Case Study:

MSDI-Alcala de Henares, Spain

Milad Jangalvaee

MSDI

Situation

MSDI

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) or Spanish Pesetas (Pst)

MSDI

Background

MSDI

Merck is a large multinational producer of animal and human health care pharmaceuticals

Merck Sharp and Dohme International (MSDI) is the division in which Merck operates internationally

Alcala de Henares, Spain is an operating facility opened in 1969

The facility produces glass ampules filled with liquid pharmaceuticals

MSDIThe Manufacturing Process

Ampules (small glass containers) are purchased from local suppliers

Ampules are washed, filled, inspected and sealed

Washing and sterilization are subjected to stringent quality control guidelines

Ampules are filled with liquid pharmaceutical

The filled ampules are inspected at a station

Workers remove any contaminated ampules

Approved ampules are sealed

Ampules are packaged and shipped

MSDIProblems with the

Inspection Process:

Additional workers were required in 1987 to meet the current production load

Additional workers required 2-3 months of training to become proficient with inspection equipment

Solution to the Problem:

MSDI proposed replacing workers with high speed inspection equipment that would meet criteria and rejection thresholds

Solution would reduce workers required from 10 to at least 4

Rejection rates would drop from 11% to 3%

MSDI

Financial Benefits of proposed equipment

MSDICost Savings Estimates

MSDI

Question 1:

What is the Net Present Value in

Pesetas (Pst) and US Dollars (USD)?

MSDIFinancial Considerations:

Equipment would have a 10 year life

Straight line depreciation would be used for tax and financial reporting

Book value and tax basis is Pts 1,605,000 with 3 years of straight line depreciation left

Market value was est. Pts 950,000

Local tax rate was determined at 35%

US Inflation Rate of 4%

Spanish Pts Inflation Rate of 8%

Exchange rate of 127Pst = $1 USD

Merck's Cost of Capital - 13%

MSDI

Peseta Discount Rate Formula

US Cost of Capital + (Spanish Inflation Rate – US Inflation Rate)

13% + (8% - 4%)

MSDIPts= Paseta 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7

Scen ario # 1U S $ I n flation 4.00%S p an ish Peseta (Pts) I n flation 8.00%

Forecasted Pts/ U S $ (I n it ial = 1 2 7 ) 1 2 7 1 3 1 .9 1 3 7 .0 1 4 2 .2 1 4 7 .7 1 5 3 .4 1 5 9 .3 1 6 5 .4 1 7 1 .8 1 7 8 .4 1 8 5 .2

Per Am p ou le Total Cost - - Old Mach in e 1 9 .2 8 2 0 .8 2 2 2 .4 9 2 4 .2 9 2 6 .2 3 2 8 .3 3 3 0 .6 0 3 3 .0 4 3 5 .6 9 3 8 .5 4Per Am p ou le Total Cost - - New Mach in e 1 5 .1 8 1 6 .3 9 1 7 .7 1 1 9 .1 2 2 0 .6 5 2 2 .3 0 2 4 .0 9 2 6 .0 2 2 8 .1 0 3 0 .3 4Op eratin g Costs - - Old Mach in e (Pts) 8 8 4 9 6 .0 8 8 6 6 2 .6 9 3 6 8 6 .7 9 7 6 3 5 .6 1 0 1 0 9 2 .2 1 0 4 8 7 3 .6 1 0 9 1 0 2 .5 1 1 3 7 6 6 .5 1 1 9 0 1 3 .7 1 2 4 8 7 3 .4Op eratin g Costs - - New Mach in e (Pts) 6 9 6 7 6 .0 6 9 8 0 7 .2 7 3 7 6 2 .8 7 6 8 7 1 .9 7 9 5 9 3 .4 8 2 5 7 0 .7 8 5 9 0 0 .2 8 9 5 7 2 .3 9 3 7 0 3 .6 9 8 3 1 7 .2Cost S avin g s (Pts) 1 8 8 2 0 .0 1 8 8 5 5 .4 1 9 9 2 3 .9 2 0 7 6 3 .7 2 1 4 9 8 .8 2 2 3 0 2 .9 2 3 2 0 2 .3 2 4 1 9 4 .1 2 5 3 1 0 .0 2 6 5 5 6 .2

Cost of New Mach in e -6 1 5 2 5 .0After Tax Cost S avin g s 0 .0 1 2 2 3 3 .0 1 2 2 5 6 .0 1 2 9 5 0 .5 1 3 4 9 6 .4 1 3 9 7 4 .2 1 4 4 9 6 .9 1 5 0 8 1 .5 1 5 7 2 6 .2 1 6 4 5 1 .5 1 7 2 6 1 .5After Tax S alvag e - Old Mach in e 1 1 7 9 .3Old Dep reciat ion Lost (After Tax) 0 .0 -1 8 7 .3 -1 8 7 .3 -1 8 7 .3 0 .0 0 .0 0 .0 0 .0 0 .0 0 .0 0 .0New Dep reciation (After Tax) 0 .0 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4 2 1 5 3 .4

Total Pts Cash F low -6 0 3 4 5 .8 1 4 1 9 9 .1 1 4 2 2 2 .2 1 4 9 1 6 .6 1 5 6 4 9 .8 1 6 1 2 7 .6 1 6 6 5 0 .3 1 7 2 3 4 .9 1 7 8 7 9 .6 1 8 6 0 4 .9 1 9 4 1 4 .9

Forecasted Pts/ U S $ (I n it ial = 1 2 7 ) 1 2 7 .0 1 3 1 .9 1 3 7 .0 1 4 2 .2 1 4 7 .7 1 5 3 .4 1 5 9 .3 1 6 5 .4 1 7 1 .8 1 7 8 .4 1 8 5 .2Total U S D Cash F low (u sin g forecastin g m eth od ) -4 7 5 .2 1 0 7 .7 1 0 3 .8 1 0 4 .9 1 0 6 .0 1 0 5 .2 1 0 4 .5 1 0 4 .2 1 0 4 .1 1 0 4 .3 1 0 4 .8

P ts NPV ( thousands) 11,191.04U S$ NPV ( thousands) ( P ts127/ U S$) 88.12$

U S$ NPV ( w ith forecasting/ U S$) $84.46

MSDI

Problems with forecasting

NPV and exchange rates

MSDI

Spanish Peseta/US Dollar exchange rates 1987-1997

0

20

40

60

80

100

120

140

160

180

200

Forecast v. Actual Peseta

1987 - 1997

Year

Pe

seta

(p

er

$1

US

D)

YearsYears

1987 127 110.8 -16.21988 131.9 113.73 -18.17 2.64%1989 137 112.24 -24.76 -1.31%1990 142.2 95.75 -46.45 -14.69%1991 147.7 99.7 -48 4.13%1992 153.4 112.95 -40.45 13.29%1993 159.3 140.42 -18.88 24.32%1994 165.4 132.31 -33.09 -5.78%1995 171.8 122.53 -49.27 -7.39%1996 178.4 130.69 -47.71 6.66%1997 185.2 150.46 -34.74 15.13%

8% InflationRate

Actual Pst Rate

(in December)

Difference(Actual – Forecast)

InflationRate

MSDI

Question 2:

How sensitive is the NPV of the new equipment to changes in the peseta/dollar exchange rate?

MSDI

Real Rate of Return Formula

(1 + Real Rate) = (1 + Nominal Rate) x (1 + Inflation Rate)

MSDI

0.0

0%

1.0

0%

2.0

0%

3.0

0%

4.0

0%

5.0

0%

6.0

0%

7.0

0%

8.0

0%

9.0

0%

10

.00

%11

.00

%12

.00

%13

.00

%14

.00

%15

.00

%16

.00

%17

.00

%18

.00

%19

.00

%20

.00

%21

.00

%22

.00

%23

.00

%24

.00

%25

.00

%

($20)

$0

$20

$40

$60

$80

$100

$120

$140

$160 USD NPV Sensitivity to PTS Inflation

Pts Inflation Rate

NP

V (

US

D)

MSDI

Pts I nflation Rate NPV ( U SD)0.00% $147.861.00% $138.692.00% $129.933.00% $121.554.00% $113.525.00% $105.826.00% $98.427.00% $91.318.00% $84.469.00% $77.87

10.00% $71.5011.00% $65.3512.00% $59.4113.00% $53.6614.00% $48.0915.00% $42.7016.00% $37.4617.00% $32.3818.00% $27.4419.00% $22.6420.00% $17.9721.00% $13.4222.00% $9.0023.00% $4.6824.00% $0.4725.00% ($3.63)

NPV Sensitiv ity to PTS I nflation* U SD I n flation held con stan t = 4 %

MSDI

Question 3:

What happens to the NPV if Spanish inflation is assumed to be less than 8% per year assuming that

expected dollar inflation remains at 4% per year?

MSDIPts= Paseta 1 9 8 7 1 9 8 8 1 9 8 9 1 9 9 0 1 9 9 1 1 9 9 2 1 9 9 3 1 9 9 4 1 9 9 5 1 9 9 6 1 9 9 7

Scen ario # 2U S $ I n flation 4.00%S pan ish Peseta (Pts) I nflation 4.00%

Forecasted Pts/ U S$ (I n it ial = 1 2 7 ) 1 27 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0

Per Am p ou le Total Cost - - Old Mach in e 1 9 .2 8 2 0 .0 5 2 0 .8 5 2 1 .6 9 2 2 .5 6 2 3 .4 6 2 4 .4 0 2 5 .3 7 2 6 .3 9 2 7 .4 4Per Am p ou le Total Cost - - New Mach in e 1 5 .1 8 1 5 .7 9 1 6 .4 2 1 7 .0 8 1 7 .7 6 1 8 .4 7 1 9 .2 1 1 9 .9 8 2 0 .7 7 2 1 .6 1Op eratin g Costs - - Old Mach ine (Pts) 8 84 96 .0 8 53 78 .8 8 68 75 .4 8 71 84 .0 8 69 27 .3 8 68 38 .9 8 69 94 .6 8 73 53 .7 8 79 98 .1 8 89 11 .1Op eratin g Costs - - New Mach in e (Pts) 6 96 76 .0 6 72 21 .7 6 84 00 .1 6 86 43 .1 6 84 40 .9 6 83 71 .3 6 84 93 .9 6 87 76 .6 6 92 84 .0 7 00 02 .8Cost Saving s (Pts) 1 88 20 .0 1 81 57 .1 1 84 75 .4 1 85 41 .0 1 84 86 .4 1 84 67 .6 1 85 00 .7 1 85 77 .1 1 87 14 .1 1 89 08 .3

Cost of New Mach in e -6 15 2 5 .0After Tax Cost Savin gs 0 .0 1 22 33 .0 1 18 02 .1 1 20 09 .0 1 20 51 .6 1 20 16 .2 1 20 03 .9 1 20 25 .5 1 20 75 .1 1 21 64 .2 1 22 90 .4After Tax S alvage - Old Mach ine 1 17 9 .3Old Dep reciation Lost (After Tax) 0 .0 -1 87 .3 -1 87 .3 -1 87 .3 0 .0 0 .0 0 .0 0 .0 0 .0 0 .0 0 .0New Dep reciation (After Tax) 0 .0 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4 2 15 3 .4

Total Pts Cash Flow -6 03 4 5 .8 1 41 99 .1 1 37 68 .2 1 39 75 .1 1 42 05 .0 1 41 69 .5 1 41 57 .3 1 41 78 .8 1 42 28 .5 1 43 17 .6 1 44 43 .8

Forecasted Pts/ U S$ (I n it ial = 1 2 7 ) 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0 1 27 .0Total U S D Cash F low (usin g forecastin g m eth od ) -4 75 .2 1 11 .8 1 08 .4 1 10 .0 1 11 .9 1 11 .6 1 11 .5 1 11 .6 1 12 .0 1 12 .7 1 13 .7

P ts NP V ( thousands) 14,416.65U S$ NP V ( thousands) ( P ts127/ U S$) 113.52$

U S$ NP V ( w ith forecasting/ U S$) $113.52

MSDI

Question 4:

Should Merck headquarters approve the MSDI

equipment purchase?

MSDI

YES

The current inflation figures of

8% (Pst) and 4% (USD)

as well as Merck's cost of capital of 13% provides the company

with a positive NPV using either

Pst or USD to evaluate the project.