Description
analysis of MSDI case used in Strategic Financial Management.
KeyWords: WACC, NPV, Forward Rate, Spot Rate.
MSDI – ALCA De HENARES, SPAIN
MSDI – ALCA De HENARES, SPAIN
Synopsis:
The case talks about a large producer of pharmaceuticals, Merck Sharpe & Dohme International, MSDI, focusing specifically on its operations in ALCA De HENARES, SPAIN. At Spain, one of the primary process consisted of washing, filling, inspecting and sealing the ampoules of Lidocaine. It is stated that in spring 1987, it was running at 200% of planned capacity. To sustain this level of production 10 more workers were needed, who in turn needed 2 – 3 months of training. An alternative that was available and being considered was investing in new equipment, which had a capacity of 6 million ampoules per year, i.e., 25% more capacity than was anticipated. Decision is required to be taken on whether or not this would be a worthwhile investment or not?
Solution:
The attached excel has the calculations pertaining to the NPV of the new machine.
MSDI Case_VerFinal.xls
We have used two methods to calculate the NPV. In the first alternative, we find out the WACC of the company in Spain by using the following formula:
WACCMERCK-SPAIN =[(1+ WACCUSA )* (1+ INFLATION RATESPAIN )/ (1+ INFLATION
RATEUSA )]-1
Then using this as the hurdle rate, we discount the cash flows to find the NPOV in pesetas.
The Pesetas NPV value is divided by the spot exchange rate to arrive at the NPV USD NPV (In Pesetas) NPV (In USD) 11993.6 2 94.44
In the second alternative, we calculate the forward rates using Law of one price (Pesetas/US $)
Forward Rate=Spot Rate* [(1+ INFLATION RATESPAIN )/ (1+ INFLATION RATEUSA )]
Then we calculate the cash flows in USD terms and then discount using the US hurdle rate.
198 7 Forward Rates using Law of one price (Pesetas /US $) 198 8 198 9 199 0 199 1 199 2 199 3 199 4 199 5 199 6 199 7
127 .0
131 .9
137 .0
142 .2
147 .7
153 .4
159 .3
165 .4
171 .8
178 .4
185 .2
Cash Flows in US $ (After Tax) NPV
-477
108
104
105
106
105
105
104
104
104
105
94. 44
In both, the cases, we get the same net present value.
Will the NPVs always be the same in both the cases? No. the NPVs are the same because of the assumption we have made, that the Fischer Relation holds true.
(WACCMERCK-SPAIN + 1)/ (1+ WACCUSA )= (1+ INFLATION RATESPAIN )/ (1+
INFLATION RATEUSA )
Regarding the analytic approach to be used, both the alternatives are not wrong and can be used. But in case of disparity between the answers given, it’s always prudent to choose the conservative estimate.
The NPV of the project would remain the same irrespective of the exchange rate. What would differ is how much it would initially cost the company or how profitable it would be to the parent company dealing in dollars. Changes in the US$ NPV assuming parity relations of the Fischer equation hold true and without considering any other macroeconomic effects.
Alternati ve1 Spot Exchange Rate NPV (In Pesetas) NPV (In USD)
127 11993.62 94.44
126 11993.62 404 95.18749 24
128 11993.62 404 93.70018 784
Alternative2 Forward Rates Cash Flows in US NPV Forward Rates Cash Flows in US $ NPV Forward 126 480.7 5 95.18 127 476.9 7 94.44 128
1988 130.9 108.6 9
1989 135.9 104.8 3
1990 141.1 105.9
1991 146.5 107
1992 152.2 106.1
199 3 158.0 105.5
1994 164.1 105.2
1995 170.4 105.0
1996
199 7 177.0 183. 8 105.3 105. 8
131.9 107.8
137.0 104.0
142.2 105.0
147.7 106.1
153.4 105.3
159.3 104.7
165.4 104.3
171.8 104.2
178.4 104.4
185. 2 105. 0
132.9
138.0
143.3
148.9
154.6
160.5
166.7
173.1
179.8
186.
Rates Cash Flows in US $ NPV
-473 93.70
107
103
104
105
104
104
104
103
104
7 104
Sensitivity to change in inflation, without taking into account macroeconomic indicators:
Spanish inflation rate % 10 9 8 7 6 5
NPV In USD 49.84 71.41 94.44 119.05 145.4 173.64
Should Merck headquarters approve the equipment purchase? As we can clearly see, the NPV is positive. But the question still remains as to whether positive NPV is proof enough to go ahead with the project. We feel that some more analysis needs to be done, a few of which is listed below: • One is looking at a product whose demand is decreasing with time. Hence equipment, with up to 25% lesser capacity could also suffice. One should try and look out for such an option if available.
( Assumption: A lesser capacity machine would cost proportionately less) • Another option that needs to be looked at is the use of this machine for other purposes, if the demand for the current product falls even more. • Assuming that the there is no other alternative equipment in accordance with point 1 is available and that one has reasonable faith in the demand forecasts provided, on e should go in for the new machine as it provides the following benefits: o o o fewer workers, less expenditure on training ( from 10 to 3-4) reduction in human error reducing in rejection rates from 11% down to 3%.
doc_512423576.doc
analysis of MSDI case used in Strategic Financial Management.
KeyWords: WACC, NPV, Forward Rate, Spot Rate.
MSDI – ALCA De HENARES, SPAIN
MSDI – ALCA De HENARES, SPAIN
Synopsis:
The case talks about a large producer of pharmaceuticals, Merck Sharpe & Dohme International, MSDI, focusing specifically on its operations in ALCA De HENARES, SPAIN. At Spain, one of the primary process consisted of washing, filling, inspecting and sealing the ampoules of Lidocaine. It is stated that in spring 1987, it was running at 200% of planned capacity. To sustain this level of production 10 more workers were needed, who in turn needed 2 – 3 months of training. An alternative that was available and being considered was investing in new equipment, which had a capacity of 6 million ampoules per year, i.e., 25% more capacity than was anticipated. Decision is required to be taken on whether or not this would be a worthwhile investment or not?
Solution:
The attached excel has the calculations pertaining to the NPV of the new machine.
MSDI Case_VerFinal.xls
We have used two methods to calculate the NPV. In the first alternative, we find out the WACC of the company in Spain by using the following formula:
WACCMERCK-SPAIN =[(1+ WACCUSA )* (1+ INFLATION RATESPAIN )/ (1+ INFLATION
RATEUSA )]-1
Then using this as the hurdle rate, we discount the cash flows to find the NPOV in pesetas.
The Pesetas NPV value is divided by the spot exchange rate to arrive at the NPV USD NPV (In Pesetas) NPV (In USD) 11993.6 2 94.44
In the second alternative, we calculate the forward rates using Law of one price (Pesetas/US $)
Forward Rate=Spot Rate* [(1+ INFLATION RATESPAIN )/ (1+ INFLATION RATEUSA )]
Then we calculate the cash flows in USD terms and then discount using the US hurdle rate.
198 7 Forward Rates using Law of one price (Pesetas /US $) 198 8 198 9 199 0 199 1 199 2 199 3 199 4 199 5 199 6 199 7
127 .0
131 .9
137 .0
142 .2
147 .7
153 .4
159 .3
165 .4
171 .8
178 .4
185 .2
Cash Flows in US $ (After Tax) NPV
-477
108
104
105
106
105
105
104
104
104
105
94. 44
In both, the cases, we get the same net present value.
Will the NPVs always be the same in both the cases? No. the NPVs are the same because of the assumption we have made, that the Fischer Relation holds true.
(WACCMERCK-SPAIN + 1)/ (1+ WACCUSA )= (1+ INFLATION RATESPAIN )/ (1+
INFLATION RATEUSA )
Regarding the analytic approach to be used, both the alternatives are not wrong and can be used. But in case of disparity between the answers given, it’s always prudent to choose the conservative estimate.
The NPV of the project would remain the same irrespective of the exchange rate. What would differ is how much it would initially cost the company or how profitable it would be to the parent company dealing in dollars. Changes in the US$ NPV assuming parity relations of the Fischer equation hold true and without considering any other macroeconomic effects.
Alternati ve1 Spot Exchange Rate NPV (In Pesetas) NPV (In USD)
127 11993.62 94.44
126 11993.62 404 95.18749 24
128 11993.62 404 93.70018 784
Alternative2 Forward Rates Cash Flows in US NPV Forward Rates Cash Flows in US $ NPV Forward 126 480.7 5 95.18 127 476.9 7 94.44 128
1988 130.9 108.6 9
1989 135.9 104.8 3
1990 141.1 105.9
1991 146.5 107
1992 152.2 106.1
199 3 158.0 105.5
1994 164.1 105.2
1995 170.4 105.0
1996
199 7 177.0 183. 8 105.3 105. 8
131.9 107.8
137.0 104.0
142.2 105.0
147.7 106.1
153.4 105.3
159.3 104.7
165.4 104.3
171.8 104.2
178.4 104.4
185. 2 105. 0
132.9
138.0
143.3
148.9
154.6
160.5
166.7
173.1
179.8
186.
Rates Cash Flows in US $ NPV
-473 93.70
107
103
104
105
104
104
104
103
104
7 104
Sensitivity to change in inflation, without taking into account macroeconomic indicators:
Spanish inflation rate % 10 9 8 7 6 5
NPV In USD 49.84 71.41 94.44 119.05 145.4 173.64
Should Merck headquarters approve the equipment purchase? As we can clearly see, the NPV is positive. But the question still remains as to whether positive NPV is proof enough to go ahead with the project. We feel that some more analysis needs to be done, a few of which is listed below: • One is looking at a product whose demand is decreasing with time. Hence equipment, with up to 25% lesser capacity could also suffice. One should try and look out for such an option if available.
( Assumption: A lesser capacity machine would cost proportionately less) • Another option that needs to be looked at is the use of this machine for other purposes, if the demand for the current product falls even more. • Assuming that the there is no other alternative equipment in accordance with point 1 is available and that one has reasonable faith in the demand forecasts provided, on e should go in for the new machine as it provides the following benefits: o o o fewer workers, less expenditure on training ( from 10 to 3-4) reduction in human error reducing in rejection rates from 11% down to 3%.
doc_512423576.doc