvestment hurdles. 4enerally& the reFuired rates of return rise with the ris) of the pro$ects& whichis consistent with the general ris)"return framewor) of finance and is representative of systems

presently being adopted at ma$or corporations.

Adjust!ents to DC, ana"ysis

4reystoc) s preliminary -3, analysis of the /erseyside pro$ect should be corrected for at

least two violations of the principles of relevant costs and could be ad$usted in other ways&depending on one s $udgment. The main issues to be resolved and the possible responses to eachare as follows'

*ngineering study ' %ecause the funds are already spent& they should not be included in thecash#flow analysis. The principle here is' -o not include sun) costs. The text of the case did nothighlight this issue& but sharp students will note it.

!orporate overhead allocation ' These charges are not incremental flows of cash but&rather& accounting allocations. 7nderta)ing the /erseyside pro$ect will not necessarily trigger more headFuarters expense indeed& many students will say that it is unli)ely to trigger more

expense!. At issue here is the principle of discounting only incremental cash flows. Again& the textdoes not highlight this issue& but sharp students will raise it.

!annibali4ation of the +otterdam plant ' 5tudents must confront the ;scope of analysis.M2 m?++ P >1.2

see E&$ibit 'N1-# !

Assumes ,7+ 5? N at the sibling

plant

N68 P O10.01 m?++ P 1=.I

see E&$ibit 'N2 !

N68 P OI.2M m?++ P 22.:

see E&$ibit 'N1-A !

The analysis suggests that on an N68 basis& the +otterdam pro$ect dominates /erseyside in boththe full and non#erosion scenarios. ?n terms of ?++& however& /erseyside dominates +otterdam.3learly& N68 and ?++ disagree in their ran)ings. 4enerally& one s preference for either pro$ectdepends on the discount rate one assumes& as shown in the table in E&$ibit 'N) and in the graphsgiven in E&$ibits 'N and 'N .

The disagreement in ran)ings offers two important learning opportunities' 1! why thedifferences arise& and 2! what to do about the situation. ?n essence& this ran)ing problem arises

because of the highly different time profiles of the two pro$ects free cash flowsGthese arecompared graphically in E&$ibit 'N3 . +otterdam s cash flows are large later on( /erseyside s arecomparatively large in the near term. 8arying the discount rate affects the attractiveness of the two

pro$ects differently. %oth pro$ects have positive N68s& and in a ;go"no#go< decision setting& bothshould be accepted. Apparently& -iamond 3hemicals can use I more capacity in polypropylene

production& but not 1@ more. Thus& only one of the two pro$ects may be accepted& no matter how good the other pro$ect loo)s independently.

Case-iscusFuest

Case-iscusFuesti

and


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The textboo) solution to this ran)ing problem is to ta)e the pro$ect with the highest N68.,irst& N68 assumes the firm reinvests cash at a rate eFual to the discount rate 10 !& whereas?++ assumes higher reinvestment rates& which may not be replicable. 5econd& N68 has astraightforward interpretation' ?t is the amount by which the mar)et value of the firm will changeif the pro$ect is underta)en. ?f we are ta)ing the investors point of view& such a statistic isextremely relevant.

n the basis of N68 calculated on the two pro$ects cash flows& James ,awn would probably find the selection too close to call. %ut perhaps the N68 analysis ignores hidden realoptions.

'$e i!pact of ea" options

This consideration is appropriate to explore with students who have been exposed tooption#pricing theory and the concept of real options. ? li)e to emphasi*e to students that thevalue of a pro$ect consists of the -3, value of determinate cash flows plus the value of optionsthe pro$ect may containGrather li)e valuing a convertible bond in which we value the bond andoption pieces separatelyG and then sum. 3onceivably& there are many options latent in both

pro$ects. 5ince the plants in +otterdam and /erseyside are identical and since the choice betweenthem is mutually exclusive& ? prefer to assume away most of the latent options by saying that theydon t help us differentiate between the two investment alternatives. owever& the % casehighlights options associated with technological change that may help us differentiate between thetwo. 'ab"e 'N2 summari*es the technology choice options latent in the two proposals'

Table TN2.

*otte da! e seyside

New technologycommitment at initiation

of pro$ect

Japanese processcontrols

No initial newtechnology commitment

ption s! present ption to switch fromJapanese to 4ermantechnologies

1. 3all option on theJapanese technology

2. ption to switchfrom Japanese to4erman technologies

>. ption to delay

The Fuestion here is whether the values of the real options are significant enough to influence themanagerial decision in this case. The learning point for students here is to see that the N68

Case #:-iscussionFuestion :


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analyses ignore the creation or destruction! of options( they focus only on the flows of cash. Anappropriate approach is to frame the investment decision as a comparison between the N68s of the two pro$ects incremental cash flows plus the values of the call options on process#controltechnology at each of the two plants. ?n other words& the simple comparison of N68s ignores animportant component of value.

'eac$ing st ategies fo t$e ea" options issue

-iscussion of the real options issue should be tailored carefully to the capabilities of theclass.

Novices ' Cith degree students who have had little or no prior exposure to option theory&the options could be treated as Fualitative considerations. ere& the approach would be to helpstudents see that the two pro$ects have very different stances toward the new technologies. Thenthe instructor could as)& 0 n your opinion, does (erseyside%s 7wait-and-see% approach have anymerit over +otterdam%s commitment to one technology today#1 This type of Fuestion can prompt

students to reflect on the potential value of flexibility.

Students familiar with option-pricing theory ' Those who can appreciate the challenges inestimating option values might benefit from a more detailed presentation of the real option aspect.

ere& the instructor can choose between at least two approaches& depending on the teachingob$ectives for the day.

ntuitive presentation ' To gain some degree of closure on the real option issue atthe intuitive level& the instructor must help the students reason through the types of options embedded in each pro$ect& assess whether they are in# or out#of#the#money& and assess the ris) of the underlying asset. The discussion that follows

argues that the +otterdam pro$ect contains an option to switch that is deeply out#of#the#money& and unli)ely to be exercised. /erseyside contains 1! a call optionon the Japanese technology& 2! an option to switch from Japanese to 4ermantechnologies& and >! an option to continue to delay further without ma)ing anyinvestment at all. The Japanese technology option is probably in#the#money. The4erman option is less clear& but one could reason that& at worst& it is probably notfar out#of#the#money. ?n short& the /erseyside options are probably more valuablethan the +otterdam options. 5ince the N68s are close& the relative option valuesmay be enough to tip the financial evaluation in /erseyside s favor.

Numeric presentation ' The actual estimation of the technology option valuesassociated with each pro$ect is the most time#consuming approach& and should be

supplemented with transparencies or handouts. ?n my experience& students left ontheir own rarely address all the reFuired issues in the numeric estimation of the pro$ects options. The teacher will need to add some structure to the unfolding of this aspect of the discussion. The structure of this presentation is similar to theintuitive approach& but employs assumptions given in the case and an option#

pricing model to arrive at numeric estimates. The sections that follow provide afoundation for this presentation.


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Nu!e ic esti!ates of option va"ue at e seyside and *otte da!

The /erseyside pro$ect contains rights to invest later in the Japanese or the 4ermancontrol systems& as well as the right to do nothing. This is a trinomial problem& the formal solutionof which goes well beyond the mastery of most /%A finance students. %ut one simplifyingassumption can reduce the situation to a more tractable solution' one can be optimistic that either the 4erman or the Japanese technology will so dominate the ;do#nothing< alternative that theoption value of continuing to wait indefinitely is Fuite small. The evidence for this optimisticassumption is that the N68 of the Japanese technology is positive( the option on the Japanesetechnology is already in#the#money. ?f the 4erman technology is successfully commerciali*ed& onecan assume that it will have a positive N68& too. ,rom this perspective& investing in either of thenew technologies is li)ely to dominate doing nothing. This reduces the choice to two alternatives'4erman or Japanese technology.

5ome students will suggest that /erseyside retain two call options& one on eachtechnologyGbut this overstates the option value at /erseyside& since one would logically not

exercise both call options. ?nstead& /erseyside really contains the option to call on one of the newtechnologies& and then to switch to the other. 4iven what we )now about the uncertaincommerciali*ation of the 4erman technology& the logical inference is that /erseyside contains acall on the Japanese technology& with an option to switch to the 4erman technology once theviability of the 4erman technology becomes )nown.

The +otterdam pro$ect ta)es a very different posture toward the new technology. ?tcommits to the Japanese technology now& but retains the flexibility to switch to the 4ermantechnology later. 5ome students will resist the notion that +otterdam would ever be re#engineeredto the 4erman technology& as suggested by the statements in the % case. Their intuition is notunreasonable. oo)ing forward from the date of the case& it is uneconomical to install theJapanese technology and use it for only five years. %y then& executives will face positive cashflows and a relatively high N68 by not switching& since the investment in the Japanese technologywill have been a sun) cost. ?t would be unli)ely for the new 4erman technology to be attractiveenough to replace what is already operating.

The rights on new technology at both /erseyside and +otterdam include switchingoptions. Cilliam /argrabe has modeled the option to switch as a uropean option to exchangeone asset for another. @ The analysis here follows his presentation'

8alue of option to switch P 6 4 NQd1R S 6 J NQd2R

6 4 P exercise price of the 4erman technology O>.=: million : !6 J P exercise price of the Japanese technology O>.=: H million for /erseyside& and O2:.MM

million I for +otterdam!

@ Cilliam /argrabe& ;The 8alue of an ption to xchange ne Asset for Another&< 3ournal of Finance >>/arch 1MI=!' 1IIL1=H.

: O>.=: million is the present value of investment outlays at +otterdam i.e.& without the right#of#way!&discounted at 10 . The assumption is that the 4erman and Japanese systems are comparable in cost.

H 6resent value of investment outlays at +otterdam i.e.& without the right#of#way!& discounted at 10 .I This consists of the sum of the forgone benefits of the Japanese technology and the cost of installing the


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8 4 P standard deviation of the 4erman#technology returns 0.0=!& % case footnote >8 J P standard deviation of the Japanese#technology returns 0.0=!& % case footnote >

P correlation of N68 4 and N68 J 0.=0!& % case footnote >8 2 P 8 J2 U 8 4 2 S 28 4 8 J VP 0.00H@ U 0.00H@ S 2 0.0= 0.0= 0.=0! P 0.002:HW=

8 P expected standard deviation of switching returns P 0.0:0H+ f P 0 M T P term to maturity : years!

?nserting those parameters into the %lac)#5choles option#pricing model gives'

/erseyside option to switch' O0.1I@ million+otterdam option to switch' O0.000 million

/erseyside s option to switch is positive but relatively small and because of thesimplifying 10 assumptions& it should be regarded as a conservative estimate. The surprisingly lowoption value reflects the high covariance between the returns on the Japanese and 4ermantechnologies.

+otterdam s option to switch is virtually worthless. The huge N68 forgone O2:.MMmillion& the ;lost< cash flows from the Japanese system in years HL1:! renders the switchingoption deeply out#of#the#money. ence& the flexibility to change technology at +otterdam isworth little.

/erseyside also contains a call option on the Japanese technology. The case and studentanalysis can provide parameters to insert in a standard %lac)#5choles option#pricing model shownin 'ab"e 'N) '

Table TN>.

Ca"" Optionon 4apanese'ec$no"ogy

Sou ce

6rice O10.01 N68 full erosion!& E&$ibit'N2

4erman technology. The present value of the +otterdam pro$ect s free cash flows under the Japanese technologyfrom years H to 1:& discounted at the 10 hurdle rate& is O2>.H million. The assumed outlay for the 4ermantechnology is O2.>M million. As mentioned in footnote :& the assumption is that the 4erman and Japanese systemsare comparable in cost. O2.>M million is the present value of the investment outlays at +otterdam& with thoseoutlays situated in years H through = rather than in 1 through >.

= ?n /argrabe s analysis& the variance of the underlying must account for the covariance between the twoexchangeable assetsGthe third term in the variance calculation accounts for this covariance. The odds of the returnon one asset greatly exceeding the other are greatly reduced when the returns on the two assets are positivelycorrelated as they are in this case.

M According to /argrabe& the ris)#free rate applicable in estimating the option to exchange is *ero. The ;stri)e price< earns a fair rate of return already because it is a fairly priced asset.

10 The analysis assumes away any value to the option to delay further investing in new technology.


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Ca"" Optionon 4apanese'ec$no"ogy

Sou ce

xercise O>.=: 68 outlays& E&$ibit 'N2Term : yrs. % case

8olatility 0.0= % case footnote >

?nterest rate 0.0:: Nominal rate in % case footnote>

Ca""-option va"ue OI.0M mm

ne final ad$ustment to the real option analysis is necessary. The calculations thus far

assume that the 4erman technology wor)s& that it moves successfully from pilot operation to full#scale commercial application. ,ootnote > of the % case indicates a :0 probability of successfulcommerciali*ation. ,or /erseyside& there is a :0 chance that the option to switch will have anyvalue and a :0 chance that they have a simple call option on Japanese technology. Thus& theoption value at /erseyside is a probabilistically weighted average of the two option outcomes asshown in 'ab"e 'N '


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Table TN@.

*e"evant Option5a"ue

( obabi"ity 6eig$ted5a"ue

'ota" 6eig$tedOption 5a"ue at

e seyside4erman technology issuccessfullycommerciali*ed

O0.1I@ m switch!O I.0M m call!OI.2H@ million

0.:0 O>.H> m

OI.1= m4erman technology isnot successfullycommerciali*ed.

OI.0M millionsimple call option!

0.:0 O>.:: m

Ana"ytica" conc"usions

To summari*e' The value of each of the pro$ects is regarded as the sum of the N68s of thecash flows and option values as shown in 'ab"e 'N '

Table TN:.

,u"" E osion No E osion

/erseyside +otterdam /erseyside +otterdam

N68 cashflows asad$usted

OI.2M m O10.01 m O1>.M2 m [email protected] m

ption value OI.1= m O0.00 m OI.1= m O0.00 m

Total value 71 8 9 ! 710801 ! 721810 ! 71 8 0 !

Chen the value of the technology options is added to the analysis& the ran)ing of the two pro$ectsreverses from the simple N68#based ran)ing. This reversal& combined with the li)elihood that thevalue of options at /erseyside is greater after accounting for the option to wait indefinitely!& will

lead many students to conclude that ,awn should accept the /erseyside pro$ect. ?f time permits&the class discussion might touch on two final Fualitative considerations.


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%ua"itative ;ssues

;nte""ectua" capita"

li*abeth ustace ma)es the argument that the +otterdam pro$ect moves -iamond3hemicals down the learning curve in the deployment of advanced control systems. earning or intellectual capital! is valuable& though it is not an asset that is readily valued. rgani*ations thattruly value this learning would attach some worth to ustace s claim. 5tudents can reflect onwhether 5ir -avid %en$amin& the raider who threatened -iamond with a ta)eover& would be

patient enough to see the value of that learning reflected in the firm s share price.

#udget ga!es

ustace has framed the political landscape in an effort to affect the economic decision.The )ey issue is whether ,awn should be influenced by them. These include a variety of gambits

previously identified by 3hris Argyris .11

1. 5ee)ing approval or support for a budget reFuest from more than one supervisor. Theassistant plant manager in the A case illustrated a related game' circumventing one sleaders altogether.!

2. 5upporting the reFuest with voluminous data the M0#page proposal!& but with the dataarranged in such a way that their significance is not clear.

>. Justifying the analysis in terms of sub$ective and lofty benefits for example& technological;learning

@. +aising and re$ecting competing alternatives at two extremes do nothing& ma)e marginalchanges!.

?f time permits& the instructor may wish to invite students to discuss the possible impact of those budget games.

Su!!a y

E&$ibit 'N9 summari*es the structure of the decision problem facing James ,awn& thedecision ma)er in the % case. The diagram shows that uncertainties about the commerciali*ationand the returns from the process technologies add considerable complexity to the either#or decision in the % case.

11 3hris Argyris& 8vercoming 8rgani4ational Defenses %oston' Allyn and %acon& 1MM0!& =.

Case #:-iscussionFuestion H


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An analysis of the two cases reveals ma$or issues to which the analyst of capital investment proposals should be attuned'

The identification of relevant cash flows

The need for internal consistency in the estimation of cash flows and the discount rate The possible influence of hidden real options& the option to switch& and the option to wait

The impact of unFuantifiable effects and of behaviors that see) to influence the wor)ing of the proposal#review process

At its most basic level& this has been an exercise in critical thin)ing& aimed at impressing thestudent with the importance of reflecting on basic economic notions.


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xhibit TN1

D;A OND CA? AND >#?

xcerpts from /orris s xpenditure 6roposal /emo +egarding the /erseyside 6ro$ect

To' James ,awn,rom' ucy /orris and ,ran) 4reystoc) 5ub$ect' 3apital xpenditure 6roposal' 6olypropylene ine nhancements /erseyside!

This memo summari*es the rationale and financial impact of capital improvements to the polypropylene line at /erseyside. The investment reFuested is OM million. 5trategic and operating benefits were summari*ed in our previous memo to you. Ce have made& however& some changes

to our investment analyses& which appear below.

Two discounted cash flow analyses accompany this memo. 6art A contains an ad$ustmentfor possible business erosion at +otterdam& while part % does not ma)e that ad$ustment.

X The results are'

rosion No rosion N68 OI.2M m O1>.M2 m?++ 22.: >1.2

X The costs of the engineering study and corporate overhead allocation have been excludedfrom the analysis& per discussions with John 3amperdown.

X Tan)#car expenditure occurs earlier in time& and changes in depreciation tax shields arereflected herein.

X The discount rate used is 10 & and the cash flows used are nominal& rather than real cashflows.

Ce would be happy to respond to any remaining Fuestions you or the board may have.


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xhibit TN1 continued!G6art A+evised and ,inal -3, Analysis' /erseyside 3apital xpenditure 6rogram

reflects charge for ,7 + 5? N of +otterdam business volume!


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xhibit TN1 continued!G6art %+evised and ,inal -3, Analysis' /erseyside 3apital xpenditure 6rogram

reflects N 3 A+4 , + + 5? N of +otterdam business volume!


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xhibit TN2D;A OND CA? AND >#?

Analysis of +otterdam 6ro$ect& xcluding ?mpact of the +ight#of#Cay ?nvestmentfinancial values in millions of %ritish pounds!


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xhibit TN>

D;A OND CA? AND >#?

-iscounted 3ash ,low +esults 3omparison

N.%. 4rey highlights region of ;crossover.#?

5ource' 3ase writer s analysis.


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xhibit TNH

D;A OND CA? AND >#?

5ource' 3ase writer s analysis.


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xhibit TNI

D;A OND CA? AND >#?

5ummary of the -ecision 6roblem ,acing James ,awn


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5upplemental Note TN1

DIAMOND CHEMICALS PLC (A) AND (B)

+elevant 3ash ,lows

The basic axiom in capital#expenditure analysis is ;3ash is ingY< i)e most slogans&however& adhering to this maxim is easier said than done. The thoughtful analyst will routinelyencounter subtle and sophisticated challenges to the basic focus on cash flow. To provide a moreoperational form of the basic axiom& here are some guidelines for use in determining which cashflows are relevant for capital#investment analysis'

X gnore sun' costs ' All investment analysis should be marginal and forwardloo)ing. ?f we include past cash flows in our analysis& we might overburdengood pro$ects with the sins of the past or ma)e bad pro$ects seem attractivesimply on the basis of past success. Ce want to stand at the margin.

X gnore fictional accrual accounting flows ' Accountants aim to answer Fuestions that are different although important! from whether a prospectiveinvestment is attractive. 1 The capital#expenditure analyst necessarily loo)sforward& rather than bac)& and see)s to consider the real economic events. neshould not mix the two perspectives. ne should be suspicious of any itemcalled a ;charge< or an ;allocation.! ow should the costs and revenues be allocated between one year and thenextD @! Chat does it cost us to ma)e a unit of our product& and so on.

This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the casestudy ;-iamond 3hemicals 6 3. A!&< 78A#,#1>:1!. 3opyright E 1MM2 by the -arden 4raduate %usiness5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals A!&< andinstructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of thisnote for classroom use.


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5upplemental Note TN1 continued!

X +eflect the e"pected timing of the cash flows ' Cith the focus on real economicevents& it is inappropriate to accelerate or delay cash flows or to lump them toone point in time.

X Don%t forget terminal values and abandonment costs ' These costs may bematerial flows of cash. Cith the increasing attention to environmental issues&abandonment costs can be huge for example& in nuclear power or pesticide

production!. ?f a pro$ect reFuires a buildup of inventory& it ma)es sense toassume a recapture of that investment at the end or to $ustify the failure torecapture it. 5imilarly& intangible assets may have a value that carries past theforecast hori*on and can be recaptured. ,inally& to assume that the businesssimply continues to operate may ma)e sense( doing so will reFuire an estimateof the ;going#concern< value of the business to be reflected at the terminus of the cash flows.

Two other related issues are most often not scrutini*ed in a capital#expenditure setting'

X 5se investment criteria that are tied to cash flow, are ris' ad)usted, and reflect the time value of money ' Throughout the business economy& the best techniFuesare still underutili*ed.

X The best capital-e"penditure analysis practices will not guarantee that theright decisions get made ' The real challenge is to get managers to thin) li)einvestors. 4ood analytical practices can help& but fundamentally& the problem is

one of compensation and incentives. 7nfortunately& good finance cannot be practiced apart from the messy world of human behavior.


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5upplemental Note TN2

DIAMOND CHEMICALS PLC (A) AND (B)

8aluing /anagerial ,lexibility and 3ommitment

ne of the limitations of discounted cash flow is that it does not capture well the strategicaspects of capital investment. 5uch strategic elements include the right to ma)e futureinvestments& the right to sell or liFuidate in the future& the right to abandon& and the right toswitch investments. All of these rights are indicators of managerial fle"ibility. Another class of strategic elements appears when managers promise to do certain things in response to others for example& invest more heavily if a competitor enters a mar)et or acFuires a new technology& buy if others choose to sell& sell if others choose to buy!. Those promises amount to managerial commitment. ne almost never sees those contingent elements reflected in -3, analyses& and for good reason' They are very uncertain. Nevertheless& they are also so important in the thin)ing of general managers that flexibility and commitment can often override the decision dictated by -3,.Chat is the careful analyst to doD

The answer is that one should define the capital#investment decision broadly to includeflexibility and commitment& and then value the strategic element of the investment. ?n other words& one must see that the value of an investment is the sum of its discounted cash flow andthe value of its fle"ibility or commitment . The challenge in thin)ing about capital investments thisway lies in placing a value on flexibility and commitment. ,ortunately& option#pricing theory canhelp with this challenge.

Si!p"e Options

The )ey tas) is to define elements of flexibility or commitment in terms of options& andthen use the theory to estimate a value. As a general rule& flexibility is analogous to a long positionin call or put options. 3onversely& commitment is analogous to a short position in call or putoptions. ere is a brief taxonomy of options latent in capital investments'

This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the casestudy ;-iamond 3hemicals 6 3. %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals %!&< and instructors whohave adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.


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9ong call ' X +ight to invest at some future date& at a certain price

X +ight to harvest1

at some future dateX 4enerally& any flexibility to invest& to enter a business& or to delay

harvesting

9ong put ' X +ight to sell at some future date at a certain price

X +ight to abandon at some future date at *ero or some certain price

X +ight to force someone else to harvest

X 4enerally& any flexibility to disinvest& to exit from a business& or toaccelerate harvesting

Short call ' X 6romise to sell if the counterparty wants to buy

X 4enerally& any commitment to disinvest or accelerate harvesting uponthe action of another party

Short put ' X 6romise to buy if the counterparty wants to sell

X 4enerally& any commitment to invest or delay harvesting upon theaction of another party

Co!p"e& Options

/ost large capital investments are a bundle of strategic options. The simple treatment of this bundle is to value the individual parts or options! and then to sum them. This simpleapproach brea)s down when the options are interdependent or mutually exclusive. The classicexample involves the flexibility to switch investments or to choose investments! at some futuredate. ,or problems that include the flexibility to switch& one needs to rely on the elegant models of option#pricing theory.

1 The word harvest is meant both literally and to stimulate the reader s thin)ing. ,or instance& consider thatyou have an option on a tree farm. The trees are immature now but will certainly grow to have commercial value.The right to extend your commercial claim on the trees is a call option. Analy*ing the trees value is Fuite similar to analy*ing the investment in an +Z- program& where each year s investment extends the harvesting hori*on byone year.


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,or instance& Cilliam /argrabe has modeled the right to switch as a uropean option toexchange one asset for another .2 The analysis here follows his presentation'

8alue of the option to switch P 6 4 NQd1R S 6 J NQd2R

where'

6 4 P exercise price of ma)ing investment 46 J P exercise price of ma)ing investment J8 4 P standard deviation of the uncertain returns on investment 48 J P standard deviation of the uncertain returns on investment J6 P correlation of N68 4 and N68 J8 2 P 8 J2 U 8 4 2 S 28 4 8 J6! .: P variance of returns in the exchangeT P term to maturity

This eFuation is nothing more than the familiar %lac)#5choles option#pricing model& the values for which may be estimated from tables in textboo)s or programs in personal computers.

Conc"usion

ptions are always valuable& even if deeply out#of#the#money. Therefore& the optionslatent in capital#expenditure decisions can prove to be of great economic significance. The

financial analyst should& when possible& attempt to estimate the value of those options andconsider them in ma)ing final recommendations.

2 Cilliam /argrabe& ;The 8alue of an ption to xchange ne Asset for Another&< 3ournal of Finance >>/arch 1MI=!' 1IIS1=H.


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5upplemental Note TN>

DIAMOND CHEMICALS PLC. (A) AND (B)

+eflections on the +eal Corld of 3apital %udgeting

3apital#budgeting analysts struggle to apply such axioms of modern finance as 1! cashflow! is )ing& 2! discount cash flows at rates consistent with their ris)& and >! N68 and -3,

are sufficient summaries of value. The -iamond 3hemicals cases illustrate the sorts of difficultiesthat can arise'

1. ncluding real options ' The value created or destroyed by an investment is the sum of the present value of expected cash flows plus the value of latent options. ptions

permeate most capital#investment problems for example& see Supp"e!enta" Note'N2 !. 8aluing real options& however& is Fuite difficult. ,irst& one needs to ta)e care toincorporate all options in the analysis( simply identifying the latent options can be achallenge. 5econd& the volatilities on which the value estimates depend are daunting toestimate. Nonetheless& as ;-iamond 3hemicals 6 3. %!&< case 21! shows& the valuesof latent options can overshadow the present values of expected cash flows.

2. !hoosing the right investment criteria and designing a good evaluation system '/anagers are responsive to the incentives and constraints that surround them. Acapital#budgeting system sends signals to managers that define what a good pro$ect is.

ne needs to be extraordinarily careful in the design of these systems in order not tosend the wrong signals. -iamond 3hemicals used four criteria& of which earnings per share 65! growth and paybac) have obvious defects see Supp"e!enta" Note 'N1 !.The flaws of ?++ emerge in instances where ?++ and N68 disagree about the ran)ingof two mutually exclusive pro$ects. The reason they disagree has to do with thedramatically different time profiles of cash flows& as indicated in ,igu e 'N1 ( the+otterdam proposal with its huge terminal value was much more sensitive to changesin discount rates than was the /erseyside proposal.

This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the casestudy ;-iamond 3hemicals 6 3. %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6 3. %!&< andinstructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of thisnote for classroom use.


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5upplemental Note TN> continued!

,igure TN1

,igu e 'N1 shows that the pro$ect ran)ings cross over as the discount rate grows from*ero to a high value. This is due to differences in the time profile of cash flows for the two

pro$ects. /erseyside s cash flows are relatively large earlier in time( +otterdam s are relatively

large later. $hen ++ and N / disagree, rely on the recommendation indicated by N /. Thereare two reasons for following this rule'

1. ?mplicit in the mathematics of discounting is the assumption that earnings on the pro$ectswill be reinvested to yield a return eFualing the discount rate. ?n N68 calculations& thisreinvestment rate of return is the weighted#average cost of capital& which is not anunreasonable assumption if chosen thoughtfully. +einvesting to yield the ?++& however&may not be reasonable to assume.

2. %asically& the analyst wants to create value for investors. N68 explicitly estimates howmuch value the pro$ects create at the investors% re:uired rate of return.

This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the casestudy ;-iamond 3hemicals 6 3 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6 3 %!&< and instructorswho have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.


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5upplemental Note TN> continued!

5tated differently& whenever you suspect that a ;crossover problem< might exist& use N68 for decision#ma)ing.

Another prominent issue under the panoply of system design is choice of discount rate.-iamond 3hemicals used a ris)#ad$usted system by functional type of pro$ect. ,inance theorywould applaud this approach as far as it goes. ne must be prepared to adapt the system tounusual proposals& however& such as +otterdam s& which could be viewed as a combination of

plant maintenance and real estate arbitrage. This instance might profit from decomposing the bundle and valuing the two pieces at their respective appropriate ris)#ad$usted discount rates.

5ltimately &no capital-e"penditure evaluation system can fully anticipate the variety of assets and pro)ects to be valued; where the educated analyst adds value is in tailoring the systemto the characteristics of the asset being valued. f course& the analyst and the company run a ris) every time the system is tailored' 3hanges in the rules send signals to managers& and one wants toavoid inadvertently sending the wrong signals. /oreover& a system that is tailored for every

pro$ect may be seen as being completely arbitrary and able to be manipulated. ,inally& decisionma)ers will filter the output of such a system in their own ways. ,or many senior corporateexecutives& the trac) record of the executive sponsoring the proposal is about as influential as

N68.

The practical implication of this example is that N68 is a necessary& but not sufficient&condition for pro$ect approval. The human#behavioral side of resource allocation potentiallyovershadows all attempts at rigorous Fuantitative analysis. This reminder leads to the third and

final barrier.

>. Dealing with political 0games1 ' ?n ;-iamond 3hemicals 6 3 %!&< li*abeth ustace hasframed the political landscape in ways that may prevent the proper economic decisionsfrom being made. ustace s behavior included the following'

This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the casestudy ;-iamond 3hemicals 6 3 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6 3 %!&< and instructorswho have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.


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tn20 diamond chemicals plc a and b

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