Answer:
The attached excel has the calculations pertaining to the NPV of the new machine.
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 NPV in pesetas. The Pesetas NPV value is divided by the spot exchange rate to arrive at the NPV in USD
In the second alternative, we calculate the forward rates using Law of one price (Pesetas/US $)
Forward Rate=Spot Rate* Expected Spot rate factor
Where Expected Spot rate factor = [(1+ INFLATION RATESPAIN )/ (1+ INFLATION RATEUSA )]
And Expected Spot rate factor ( Interest rate) = [(1+ INTEREST RATESPAIN )/ (1+ INTEREST RATEUSA )]
Then we calculate the cash flows in USD terms and then discount using the US hurdle rate as in case 1.
2. How and why do these net present values differ? Which analytic approach should Merck use to evaluate this project? Why?
Answer:
We get the same net present value as in case 1. However if we use the historical inflation data and interest rates to calculate the exchange rate there is a difference in the NPV. The Net Present Values are different because of the change in the macroeconomic indicators.
The NPVs are the same in case 1 because of the assumption we have made, that the Fischer Relation holds true.
(WACCMERCK-SPAIN + 1)/ (1+ WACCUSA )= (1+ INFLATION RATESPAIN )/ (1+ INFLATION RATEUSA )
The approach which is the most conservative one should be used i.e. considering the historical inflation data. The IRR is also quite good. Here one should try to be conservative because the demand for the product is going to decrease in the years. So if the company decides to buy the equipment even when the demand is going to fall it should be conservative in its decision making.
3. How sensitive is the NPV of the new equipment to changes in the peseta /dollar exchange rate? What happens to the NPV if Spanish inflation is assumed to be less than 8 percent per year (assume that expected dollar inflation remains at 4 percent per year)?
Answer:
As the inflation decreases from 8% to 4% the values of peseta/dollar exchange rate for the corresponding years from 1987 to 1997 also decreases. This is because the expected spot rate factor is directly depended on the inflation rate. The decrease in expected spot rate leads to lesser increase in forward spot exchange rates which increases the differential cash flow in dollar whcih ultimately results in increasing NPV.
EXCHANGE RATE VARIATION
P
E
S
E
T
A
/
$
Sensitivity to change in inflation
NPV
Inflation
4. 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 fewer workers, less expenditure on training ( from 10 to 3-4)
o reduction in human error
o reducing in rejection rates from 11% down to 3%.
