Dorechester Mini Case 1

Dorchester Ltd. is a British confectioner specializing in high-quality chocolates. Through its facilities in the United Kingdom, Dorchester manufactures candies that it sells throughout Western Europe and the U.S.

With its current U.K.-based manufacturing facilities, Dorchester has been able to supply the U.S. market with 290,000 pounds (lbs) of candy per year. This limited supply has allowed its U.S. sales affiliate, located in Boston, to penetrate the U.S. market no farther West than St. Louis.

Dorchester believes that a new manufacturing facility located in the U.S., which would take one year to build and become operative, would allow it to supply the entire U.S. market. Dorchester estimates demand in the entire U.S. market the first year when the new facility would be operative (i.e., year 1) at 390,000 pounds, with subsequent growth at a 5% annual rate.

Having this new manufacturing facility would free up the amount currently shipped by Dorchester from the U.K. to the U.S. Dorchester believes that this idle capacity would only be a short-run problem. The firm believes the economic development taking place in Eastern Europe will allow it to sell there the full amount presently shipped to the U.S. from the U.K. within a period of five years (20% in year 1, 40% in year 2, , and 100% in year 5).

Dorchester presently (i.e., in year 0) generates an operating profit of 3.00 per pound on its U.S. exports from the U.K, which grows with U.K. inflation. Once the U.S. manufacturing facility is operating (i.e., in year 1), Dorchester expects that it will be able to initially price its product at $7.70 per pound, which would represent an operating profit of $4.40 per pound and is expected to keep track with the U.S. price level.

U.S. inflation is forecast at a rate of 3% for the next several years, while U.K. inflation is forecast at 4.5%. The current spot exchange rate is $1.50/. Dorchester uses PPP to forecast future exchange rates.

The new manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount by combining equity and debt, in line with its target leverage of 40%. Dorchester plans to raise the debt required to build the plant in the U.K., where it can issue a non-amortizing seven-year bond to borrow pounds sterling at 10.75% per annum. Dorchester estimates its domestic all-equity cost of capital to be 15%.

The corporate tax rates in the U.S. and the U.K. are both 35 percent. The U.S. Internal Revenue Service will allow Dorchester to depreciate the new facility over a seven-year period. After that time, the confectionery equipment, which accounts for the bulk of the investment, is expected to have substantial market value.

Answer the following questions using the information given above:

1. Should Dorchester build the new manufacturing plant in the U.S.? To answer the question, calculate how large the terminal value of the new manufacturing facility would need to be for the APV of the facility to be positive.

2. How does your answer to question 1 change if instead of raising the debt required to build the plant in the U.K., Dorchester borrows the same equivalent amount in dollars in the U.S. at a 9.5% annual interest rate, using again a non-amortizing seven-year bond?

3. Suppose now that the U.S. decreases the corporate income tax rate to 21%. How does your answer to question 1 change?

4. Suppose now that both the U.S. and the U.K. decrease the corporate income tax rate to 21%. How does your answer to question 1 change?

5. How would the answer to question 1 change if Dorchester were able to increase its sales in Eastern Europe faster than in the original forecast, selling there the full amount presently shipped to the U.S. from the U.K. within a period of three years (33.3% in year 1, 66.7% in year 2, and 100% in year 3)?

t Calculation of the Present Value of the Depreciation 1ax Shields Calculation of the Present Value of the After-lax Operating Cash Flows Calculation of the Present Value of the Interest lax Shields PV af deprodlation Ouantity sold in tha Opcrating profit Quantity oflast als duc to n Lost operating profit perating profit Incremental Incrementa Outstanding lan balanc (bcginning of year U.s. with thnw from U.s.salcs with from loat sales d from profit from U.S. sales operating profit U.S. sales PV of interest tar the new plant to new plant Principal payment Interest payment Year Expected sE/S in lbs in lbs Isers) x OCF, in ) 1.tjl/I1HW.1nEl 16 1 Surm 18 Caiculared iopts Initial Investment (E Self/5) npurs given APV before considering the terminal value (in E) initial investment in year 7,000, 000 E466 900 1.50 0.6557 UK. inflation d UlS. inflation 45% . corp. tax it.) U.S. corp. tax Max fU.K. tex rate, U.S. tax rste 35% 35% Year1 US. sales wnew plant (los) Annual sales growth in the U.S 390,000 Year 1 operating profit in U.S. w new plant (S/lb) Growth in operating profit in U.s 54.40 Inputs for lost saies caicuation Current (0) US sales w/U.K. plants lb) % current US. sales sold in East Eur lyr 1) 56 current US. sales sold in East Eur(yr 2) 90,000 20% current U.S.sales sold in East Eur (yr 3) 6 current U.S.sales sold in East Eur (yr 4) % current us. sales sold in East Eur(yr 5) 60% 100% Current ( ) oper,protit ot U.s sales w U.K. plants Growth in operating profit in of US sales wUK plants 45% Cost of copia All-equity cost of capital Domestic cost of debt 15% 10.75% Target leverage Annual loan amortization before maturity (in %) t Calculation of the Present Value of the Depreciation 1ax Shields Calculation of the Present Value of the After-lax Operating Cash Flows Calculation of the Present Value of the Interest lax Shields PV af deprodlation Ouantity sold in tha Opcrating profit Quantity oflast als duc to n Lost operating profit perating profit Incremental Incrementa Outstanding lan balanc (bcginning of year U.s. with thnw from U.s.salcs with from loat sales d from profit from U.S. sales operating profit U.S. sales PV of interest tar the new plant to new plant Principal payment Interest payment Year Expected sE/S in lbs in lbs Isers) x OCF, in ) 1.tjl/I1HW.1nEl 16 1 Surm 18 Caiculared iopts Initial Investment (E Self/5) npurs given APV before considering the terminal value (in E) initial investment in year 7,000, 000 E466 900 1.50 0.6557 UK. inflation d UlS. inflation 45% . corp. tax it.) U.S. corp. tax Max fU.K. tex rate, U.S. tax rste 35% 35% Year1 US. sales wnew plant (los) Annual sales growth in the U.S 390,000 Year 1 operating profit in U.S. w new plant (S/lb) Growth in operating profit in U.s 54.40 Inputs for lost saies caicuation Current (0) US sales w/U.K. plants lb) % current US. sales sold in East Eur lyr 1) 56 current US. sales sold in East Eur(yr 2) 90,000 20% current U.S.sales sold in East Eur (yr 3) 6 current U.S.sales sold in East Eur (yr 4) % current us. sales sold in East Eur(yr 5) 60% 100% Current ( ) oper,protit ot U.s sales w U.K. plants Growth in operating profit in of US sales wUK plants 45% Cost of copia All-equity cost of capital Domestic cost of debt 15% 10.75% Target leverage Annual loan amortization before maturity (in %)