Late one afternoon Morris Plant Manager of Diamond Chemicals Merseyside was discussing a capital project with her controller that Morris wanted to propose to senior management. The project consisted of a 9 million pounds expenditure to renovate and rationalize the polypropylene production line at the Merseyside plant in order to make up for the deferred maintenance and to exploit opportunities to achieve production efficiency. The proposed Capital Program
Morris had assumed responsibility for the Merseyside works only 12 months previously, following a rapid rise from the entry position of shift engineer nine years before. When she assumed responsibility she undertook a detailed review of the operations and discovered significant opportunities for improvement in polypropylene production. Some of those opportunities stemmed from a deferral of maintenance over preceding five years. In an effort to enhance operating results previous manager had limited the capital expenditure to the most essential. Now, what previously had been the routine and deferrable was becoming most essential. Morris proposed an expenditure of 9million pounds on this program. The entire polymerization line would need to be shut down for 45 days. Merseyside customers would buy from competitors. Morris believes that loss of customers would not be permanent. The benefits would be lower energy requirement1 as well as a 7% greater manufacturing throughput.
In addition, the project was expected to improve gross margin (before depreciation and energy saving) from 11.5% to 12.5%. The engineering group at Merseyside was highly confident that efficiencies would be realized. Merseyside currently produced 250000meteric tons of polypropylene averaged Pound 541 per ton. The tax rate required is 30%. Morris discovered that any plant facilities which are to be replaced had been completely depreciated. New asset could expect to have life of 15years. Depreciation can be charged on the basis of straight-line method. Morris includes in the first year 500000 million pounds as preliminary expenses spent in the past on efficiency and design studies. Finally corporate manual stipulated that overhead costs be reflected in the project analyses at the rate of 3.5% times the book value of the asset acquired in the project. Prepare a discounted cash flow summary for the next 15 years assuming a hurdle rate to be 10%. Evaluate the project in the light of various capital budgeting techniques. 1.Morris characterized the energy saving as percentage of sales and assumed saving would be 1.25% of sales in the first 5 Years and 0.75% in years 6-10.