MSDI

Alcala de Henares Manager (Route B) Analysis

Years Ending December 31 1988 1989 1990 1991 1992 1993
Projected Ampule Volume
(000) 4,590 4,258 4,166 4,020 3,854 3,702
Projected Operating Costs
Semiautomatic Equipment:*
Materials 14,872 14,900 15,744 16,407 16,988 17,624
Direct Labor 29,376 29,431 31,099 32,410 33,557 34,812
Overhead** 44,248 44,331 46,843 48,817 50,546 52,436
TOTAL 88,496 88,662 93,686 97,634 101,091 104,872
Projected Operating Costs,
New Photoelectric Equipment:*
Materials 13,678 13,704 14,480 15,091 15,625 16,210
Direct Labor 11,750 11,773 12,440 12,964 13,423 13,925
Overhead** 44,248 44,331 46,843 48,817 50,546 52,436
TOTAL 69,676 69,808 73,763 76,872 79,594 82,571
Equipment cost 61,525
Less salvage 950
Less tax loss 229
Net Investment 60,346
Annual Cash Savings 18,820 18,854 19,923 20,762 21,497 22,301
Less Added Depreciation 5,618 5,618 5,618 6,153 6,153 6,153
Taxable income 13,203 13,237 14,306 14,610 15,345 16,149
Taxes 4,621 4,633 5,007 5,113 5,371 5,652
Net Cash Flow (60,346) 14,199 14,221 14,916 15,649 16,126 16,649
Discount Rate 20% <-----Reflects (if nothing else) the differences in inflation rates Spain vs US. Merck's USD WACC adjusted for
Spain. You can look at this as the Merck corporate risk premium (15%-8.6%) + Spanish gov. rate of 13.2%
However, it may also reflect some country risk, which is OK. In any case we are discounting pesetas at a peseta rate.
NPV = 5,306 pesetas (000s)
IRR = 22.4% Note that the IRR is a little skinny relative to the discount rate. There is not a lot of room for added risk. On the
other hand, this project is cost reduction in a stable product line. Unless there is some unknown technological risk,
NPV 41,781 $ USD one could very well argue for a lower discount rate. Merck corporate rate reflects risks in R&D that this project does
not have. There is exchange rate risk. But that is John Veniero's problem.
John Veniero Analysis (Merck Corporate-Route A)
My thinking is that John would want to do everything in USD. That presents him with a problem--expected exchange rates.
There is also an issue of exchange rate risk management and financing; however this is not well developed in the material.
Looking at the financing problem, we have no knowledge of the availability of internal (peseta) financing. Therefore we cannot
say that financing through peseta debt is appropriate. Financing a peseta investment in USD does not seem right, but even
here, we don't know what Merk's overall exposure in Spain is, much less its world-wide situation or its approach to FX exposure
management--centralized, regional, local?
If you forecast exchange rates using International Fisher based on comparative government interest rates, you will get the essentially same
NPV in USD as above. Check it out. So why bother. The only reason to look at the problem is if you want to consider some other
approach. To emphasize again, there is a difference between valuation (NPV) and exchange risk considerations.
Here, there is a bigger difference between current inflation rates in the two countries than the difference in interest rates.
Suppose you use PPP for an exchange rate forecast using recent history:
Net Cash Flow pts -60345.75 14199.125 14221.23 14916.08 15648.68 16126.43 16649.03
PPP Exchange rate 127 135.6 144.8 154.6 165.1 176.2 188.2
(1.9% US, 8.8% Spain)
Net Cash Flow USD (475,163) $ 104,714 $ 98,225 $ 96,491 $ 94,810 $ 91,508 $ 88,482 $
NPV @ 15% (6,227) $
IRR = 14.6%
So, if you like PPP and these inflation forecasts, the project looks like it is not worth doing!
Plus there is the exchange risk problem, which might be offset by project safety (relatively predictable cash flows).
The point of all this was intended to suggest the potential for conflicts between local and corporate management.
Comparison of Exchange Rate Models:
PPP
Spanish Inflation Rate = 8.0%
US Inflation Rate = 2.0%
PPP Exchange Rate Forecast 134.5 142.4 150.8 159.6 169.0 179.0
IFE
Spanish Interest Rate = 13.2%
US Interest Rate = 8.6%
IFE Exchange Rate Forecast 132.4 138.0 143.8 149.9 156.3 162.9
1994 1995 1996 1997
3,566 3,443 3,335 3,240
18,334 19,118 20,000 20,985
36,216 37,764 39,506 41,451
54,551 56,883 59,506 62,436
109,101 113,765 119,012 124,872
16,863 17,584 18,395 19,301
14,487 15,106 15,803 16,581
54,551 56,883 59,506 62,436
85,901 89,573 93,704 98,318
23,200 24,192 25,308 26,554
6,153 6,153 6,153 6,153
17,048 18,040 19,156 20,402
5,967 6,314 6,704 7,141
17,233 17,878 18,604 19,413
<-----Reflects (if nothing else) the differences in inflation rates Spain vs US. Merck's USD WACC adjusted for
You can look at this as the Merck corporate risk premium (15%-8.6%) + Spanish gov. rate of 13.2%
However, it may also reflect some country risk, which is OK. In any case we are discounting pesetas at a peseta rate.
Note that the IRR is a little skinny relative to the discount rate. There is not a lot of room for added risk. On the
other hand, this project is cost reduction in a stable product line. Unless there is some unknown technological risk,
one could very well argue for a lower discount rate. Merck corporate rate reflects risks in R&D that this project does
not have. There is exchange rate risk. But that is John Veniero's problem.
My thinking is that John would want to do everything in USD. That presents him with a problem--expected exchange rates.
There is also an issue of exchange rate risk management and financing; however this is not well developed in the material.
Looking at the financing problem, we have no knowledge of the availability of internal (peseta) financing. Therefore we cannot
say that financing through peseta debt is appropriate. Financing a peseta investment in USD does not seem right, but even
here, we don't know what Merk's overall exposure in Spain is, much less its world-wide situation or its approach to FX exposure
If you forecast exchange rates using International Fisher based on comparative government interest rates, you will get the essentially same
NPV in USD as above. Check it out. So why bother. The only reason to look at the problem is if you want to consider some other
approach. To emphasize again, there is a difference between valuation (NPV) and exchange risk considerations.
Here, there is a bigger difference between current inflation rates in the two countries than the difference in interest rates.
17233.38 17878.18 18603.58 19413.48
200.9 214.5 229.0 244.5
85,780 $ 83,345 $ 81,227 $ 79,388 $
Plus there is the exchange risk problem, which might be offset by project safety (relatively predictable cash flows).
189.5 200.6 212.4 224.9
169.8 177.0 184.5 192.3