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CASES 20 AND 21

DIAMOND CHEMICALS PLC (A) AND (B)


Teaching Note
Synopsis and Objectives
These two cases present the capital investment decisions under consideration by
executives of a large chemicals firm in January 2001. The A case case 20! presents a go"no#go
pro$ect evaluation regarding improvements to a polypropylene production plant. The % case case
21! reviews the same pro$ect but from one level higher& where the executive faces an either"or
investment decision between two mutually exclusive pro$ects. The ob$ective of the two cases is to
expose students to a wide range of capital budgeting issues'
A case: go/no-go decision
1. The identification of relevant cash flows( in particular& the treatment of'
a. sun) costs
b. cash flows obtained by cannibali*ing another activity within the firm
c. exploitation of excess transportation capacity
d. corporate overhead allocations
e. cash flows of unrelated pro$ects
This teaching note and the associated cases were written by +obert ,. %runer& drawing on the general experience of
-r. ,ran) .. /cTigue& a consultant in the chemical industry. The author than)s 0en 1ades for a number of
valuable analytic insights. Any errors remain the author2s. -iamond 3hemicals is a fictional company& reflecting
the issues facing actual firms. The development of the cases was supported financially by the 3iticorp 4lobal
5cholars 6rogram. 3opyright 2001 by the 7niversity of 8irginia -arden 5chool ,oundation& 3harlottesville& 8A.
All rights reserved. To order copies, send an e-mail to sales9dardenpublishing.com. No part of this publication
may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means
electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School
Foundation. +ev. 10"0:.
Suggestions fo co!p"e-
!entay cases egading
capita" budgeting:
;,onderia di Torino< case
1=!& ;4en*yme"4eltex
6harmaceuticals Joint
8enture&< case 22!.
f. inflation.
2. The critical assessment of a capital#investment evaluation system.
>. The treatment of conflicts of interest and other ethical dilemmas that may arise in
investment decisions.
# case: eit$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 change
operating technologies.
@. The identification of some classic games or types of human behavior that can be
counterproductive in the resource#allocation process.
Suggested %uestions fo Advance Study
Two 1xcel spreadsheet files support student analysis of these cases'
3ase 5preadsheet ,ile
-iamond 3hemicals 6A3. A! 3aseB20.xls
-iamond 3hemicals 6A3. %! 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 Aucy /orris as) ,ran) 4reystoc) to ma)e in his
discounted cash flow -3,! analysisD ChyD Chat should /orris be prepared to
say 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 general
experience of -r. ,ran) .. /cTigue& a consultant in the chemical industry. The author than)s 0en 1ades for a
number of valuable analytic insights. Any errors remain the author2s. -iamond 3hemical is a fictional company&
reflecting the issues facing actual firms. The development of cases was supported financially by the 3iticorp
4lobal 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 publication
may 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.
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 general
experience of -r. ,ran) .. /cTigue& a consultant in the chemical industry. The author than)s 0en 1ades for a
number of valuable analytic insights. Any errors remain the author2s. -iamond 3hemical is a fictional company&
reflecting the issues facing actual firms. The development of cases was supported financially by the 3iticorp
4lobal 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 publication
may 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.
# case
As described below& if the % case is taught on a stand#alone basis& the instructor should
distribute 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 3hemicals2 investment
criteriaD 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 1li*abeth 1ustace and Aucy /orris have advocated
their respective pro$ectsD .ow might those differences in style have affected the outcome
of the decisionD
:. Chich pro$ect should James ,awn propose to the chief executive officer and the board of
directorsD
'eac$ing Out"ine
The two cases are meant to be taughtGone eachGin seFuential class sessions. The
instructor could& however& teach the A case alone in a straightforward manner& and the % case
alone by distributing 4reystoc)2s revised discounted cash flow -3,! analysis included here as
E&$ibit 'N1! along with the % case.
("an fo t$e A case
1. ow does Diamond !hemicals evaluate its capital-e"penditure proposals# $hy such a
complicated scheme#
The purpose of this opening is to focus students2 thin)ing on the hurdles that the
/erseyside pro$ect must clear. ?t also affords an opportunity to discuss the relative merits
of 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 in
another 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.
:. $hat did the analyst from the Treasury Staff mean by his comment about inflation# Do
you agree with it#
At this stage of the discussion& students should review the need for internally consistent
assumptions about inflation.
H. ow should &reystoc' modify his D!F analysis#
This Fuestion turns to a summary of the ad$ustments needed to produce an acceptable
-3, analysis.
I. $hat is the (erseyside pro)ect worth to Diamond !hemicals#
6roducing& in class& a revised -3, analysis helps to provide students with closure on the
discussion.
("an fo t$e # case
1. Do you endorse *ustace%s analysis of the pro)ect at +otterdam# ow would you improve
on it#
This open#ended Fuestion is intended to stimulate a critiFue of 1ustace2s analysis. The )ey
point of ob$ection is her inclusion of the right#of#way in the analysis. A brief discussion
should establish that the option of the right#of#way should be exercised regardless of
whether the pro$ect at the +otterdam plant is underta)en. Therefore& the cash flows
associated 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 the
inconsistent 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 massive
differences in the time profiles of cash flow.
@. $hat should one do when -++ and N./ disagree in ran'ing mutually e"clusive pro)ects#
The answer is that one should focus on the ran)ing by N68& because it embodies a more
reasonable reinvestment#rate assumption than ?++ and because& in theory& N68 is the
amount by which the mar)et value of eFuity will change if the pro$ect is underta)en.
5tudents will need to chew this over a bit( the instructor might be prepared with some
comments 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.
H. Should Fawn be swayed by *ustace%s rhetoric#
1ustace2s behavior displays a number of classic games used by people attempting to
influence the resource#allocation process. 5tudents should see that such games tend to
obstruct rather than improve the process.
I. $hich pro)ect should Fawn approve# ow should he )ustify his decision to the board of
directors, who have already been e"posed to *ustace%s ideas#
The instructor can close the discussion with a vote and some summary comments on the
wide range of issues that might have driven the decision another way in a different setting.
Supp"e!enta" 'ec$nica" Notes
At the end of this teaching note are three supplemental notes the instructor may choose to
distribute 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 be
useful if distributed in advance of the discussion of the % case.
Supp"e!enta" Note 'N)' ;+eflections on the +eal Corld of 3apital %udgeting&< is useful
as a wrap#up note for distribution after discussions of both cases.
Co""atea" *eadings fo t$e # Case
The application of option#pricing theory to decisions involving real asset investments may
be new to students. Thus& supplementing their study of the % case with some of the following
readings might be useful'
%realey& +ichard A.& /yers& 5tewart 3.& and Allen& ,ran)lin. ;Jptions.< 6art H!
.rinciples of !orporate Finance. =th edition New Kor)' /c4rawL.ill .igher
1ducation& 200H!.
0ester& 3arl. ;Today2s Jptions for Tomorrow2s 4rowth.< arvard 2usiness
+eview /archLApril 1M=@!' 1:>L1H0.
/argrabe& Cilliam. ;The 8alue of an Jption to 1xchange Jne Asset for Another.<
3ournal of Finance >> /arch 1MI=!' 1IIL1=H.
Trigeorgis& Aenos& and 5cott 6. /ason. ;8aluing /anagerial ,lexibility.< (idland
!orporate Finance 3ournal 5pring 1M=I!' 1@L21.
Ana"ysis of t$e A Case
Citi+ue of capita"-invest!ent ana"ysis at Dia!ond C$e!ica"s
The A case presents information regarding -iamond 3hemicals2 investment criteria and
thus affords opportunities for the students to thin) critically about the incentives and the side
effects of the four hurdles.
*.S growth' This ob$ective is dubious. 1arnings per share can be easily
manipulated by changes in accounting policies& and the figure ignores the
investment 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 considerable
volume of academic evidence that the mar)et is not fooled by cosmetic changes in
165 but& instead& the mar)et values cash flows. ,inally& the method of
implementing this criterion may penali*e small pro$ects that ma)e a relatively
insignificant contribution to the corporation%s 165.
.aybac'' The classic flaws of paybac) are that it ignores the time value of money
and ignores cash flows occurring after the paybac) hori*on. Jne possible reason
that firms use this measure is that they feel financially constrained in their ability to
finance new pro$ects and wish to underta)e only those pro$ects that do not impose
Case A:
-iscussion
Fuestion 1
an unacceptable drag on the firm2s finances. Jne effect of the paybac) criterion is
to focus managers2 attention on near#term performance& possibly to the detriment
of longer#term investing.
N./ and -++' These measures most closely reflect the interests of investors and
fully account for the entire life of a pro$ect. 7nfortunately& they are also somewhat
more difficult to use than the other two measures& and may not always agree& as
shown in the % case analysis.
Jne virtue of -iamond 3hemicals2 evaluation approach is the system of varying
investment hurdles. 4enerally& the reFuired rates of return rise with the ris) of the pro$ects& which
is consistent with the general ris)"return framewor) of finance and is representative of systems
presently being adopted at ma$or corporations.
Adjust!ents to DC, ana"ysis
4reystoc)2s 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 one2s $udgment. The main issues to be resolved and the possible responses to each
are as follows'
*ngineering study' %ecause the funds are already spent& they should not be included in the
cash#flow analysis. The principle here is' -o not include sun) costs. The text of the case did not
highlight this issue& but sharp students will note it.
!orporate overhead allocation' These charges are not incremental flows of cash but&
rather& accounting allocations. 7nderta)ing the /erseyside pro$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 text
does not highlight this issue& but sharp students will raise it.
!annibali4ation of the +otterdam plant' 5tudents must confront the ;scope of analysis<
issue and ta)e into account the investors% perspective. 7nless managers adopt the perspective of
the owners of the corporation& they may ma)e suboptimal investment decisions. 6articularly
interesting here is the ambiguity about whether +otterdam will inevitably be cannibali*ed.
1vidently& the director of sales thin)s it will& whereas the mar)eting vice president thin)s it will
not if sales can be ta)en away from 5aone#6oulet and"or 8aysol 5.A. the competitors with the
next lowest costs!. -ifferent classes of students will have different $udgments about this issue& but
the comments in the case about the severity of the current recession are li)ely to suggest to
students that cannibali*ation is more probable than not. ?f cannibali*ation is expected to occur&
then +otterdam2s decline in after#tax gross profits must be reflected in the cash flows of the
/erseyside pro$ect.
5se of e"cess capacity in tan' cars' 7nderta)ing the /erseyside pro$ect will trigger no
purchase of tan) cars today& so some students will argue that the proposed shadow charge for
tan)#car capacity is inappropriate to include in the analysis. The counterargument is that
Case A:
-iscussion
Fuestions 2& >&
:& and H.
/erseyside will trigger an earlier expenditure than it would have otherwise. The proper
ad$ustment here is to reflect the change in timing of expected cash flows.
A second issue to consider is whose interests are at sta)e. 4reystoc) seems to suggest that
the pro$ect should be evaluated from the narrow perspective of the /erseyside Cor)s or the
?ntermediate 3hemicals 4roup& but a basic principle of capital budgeting is that pro$ects should be
evaluated from the standpoint of investors in the entire company. Thus& accounting for secondary
effects induced by underta)ing a pro$ect is appropriate no matter how far afield those effects are
from the business unit in Fuestion.
The final issue regarding the tan) cars has to do with the interdependence of excess
capacity and the cannibali*ation issue. ?f the class has decided that /erseyside will erode the
volume of +otterdam& some students may be tempted to argue that the spare capacity absorbed by
/erseyside will be offset by an increase in spare capacity from the decline in volume at
+otterdam. %ut the A case explicitly states that the rolling stoc) is not usable outside %ritain&
because of differences in trac) gauge.
!hanges in inventory' 5tudents often neglect to reflect in their expenditure analyses the
changes in wor)ing capital resulting from a pro$ect. 4reystoc) has shown an increase in raw
materials and wor) in process C?6! inventory driven by the increased throughput at the plant.
.e has ignored the potential recapture of that inventory& however& at the end of the pro$ect life.
The buildup of inventory does not simply vanish at the end of year 1:. 3ash in the amount of the
inventory buildup is thus shown in E&$ibits 'N1 and 'N2 as being returned during the 1:
th
year&
the last year of the pro$ect. ?nventory ad$ustments must also reflect the reduced wor)ing capital
reFuirement at +otterdam brought about by cannibali*ation. Those ad$ustments are reflected as
necessary in E&$ibits 'N1 and 'N2.
,d)ustment for inflation' 4reystoc)2s analysis in the A case indeed mismatches cash flows
and discount rates. 5tudents should be encouraged to discuss the need for internally consistent
assumptions about inflation in both cash flows and discount rate. The modification is
straightforward' students should inflate cash flows at >N and )eep the current discount rate of
10N.
1

1 5ome students might assume 0N inflation and use a IN discount rate. This is also correct but reFuires more
complicated ad$ustments. ?f students want to use real cash flows& they must also deflate the depreciation figures by
the annual inflation rate to reflect the loss in purchasing power of the tax savings associated with the depreciation.
E&taneous cas$ f"o-s and et$ics
4riffin Tewitt2s proposal to include the 163 ethylene#propylene#copolymer rubber!
pro$ect is characteristic of the )inds of adverse games that operating managers can play with
capital budgeting. ,or another example& Joseph %ower recounts how one manager built almost an
entire plant on the basis of small investment authori*ations that were within a manager2s own
power to approve.
2
The manager was caught when he submitted an investment proposal for a
chimney the cost of which exceeded his personal authori*ation limit!.
4reystoc)2s analysis should not be modified to include the 163 pro$ect for two reasons'
1. To do so is to violate the basic axiom of relevant cash flows' Jne should include only
those flows of cash that are incremental to the pro$ect being valued. As the case states& the
163 pro$ect is ;separate and independent< from the polypropylene#line renovation( its
flows simply do not belong in this valuation analysis.
2. To do so is at the least surreptitious and practically amounts to lying about the nature of
the pro$ect. 5enior executives have already re$ected the pro$ect. To include it in the
polypropylene pro$ect is to willfully undercut one2s own leaders& a failure of one2s
responsibility as an agent. The conflict of interest underlying this principal#agent
brea)down is clear in Tewitt2s own comments to maximi*e plant si*e& to maximi*e
personal bonuses& and to avoid layoffs because they are painful to ma)e. .e advocates this
step despite the implication that the shareholders will be worse off from this investment.
,inally& the potential personal ris)s to /orris are disproportionately greater than any
benefits she might receive. ,ailures of one2s duties as an agent tend not to be well received
in large& bureaucratic organi*ations.
Su!!ay of evisions and t$ei i!pact
3ontained in E&$ibit 'N1 is a memo from 4reystoc) and /orris to ,awn& the )ey
decision ma)er& in which changes have been made to reflect ad$ustments based on these five
issues. 5pecifically& the costs of the engineering study and overhead allocation have been dropped
from the cash flows. The forecast is given for cases of no erosion and full erosion of business at
the sibling plant. The cash#flow effect from the change in timing of new tan) cars is reflected& as
are the changes in inventory. The cash flows are discounted at the nominal rate of 10N& and
2 5ee Joseph A. %ower& (anaging the +esource ,llocation .rocess6 , Study of !orporate .lanning and
-nvestment %oston' -ivision of +esearch& .arvard %usiness 5chool& 1MI0!.
Case A:
-iscussion
Fuestion @
Case A:
-iscussion
Fuestion I
inflation of >N is incorporated into the models. ?n sum& the pro$ect offers a N68 of %ritish
pounds! OI.2M million and an ?++ of 22.:N or& if no ad$ustment were made for erosion& O1>.M2
million and >1.2N!. ?f the /erseyside pro$ect were to be evaluated now on a stand#alone& go"no#
go basis& it should be accepted.
The revised estimates in E&$ibit 'N1 afford a focal point for the students with which to
continue the analysis in the % case. ?deally& the instructor would hand out copies of E&$ibit 'N1
with little or no comment other than to say& ;This is how ,ran) 4reystoc) finally decided to
model the pro$ect.< The instructor should ta)e care not to hand out the memo as a ;solution< to
the case& because that might dampen any emphasis made earlier in the class about the large gray
area for $udgment in capital#expenditure analysis. ?n other words& E&$ibit 'N1 should not be
presented as the ;right< answer to the A case. An added caution is that once distributed& E&$ibit
'N1 may enter the body of solutions that students at some schools pass along to succeeding
classes. Thus& distribution of this exhibit may impair the Fuality of discussion the next time the
case is taught.
An alternative approach is for the instructor to allow the students to revise their own
analyses of the A case& consistent with the class discussions& and then to use those analyses as a
basis for discussion of the % case. This approach encourages variability in student analyses.
Ana"ysis of t$e # Case
Citi+uing E"i.abet$ Eustace/s ana"ysis: t$e ig$t-of--ay
As with the A case& students should be encouraged to scrutini*e the -3, analysis and offer
suggestions for possible improvement. ?n most respects& 1ustace2s analysis seems appropriate&
although as in the case with /erseyside& this teaching note recommends that nominal cash flows
and nominal discount rates be used. ?n addition& a close reading of the nature of the investment in
the right#of#way suggests that the right#of#way should be purchased& regardless of whether the
+otterdam pro$ect is underta)en. -iamond holds an in#the#money option to purchase for O>.:
million the right#of#way& which has a current mar)et value of OH million. This option is to expire in
six months. 1ven if the +otterdam pro$ect is not underta)en& -iamond should exercise the option
and sell the right#of#way at a profit& despite the fact that& in the % case& a director of the company
is Fuoted as asserting that land speculation is not -iamond2s business. ?f there were any
speculation& it occurred when -iamond bought the option in the first place( now it is time to
harvest a luc)y profit. ?n short& the exercise of the option is not incremental to the pro$ect( the
O>.: million outlay today& and the O>: million terminal value in 200H should be removed from the
cash flows of the +otterdam pro$ect.
>
?n my experience teaching this case& many students will ob$ect to 1ustace2s inclusion of the
right#of#way in the analysis for another reason' The lump#sum terminal value& which significantly
influences the N68 of the pro$ect& is uncertain. The consultant2s unsubstantiated estimate of a
terminal value of O>: million 1: years into the future is easy to challenge. Chile it is appropriate
> 1ustace2s analysis is incorrect for another reason. 5he used the O>.: million cash outlay the exercise price of
the option! rather than the OH million value of the land as the ;investment< in land. The OH million value is correct&
as it reflects the true opportunity cost of the land invested in the pro$ect. %ut this error is moot anyway since the
investment flows for the right#of#way should be removed from the pro$ect analysis.
Case #:
-iscussion
Fuestion 1
to scrutini*e ;)ey value drivers&< the instructor should ta)e care not to let students dispense with
the right#of#way simply because of its si*e or difficulty to value. ?f the problem is credibility& then
the answer is to get better information. ?t remains that the )ey intellectual test of whether to
include a flow of cash in a -3, analysis is whether that flow is incremental to the pro$ect.
E&$ibit 'N2 ad$usts the -3, valuation of the +otterdam pro$ect by excluding the cash
flows associated with the right#of#way& and by using nominal cash flows and discount rates. The
result is an N68 for the +otterdam pro$ect that is considerably lower than initially pro$ected. Also&
comparing the ?++s and N68s of +otterdam and /erseyside under the assumption of full erosion
yields inconsistent ran)ings. 'ab"e 'N1 shows the situation facing James ,awn in the % case'
Table TN1.
*otteda! (oject
without right#of#way!
0eseyside
(oject
Assumes NJ 1+J5?JN
at the sibling plant
N68 P O1@.M0 m
?++ P 22.2N
see E&$ibit 'N2!
N68 P O1>.M2 m
?++ P >1.2N
see E&$ibit 'N1-#!
Assumes ,7AA
1+J5?JN at the sibling
plant
N68 P O10.01 m
?++ P 1=.IN
see E&$ibit 'N2!
N68 P OI.2M m
?++ P 22.:N
see E&$ibit 'N1-A!
The analysis suggests that on an N68 basis& the +otterdam pro$ect dominates /erseyside in both
the full and non#erosion scenarios. ?n terms of ?++& however& /erseyside dominates +otterdam.
3learly& N68 and ?++ disagree in their ran)ings. 4enerally& one2s preference for either pro$ect
depends on the discount rate one assumes& as shown in the table in E&$ibit 'N) and in the graphs
given in E&$ibits 'N1 and 'N2.
The disagreement in ran)ings offers two important learning opportunities' 1! why the
differences 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$ects2 free cash flowsGthese are
compared graphically in E&$ibit 'N3. +otterdam2s cash flows are large later on( /erseyside2s are
comparatively 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& both
should be accepted. Apparently& -iamond 3hemicals can use IN more capacity in polypropylene
production& but not 1@N more. Thus& only one of the two pro$ects may be accepted& no matter
how good the other pro$ect loo)s independently.
Case #:
-iscussion
Fuestion 2
Case #:
-iscussion
Fuestions >
and @
The textboo) solution to this ran)ing problem is to ta)e the pro$ect with the highest N68.
,irst& N68 assumes the firm reinvests cash at a rate eFual to the discount rate 10N!& whereas
?++ assumes higher reinvestment rates& which may not be replicable. 5econd& N68 has a
straightforward interpretation' ?t is the amount by which the mar)et value of the firm will change
if the pro$ect is underta)en. ?f we are ta)ing the investors2 point of view& such a statistic is
extremely relevant.
Jn the basis of N68 calculated on the two pro$ects2 cash flows& James ,awn would
probably find the selection too close to call. %ut perhaps the N68 analysis ignores hidden real
options.
'$e i!pact of ea" options
This consideration is appropriate to explore with students who have been exposed to
option#pricing theory and the concept of real options. ? li)e to emphasi*e to students that the
value of a pro$ect consists of the -3, value of determinate cash flows plus the value of options
the pro$ect may containGrather li)e valuing a convertible bond in which we value the bond and
option pieces separatelyG and then sum. 3onceivably& there are many options latent in both
pro$ects. 5ince the plants in +otterdam and /erseyside are identical and since the choice between
them is mutually exclusive& ? prefer to assume away most of the latent options by saying that they
don2t help us differentiate between the two investment alternatives. .owever& the % case
highlights options associated with technological change that may help us differentiate between the
two. 'ab"e 'N2 summari*es the technology choice options latent in the two proposals'
Table TN2.
*otteda! 0eseyside
New technology
commitment at initiation
of pro$ect
Japanese process
controls
No initial new
technology commitment
Jptions! present Jption to switch from
Japanese to 4erman
technologies
1. 3all option on the
Japanese technology
2. Jption to switch
from Japanese to
4erman technologies
>. Jption to delay
The Fuestion here is whether the values of the real options are significant enough to influence the
managerial decision in this case. The learning point for students here is to see that the N68
Case #:
-iscussion
Fuestion :
analyses ignore the creation or destruction! of options( they focus only on the flows of cash. An
appropriate approach is to frame the investment decision as a comparison between the N68s of
the two pro$ects2 incremental cash flows plus the values of the call options on process#control
technology at each of the two plants. ?n other words& the simple comparison of N68s ignores an
important component of value.
'eac$ing stategies fo t$e ea" options issue
-iscussion of the real options issue should be tailored carefully to the capabilities of the
class.
Novices' Cith degree students who have had little or no prior exposure to option theory&
the options could be treated as Fualitative considerations. .ere& the approach would be to help
students see that the two pro$ects have very different stances toward the new technologies. Then
the instructor could as)& 0-n your opinion, does (erseyside%s 7wait-and-see% approach have any
merit 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 in
estimating 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 teaching
ob$ectives for the day.
-ntuitive presentation' To gain some degree of closure on the real option issue at
the intuitive level& the instructor must help the students reason through the types of
options embedded in each pro$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$ect contains an option to switch that is deeply out#
of#the#money& and unli)ely to be exercised. /erseyside contains 1! a call option
on the Japanese technology& 2! an option to switch from Japanese to 4erman
technologies& and >! an option to continue to delay further without ma)ing any
investment at all. The Japanese technology option is probably in#the#money. The
4erman option is less clear& but one could reason that& at worst& it is probably not
far out#of#the#money. ?n short& the /erseyside options are probably more valuable
than the +otterdam options. 5ince the N68s are close& the relative option values
may be enough to tip the financial evaluation in /erseyside2s favor.
Numeric presentation' The actual estimation of the technology option values
associated with each pro$ect is the most time#consuming approach& and should be
supplemented with transparencies or handouts. ?n my experience& students left on
their own rarely address all the reFuired issues in the numeric estimation of the
pro$ects2 options. The teacher will need to add some structure to the unfolding of
this aspect of the discussion. The structure of this presentation is similar to the
intuitive approach& but employs assumptions given in the case and an option#
pricing model to arrive at numeric estimates. The sections that follow provide a
foundation for this presentation.
Nu!eic esti!ates of option va"ue at 0eseyside and *otteda!
The /erseyside pro$ect contains rights to invest later in the Japanese or the 4erman
control systems& as well as the right to do nothing. This is a trinomial problem& the formal solution
of which goes well beyond the mastery of most /%A finance students. %ut one simplifying
assumption 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 the
option value of continuing to wait indefinitely is Fuite small. The evidence for this optimistic
assumption is that the N68 of the Japanese technology is positive( the option on the Japanese
technology is already in#the#money. ?f the 4erman technology is successfully commerciali*ed& one
can assume that it will have a positive N68& too. ,rom this perspective& investing in either of the
new 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 each
technologyGbut 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 new
technologies& and then to switch to the other. 4iven what we )now about the uncertain
commerciali*ation of the 4erman technology& the logical inference is that /erseyside contains a
call on the Japanese technology& with an option to switch to the 4erman technology once the
viability of the 4erman technology becomes )nown.
The +otterdam pro$ect ta)es a very different posture toward the new technology. ?t
commits to the Japanese technology now& but retains the flexibility to switch to the 4erman
technology later. 5ome students will resist the notion that +otterdam would ever be re#engineered
to the 4erman technology& as suggested by the statements in the % case. Their intuition is not
unreasonable. Aoo)ing forward from the date of the case& it is uneconomical to install the
Japanese technology and use it for only five years. %y then& executives will face positive cash
flows and a relatively high N68 by not switching& since the investment in the Japanese technology
will have been a sun) cost. ?t would be unli)ely for the new 4erman technology to be attractive
enough to replace what is already operating.
The rights on new technology at both /erseyside and +otterdam include switching
options. Cilliam /argrabe has modeled the option to switch as a 1uropean option to exchange
one asset for another.
@
The analysis here follows his presentation'
8alue of option to switch P 64NQd1R S 6JNQd2R
64 P exercise price of the 4erman technology O>.=: million
:
!
6J 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 Jption to 1xchange Jne 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 10N. 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 10N.
I This consists of the sum of the forgone benefits of the Japanese technology and the cost of installing the
84 P standard deviation of the 4erman#technology returns 0.0=!& % case footnote >
8J P standard deviation of the Japanese#technology returns 0.0=!& % case footnote >
T P correlation of N684 and N68J 0.=0!& % case footnote >
8
2
P 8J
2
U 84
2
S 2848JT 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 0N
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
/erseyside2s option to switch is positive but relatively small and because of the
simplifying
10
assumptions& it should be regarded as a conservative estimate. The surprisingly low
option value reflects the high covariance between the returns on the Japanese and 4erman
technologies.
+otterdam2s option to switch is virtually worthless. The huge N68 forgone O2:.MM
million& the ;lost< cash flows from the Japanese system in years HL1:! renders the switching
option deeply out#of#the#money. .ence& the flexibility to change technology at +otterdam is
worth little.
/erseyside also contains a call option on the Japanese technology. The case and student
analysis can provide parameters to insert in a standard %lac)#5choles option#pricing model shown
in 'ab"e 'N)'
Table TN>.
Ca"" Option
on 4apanese
'ec$no"ogy
Souce
6rice O10.01
N68 full erosion!& E&$ibit
'N2
4erman technology. The present value of the +otterdam pro$ect2s free cash flows under the Japanese technology
from years H to 1:& discounted at the 10N hurdle rate& is O2>.H million. The assumed outlay for the 4erman
technology is O2.>M million. As mentioned in footnote :& the assumption is that the 4erman and Japanese systems
are comparable in cost. O2.>M million is the present value of the investment outlays at +otterdam& with those
outlays situated in years H through = rather than in 1 through >.
= ?n /argrabe2s analysis& the variance of the underlying must account for the covariance between the two
exchangeable assetsGthe third term in the variance calculation accounts for this covariance. The odds of the return
on one asset greatly exceeding the other are greatly reduced when the returns on the two assets are positively
correlated as they are in this case.
M According to /argrabe& the ris)#free rate applicable in estimating the option to exchange is *ero. The ;stri)e
price< earns a fair rate of return already because it is a fairly priced asset.
10 The analysis assumes away any value to the option to delay further investing in new technology.
Ca"" Option
on 4apanese
'ec$no"ogy
Souce
1xercise O>.=: 68 outlays& E&$ibit 'N2
Term : yrs. % case
8olatility 0.0= % case footnote >
?nterest rate 0.0::
Nominal rate in % case footnote
>
Ca""-option va"ue OI.0M mm
Jne final ad$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 :0N probability of successful
commerciali*ation. ,or /erseyside& there is a :0N chance that the option to switch will have any
value and a :0N chance that they have a simple call option on Japanese technology. Thus& the
option value at /erseyside is a probabilistically weighted average of the two option outcomes as
shown in 'ab"e 'N1'
Table TN@.
*e"evant Option
5a"ue
(obabi"ity 6eig$ted
5a"ue
'ota" 6eig$ted
Option 5a"ue at
0eseyside
4erman technology is
successfully
commerciali*ed
O0.1I@ m switch!
O I.0M m call!
OI.2H@ million
0.:0 O>.H> m
OI.1= m
4erman technology is
not successfully
commerciali*ed.
OI.0M million
simple call option!
0.:0 O>.:: m
Ana"ytica" conc"usions
To summari*e' The value of each of the pro$ects is regarded as the sum of the N68s of the
cash flows and option values as shown in 'ab"e 'N2'
Table TN:.
,u"" Eosion No Eosion
/erseyside +otterdam /erseyside +otterdam
N68 cash
flows as
ad$usted
OI.2M m O10.01 m O1>.M2 m O1@.M0 m
Jption value OI.1= m O0.00 m OI.1= m O0.00 m
Total value 711819 ! 710801 ! 721810 ! 7118:0 !
Chen the value of the technology options is added to the analysis& the ran)ing of the two pro$ects
reverses from the simple N68#based ran)ing. This reversal& combined with the li)elihood that the
value of options at /erseyside is greater after accounting for the option to wait indefinitely!& will
lead many students to conclude that ,awn should accept the /erseyside pro$ect. ?f time permits&
the class discussion might touch on two final Fualitative considerations.
%ua"itative ;ssues
;nte""ectua" capita"
1li*abeth 1ustace ma)es the argument that the +otterdam pro$ect moves -iamond
3hemicals down the learning curve in the deployment of advanced control systems. Aearning or
intellectual capital! is valuable& though it is not an asset that is readily valued. Jrgani*ations that
truly value this learning would attach some worth to 1ustace2s claim. 5tudents can reflect on
whether 5ir -avid %en$amin& the raider who threatened -iamond with a ta)eover& would be
patient enough to see the value of that learning reflected in the firm2s share price.
#udget ga!es
1ustace 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. The
assistant plant manager in the A case illustrated a related game' circumventing one2s
leaders altogether.!
2. 5upporting the reFuest with voluminous data the M0#page proposal!& but with the data
arranged 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 marginal
changes!.
?f time permits& the instructor may wish to invite students to discuss the possible impact of those
budget games.
Su!!ay
E&$ibit 'N9 summari*es the structure of the decision problem facing James ,awn& the
decision ma)er in the % case. The diagram shows that uncertainties about the commerciali*ation
and the returns from the process technologies add considerable complexity to the either#or
decision in the % case.
11 3hris Argyris& 8vercoming 8rgani4ational Defenses %oston' Allyn and %acon& 1MM0!& =.
Case #:
-iscussion
Fuestion H
An analysis of the two cases reveals ma$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 the
student with the importance of reflecting on basic economic notions.
1xhibit TN1
D;A0OND C<E0;CA=S (=C >A? AND >#?
1xcerpts from /orris2s 1xpenditure 6roposal /emo +egarding the /erseyside 6ro$ect
To' James ,awn
,rom' Aucy /orris and ,ran) 4reystoc)
5ub$ect' 3apital 1xpenditure 6roposal' 6olypropylene Aine 1nhancements /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$ustment
for possible business erosion at +otterdam& while part % does not ma)e that ad$ustment.
X The results are'
1rosion No 1rosion
N68 OI.2M m O1>.M2 m
?++ 22.:N >1.2N
X The costs of the engineering study and corporate overhead allocation have been excluded
from the analysis& per discussions with John 3amperdown.
X Tan)#car expenditure occurs earlier in time& and changes in depreciation tax shields are
reflected herein.
X The discount rate used is 10N& and the cash flows used are nominal& rather than real cash
flows.
Ce would be happy to respond to any remaining Fuestions you or the board may have.
1xhibit TN1 continued!G6art A
+evised and ,inal -3, Analysis' /erseyside 3apital 1xpenditure 6rogram
reflects charge for ,7AA 1+J5?JN of +otterdam business volume!
1xhibit TN1 continued!G6art %
+evised and ,inal -3, Analysis' /erseyside 3apital 1xpenditure 6rogram
reflects NJ 3.A+41 ,J+ 1+J5?JN of +otterdam business volume!
1xhibit TN2
D;A0OND C<E0;CA=S (=C >A? AND >#?
Analysis of +otterdam 6ro$ect& 1xcluding ?mpact of the +ight#of#Cay ?nvestment
financial values in millions of %ritish pounds!
1xhibit TN>
D;A0OND C<E0;CA=S (=C >A? AND >#?
-iscounted 3ash ,low +esults 3omparison
N.%. 4rey highlights region of ;crossover.<
5ource' case writer analysis.
1xhibit TN@
D;A0OND C<E0;CA=S (=C >A? AND >#?
5ource' 3ase writer2s analysis.
1xhibit TN:
D;A0OND C<E0;CA=S (=C8 >A? AND >#?
5ource' 3ase writer2s analysis.
1xhibit TNH
D;A0OND C<E0;CA=S (=C >A? AND >#?
5ource' 3ase writer2s analysis.
1xhibit TNI
D;A0OND C<E0;CA=S (=C >A? AND >#?
5ummary of the -ecision 6roblem ,acing James ,awn
5upplemental Note TN1
DIAMOND CHEMICALS PLC (A) AND (B)
+elevant 3ash ,lows
The basic axiom in capital#expenditure analysis is ;3ash is 0ingY< Ai)e most slogans&
however& adhering to this maxim is easier said than done. The thoughtful analyst will routinely
encounter subtle and sophisticated challenges to the basic focus on cash flow. To provide a more
operational form of the basic axiom& here are some guidelines for use in determining which cash
flows are relevant for capital#investment analysis'
X -gnore sun' costs' All investment analysis should be marginal and forward
loo)ing. ?f we include past cash flows in our analysis& we might overburden
good pro$ects with the sins of the past or ma)e bad pro$ects seem attractive
simply 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 prospective
investment is attractive.
1
The capital#expenditure analyst necessarily loo)s
forward& rather than bac)& and see)s to consider the real economic events. Jne
should not mix the two perspectives. Jne should be suspicious of any item
called a ;charge< or an ;allocation.<
X -gnore cash flows of unrelated pro)ects' To analy*e a capital#expenditure
proposal fairly reFuires that one focus only on the cash flows that are
incremental to the pro)ect. To do otherwise would confound the analysis and
may very well be unethical.
X +eflect the impact of the pro)ect anywhere it may occur in the company'
/anagers are called upon to account for the investors2 perspective in ma)ing
their investment decisions. Jne should be extremely suspicious of analyses that
ignore possible side effects on other divisions of the company.
1

Accounting Fuestions include& 1! .ow did the firm do last year as opposed to the year beforeD 2! Cere the
accounting statements fairly )eptD >! .ow should the costs and revenues be allocated between one year and the
nextD @! 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 case
study ;-iamond 3hemicals 6A3. A!&< 78A#,#1>:1!. 3opyright E 1MM2 by the -arden 4raduate %usiness
5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals A!&< and
instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this
note for classroom use.
5upplemental Note TN1 continued!
X +eflect the e"pected timing of the cash flows' Cith the focus on real economic
events& it is inappropriate to accelerate or delay cash flows or to lump them to
one point in time.
X Don%t forget terminal values and abandonment costs' These costs may be
material 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 to
assume a recapture of that investment at the end or to $ustify the failure to
recapture it. 5imilarly& intangible assets may have a value that carries past the
forecast hori*on and can be recaptured. ,inally& to assume that the business
simply continues to operate may ma)e sense( doing so will reFuire an estimate
of 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 techniFues
are still underutili*ed.
X The best capital-e"penditure analysis practices will not guarantee that the
right decisions get made' The real challenge is to get managers to thin) li)e
investors. 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.
5upplemental Note TN2
DIAMOND CHEMICALS PLC (A) AND (B)
8aluing /anagerial ,lexibility and 3ommitment
Jne of the limitations of discounted cash flow is that it does not capture well the strategic
aspects of capital investment. 5uch strategic elements include the right to ma)e future
investments& the right to sell or liFuidate in the future& the right to abandon& and the right to
switch 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. Jne 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 include
flexibility 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 and
the value of its fle"ibility or commitment. The challenge in thin)ing about capital investments this
way lies in placing a value on flexibility and commitment. ,ortunately& option#pricing theory can
help with this challenge.
Si!p"e Options
The )ey tas) is to define elements of flexibility or commitment in terms of options& and
then use the theory to estimate a value. As a general rule& flexibility is analogous to a long position
in call or put options. 3onversely& commitment is analogous to a short position in call or put
options. .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 case
study ;-iamond 3hemicals 6A3. %!&<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 who
have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for
classroom use.
5upplemental Note TN2 continued!
9ong call' X +ight to invest at some future date& at a certain price
X +ight to harvest
1
at some future date
X 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 to
accelerate harvesting
Short call' X 6romise to sell if the counterparty wants to buy
X 4enerally& any commitment to disinvest or accelerate harvesting upon
the 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 the
action 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 simple
approach brea)s down when the options are interdependent or mutually exclusive. The classic
example involves the flexibility to switch investments or to choose investments! at some future
date. ,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 reader2s thin)ing. ,or instance& consider that
you 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 trees2 value is Fuite similar
to analy*ing the investment in an +Z- program& where each year2s investment extends the harvesting hori*on by
one year.
5upplemental Note TN2 continued!
,or instance& Cilliam /argrabe has modeled the right to switch as a 1uropean option to
exchange one asset for another.
2
The analysis here follows his presentation'
8alue of the option to switch P 64NQd1R S 6JNQd2R
where'
64 P exercise price of ma)ing investment 4
6J P exercise price of ma)ing investment J
84 P standard deviation of the uncertain returns on investment 4
8J P standard deviation of the uncertain returns on investment J
6 P correlation of N684 and N68J
8
2
P 8J
2
U 84
2
S 2848J6!
.:
P variance of returns in the exchange
T 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
Jptions are always valuable& even if deeply out#of#the#money. Therefore& the options
latent 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 and
consider them in ma)ing final recommendations.
2

Cilliam /argrabe& ;The 8alue of an Jption to 1xchange Jne Asset for Another&< 3ournal of Finance >>
/arch 1MI=!' 1IIS1=H.
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! cash
flow! 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 difficulties
that 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. Jptions
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 to
incorporate all options in the analysis( simply identifying the latent options can be a
challenge. 5econd& the volatilities on which the value estimates depend are daunting to
estimate. Nonetheless& as ;-iamond 3hemicals 6A3. %!&< case 21! shows& the values
of 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. A
capital#budgeting system sends signals to managers that define what a good pro$ect is.
Jne needs to be extraordinarily careful in the design of these systems in order not to
send the wrong signals. -iamond 3hemicals used four criteria& of which earnings per
share 165! growth and paybac) have obvious defects see Supp"e!enta" Note 'N1!.
The flaws of ?++ emerge in instances where ?++ and N68 disagree about the ran)ing
of two mutually exclusive pro$ects. The reason they disagree has to do with the
dramatically different time profiles of cash flows& as indicated in ,igue 'N1( the
+otterdam proposal with its huge terminal value was much more sensitive to changes
in discount rates than was the /erseyside proposal.
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case
study ;-iamond 3hemicals 6A3. %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool
,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6A3. %!&< and
instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this
note for classroom use.
5upplemental Note TN> continued!
,igure TN1
,igue '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. /erseyside2s cash flows are relatively large earlier in time( +otterdam2s are relatively
large later. $hen -++ and N./ disagree, rely on the recommendation indicated by N./. There
are two reasons for following this rule'
1. ?mplicit in the mathematics of discounting is the assumption that earnings on the pro$ects
will be reinvested to yield a return eFualing the discount rate. ?n N68 calculations& this
reinvestment rate of return is the weighted#average cost of capital& which is not an
unreasonable 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 how
much value the pro$ects create at the investors% re:uired rate of return.
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case
study ;-iamond 3hemicals 6A3 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool
,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6A3 %!&< and instructors
who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for
classroom use.
5upplemental Note TN> continued!
5tated differently& whenever you suspect that a ;crossover problem< might exist& use N68 for
decision#ma)ing.
Another prominent issue under the panoply of system design is choice of discount rate.
-iamond 3hemicals used a ris)#ad$usted system by functional type of pro$ect. ,inance theory
would applaud this approach as far as it goes. Jne must be prepared to adapt the system to
unusual proposals& however& such as +otterdam2s& which could be viewed as a combination of
plant maintenance and real estate arbitrage. This instance might profit from decomposing the
bundle and valuing the two pieces at their respective appropriate ris)#ad$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 system
to the characteristics of the asset being valued. Jf 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 to
avoid inadvertently sending the wrong signals. /oreover& a system that is tailored for every
pro$ect may be seen as being completely arbitrary and able to be manipulated. ,inally& decision
ma)ers will filter the output of such a system in their own ways. ,or many senior corporate
executives& the trac) record of the executive sponsoring the proposal is about as influential as
N68.
The practical implication of this example is that N68 is a necessary& but not sufficient&
condition for pro$ect approval. The human#behavioral side of resource allocation potentially
overshadows all attempts at rigorous Fuantitative analysis. This reminder leads to the third and
final barrier.
>. Dealing with political 0games1' ?n ;-iamond 3hemicals 6A3 %!&< 1li*abeth 1ustace has
framed the political landscape in ways that may prevent the proper economic decisions
from being made. 1ustace2s behavior included the following'
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case
study ;-iamond 3hemicals 6A3 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool
,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6A3 %!&< and instructors
who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for
classroom use.
5upplemental Note TN> continued!
5ee)ing approval or support of a budget reFuest from more than one supervisor
5upporting the reFuest with voluminous data the M0#page proposal!& but with the
data arranged 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 marginal
changes!
Jther classic games are'
5elling a new program modestly& thereby concealing its real magnitude
3oncealing a politically unattractive program within an attractive program
6laying competing committees or managers against each other
The reality is that games such as those permeate the capital#investment environment in most
corporations and are believed to have a significant influence on decisions.
>
Chat is to be doneD The naive conclusion from all of this is that -3,#based systems are of
little practical use. 0nowledgeable analysts can draw a different conclusion' -3, is easy to misuse
and abuse& but in a world of economic ris)& strategic uncertainty& and politics& it can be
enormously helpful in focusing managers2 thin)ing on the economic conseFuences of their actions.
?n sum& where the budgeting analyst adds value is by ma)ing the process of capital#expenditure
analysis wor) rigorously& fairly& and honestlyGnot an easy tas)& but certainly worthy wor).
>

5ee 3hris Argyris& 8vercoming 8rgani4ational Defenses %oston' Allyn and %acon& 1MM0!. The discussion of
games in this note draws on insights discussed at more length by Argyris. 6age = of his boo) identifies a number of
specific gambits& some of which are mentioned here.
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case
study ;-iamond 3hemicals 6A3 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool
,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 6A3 %!&< and instructors
who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for
classroom use.