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MSDI – Alcala de Henares, Spain

Submitted By: Jaya Prakash Kommu, 2009PGP098

Problem Statement
Merk & Co., Inc was reviewing an investment proposal from MSDI, its facility in Spain. The value of this
investment has to be evaluated using discounted cash flow method. The problem which the company has to
solve is to decided among the following three options:

 Discounted cash flow analysis should be performed in USD


 Discounted cash flow analysis should be performed in pesetas
 Discounted cash flow is independent of currency

Case Facts

Merck & Co., Inc


 Large multinational producer of pharmaceuticals for human and animal health care
 1987 Projected sales: ~ $5 billion
 Year ended December 31, 1986
 Reported earnings: $676 million
 Reported sales: $4,129 million
 Company’s extensive international operations are conducted primarily through subsidiaries grouped
within its MSDI division and the facilities include:
o Manufacturing facilities
o Research laboratories
o Experimental farms in 20 countries
o Sales and marketing subsidiaries in many more
 In 1986: subsidiaries outside the US recorded sales approx half of Merck’s sales and pretax income of
slightly less than 40%

Operations at Alcala de Herares


 Manufacturing facility, research laboratory and experimental farm owned by Merck
 Primary production process – washing, filling, inspecting and sealing of ampoules of Lidocaine. The
process was semi-automated.
 In 1987, the increase in capacity resulted in shortage of resources. The alternatives available are:
o An added shift of 10 workers
o Photo electric sensing machinery + 4 workers

Jaya Prakash Kommu


New cost saving proposal
Comparison between the new and old proposals
Semi-automated Fully automated
Workers required 10 4, under favorable conditions 3
Training 2 to 3 months Less that semi-automated approach
Rejection rate of ampules 11% 3%
Direct training and labor cost High Low
Capacity 4.8 million ampoules per yr 6 million ampoules per year

Analysis

Three possibilities
The following three cases are possible in the way Merck & Co., Inc deals with its cash flows from its
subsidiaries.

1. The cash flows which come in peseta are reinvested in the local currency (peseta). Therefore the
opportunity cost of capital(the rate at which cash flows are discounted) should be that of peseta
2. The cash flows which come in peseta are converted to USD as an when they are received.
3. The cash flows conversion to dollars does not follow a pattern.

Possible valuation approaches


For each of the three cases mentioned above the corresponding valuation approaches are as follows:

1. Use cash flows in peseta and discount them using peseta discount rate (opportunity cost at subsidiary).
NPV that is obtained is in peseta which is converted to USD using the spot rate.
2. Convert the cash flows from peseta into USD using future exchange rates. Calculate NPV using $
discount rate.
3. Estimate the rate at which peseta cash flows are converted to dollars. Get the corresponding $ amount
and discount it using $ discount rate.

If parity condition holds in two currencies, then all the three approaches will result in the save value. Therefore
the value of the investment is independent of the approach. However in the next five years peseta is predicted
to appreciate against dollar. The reason is because of the improvements in performance of Spanish economy
in the recent years. The GDP has doubled in the past 4 years (from 1984 to 1987).

Merck & Co., Inc can reinvest their cash flows in peseta because of the following reasons:

 Spanish economy is developing, and it makes more sense for Merck & Co., Inc to reinvest their cash
flows in local currency.
 Operations at Alcala de Henares is into research are development and not sales. Therefore the cash
realized might not be translated readily into dollars.

Therefore valuation approach 1 can be used for the purpose of evaluating the value of the investment.

Jaya Prakash Kommu