Brian Baker

A35020136
FI 451 Section 1
Case 2

Case 2: MSDI – Alcala de Henares, Spain

For all three questions, assume the followings:

- All international parity conditions hold (unless otherwise stated)
- Merck’s weighted average cost of capital is 15% for a similar U.S. project
- U.S. annual inflation rate is expected to be 5%

Question 1
Should Merck invest in the new photoelectric inspection equipment?

Question 2
Suppose the International Fisher Relation does not hold, i.e., the Spanish weighted average cost of capital is 25%.
Should Merck invest in the new photoelectric inspection equipment?

Q1.
Merk Sharp and Dohme International (MSDI) should invest in the new photoelectric
inspection equipment in Madrid, Spain. They should make this investment, unless there is
another that would offer a higher net present value, which might be true of the similar US
project, considering cost of capitol is lower in the US by more than 3 percentage points. It is not
possible to say it is more attractive, however without knowing more specifics about the US
project. Considering everything that the Madrid project has going for it, MSDI should invest in
it.
The Madrid proposal has many attractive properties, including fewer workers, that
require less expensive training, which results in direct labor savings. The old way needed 10
people working a shift while the new method would require only 3-4 people working the
inspection. Using the new equipment would also remove human error from the process,
reducing rejection rates from 11% down to 3%. All of the advantages are nice to have, but with
this operation the main issue was will it provide the company with a positive net present value,
when the project is all said and done.
The issue of what currency to compute the discounted cash flows analysis currency is
unnecessary since it would not matter in the final outcome of the NPV. Also the speculation that
the peseta would appreciate over the coming years is a positive note, but considering the wide
range and uncertainty of analysts it would not be a sufficient reason to pursue the project.
To decide if the project is satisfactory to do cash flows must be calculated. By selling the
old equipment and purchasing the new equipment the company would be starting off with a net
cash flow of -60345750 pesetas in year 0. Considering the depreciation and savings generated
by the new equipment cash flows for the following years would be positive starting at 14386375
peseta in the first year and growing to 19413475 peseta by the 10th and final year. By entering
the cash flows shown on the attatched spreadsheet for each year into a financial calculator and
discounting at the weighted average cost of capitol for the project of 18.3%, found by using the
international parity conditions, the net present value can be found. The NPV in peseta is
9948376, by using the spot rate given of USD 127/Pst the NPV in USD can be calculated and is
78334. Considering that the NPV is so overwhelmingly positive MSDI should pursue the project
and implement the new inspection equipment in Madrid.
 Brian Baker
A35020136
FI 451 Section 1
Case 2

Q2
If the International Fisher Relation did not hold resulting in an increase of the Spanish
weighted average cost of capital to 25%, MSDI would need to reconsider the proposal. Using all
the same cash flows as previously, simply changing the discount rate to 25% reveals NPV is now
negative. The new WACC causes the NPV to sink to -4628881 peseta or 36448 USD. Now that
the NPV has become negative and so negative at that MSDI should no longer look to make the
investment, and should examine the similar US project more closely.