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A Merck financial analyst must determine

whether a Discounted Cash Flow Analysis


for new equipment at an operating
subsidiary MSDI – Alcala de Henares, Spain
should be made through US Dollars (USD)

MSDI—
Alcala de
Henares,
Spain
HBS: 9-289-029

Submitted By:
Durgesh Nandini Mohanty
Ila Mishra
Ritika Gupta
Background Knowledge:
Here we study about some parity conditions, which help us study the international markets better.

Purchasing Power Parity:

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium
when their purchasing power is the same in each of the two countries. This means that the exchange rate between
two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a
country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must
depreciated in order to return to PPP.

Absolute PPP - This concept posits that the exchange rate between two countries will be identical to the ratio of
the price levels for those two countries.

Relative PPP - Relative purchasing power parity relates the change in two countries' expected inflation rates to
the change in their exchange rates. Inflation reduces the real purchasing power of a nation's currency.

S1 / S0 = (1 + Iy) ÷ (1 + Ix)

Where,

S0 is the spot exchange rate at the beginning of the time period (measured as the "y" country price of one unit of
currency x)

S1 is the spot exchange rate at the end of the time period.

Iy is the expected annualized inflation rate for country y, which is considered to be the foreign country.

Ix is the expected annualized inflation rate for country x, which is considered to be the domestic country.

Uncovered Interest Rate Parity:

Uncovered Interest Rate Parity (UIRP) predicts that high yield currencies should be expected to depreciate. It also
predicts that, ceteris paribus, a real interest rate increase should appreciate the currency. For example, an expected
5% depreciation of the pound against the dollar will be compensated through a 5% rise in the interest rate of the
pound. Any difference in these percentages would result in arbitrage, breaking the 5% to 5% parity. Uncovered
interest rate parity is also known as the International Fisher Effect.
Case Background:
In June 1987 Merck Sharp and Dohme International (MSDI) was considering an investment proposal for the
purchase and installation of new automatic inspection equipment for the filling of glass ampules with liquid
pharmaceutical products. The equipment was expected to result in significant savings of labor and materials. Total
cost of the equipment would come to 61.525 million pesetas (Pts), or nearly $500,000. The equipment had to be
purchased from Italy and installed in Spain and approved from their corporate headquarters in New Jersey.

Merck & Co’s extensive international operations are conducted primarily through subsidiaries grouped within its
MSDI division. The facility at Alcala de Henares was active since 1969 and was involved in of washing, filling,
inspecting, and sealing the ampules of Lidocaine. The new equipment would save costs in the sense that it would
reduce the number of workers from 10 to 4 or even 3 for the same volume of production. Also, the rejection of
ampules would drop from 11% to a mere 3%. Depreciation would happen for 10 years in straight line depreciation
method. The equipment being replaced would be replaced at its scrap value.

Problems Identified:
Some of the issues identified in the case have been elucidated below:

 To determine the NPV of the prospective investment, it is to be decided whether the discounted cash flow
analysis (DCF) of the investment should be done in dollars or in the Spanish currency of Pesetas.
 To determine whether the usage of the two currencies causes a difference in the value of the NPV and
calculate the value of the difference. This was pertaining to the fact that the borrowing rates in both the
countries are different.

Analysis:
Assumptions:

1. As the cost of capital is not mention, we are doing calculations for three cases.
Case 1: Wacc($)= 15%
Case 2: Wacc($)= 13%
Case 3: Wacc($)= 17%

2. Assuming the historical Inflation for US= 2% and Spain = 8%


Here, we are analysing different model for accounting the exchange rate change in valuing the project.
13% 15% 17%
NPV using peseta 6150.981 1333.392 -2935.5
NPV using PPP method($) 29855.78 -6227.28 -38233
NPV using UIP method($) 46107.94 8406.708 -25004.7

We can see that if we value in terms of Dollar by using the PPP or UIP model, there is contradiction in
valuing in dollar. Also there is more uncertainty as we have to predict the cash flow in dollar using
expected exchange rate which might affect the total valuation as it is very sensitive to the exchange rate
variation.

Conclusion:
1. The NPV should be calculated in pesetas rather than in USD because the cash flows to the firm
(MSDI) will be in pesetas. So, if the NPV calculated will be in USD, any small change in the currency
rates will lead to major fluctuations in the value of the project. To avoid this difficulty, it is prudent to
use pesetas as the currency for calculating the NPV.
2. NPV is different for different countries because the rate of inflation is different for the projected
period.

Any small change in the interest rates will lead to a large fluctuation in value of the equipment when it is valued in
terms of USD using PPP and UIP methods.

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