Mini-Case of IAPV: Dorchester, Ltd.

Dorchester Ltd. is an old-line confectioner specializing in high-quality chocolates. Through

its facilities in the United Kingdom, Dorchester manufactures candies that it sells throughout

Western Europe and the United States. Dorchester has been exporting to the U.S. market at 65,000

pounds of candy per year without growth because of limited production capacity. Dorchester

believes that the U.S. market is much bigger. If Dorchester builds a separate manufacturing facility

in the United States, its output would supply the entire U.S. market, replacing the existing exports

and further expand the market. Dorchester currently estimates initial demand in the North

American market at 390,000 pounds (when the plant finishes one year from now), with growth at

a 5 percent annual rate thereafter.

Dorchester presently realizes 2.87 profit per pound on its North American exports. Once

the U.S. manufacturing facility is operating, Dorchester expects that it will be able to initially price

its product at $7.70 per pound. This price would represent an operating profit of $4.40 per pound.

Both sales price and operating costs are expected to keep track with the U.S. price level; U.S.

inflation is forecast at a rate of 3 percent for the next several years. In the U.K., long-run inflation

is expected to be 4.5 percent, depending on which economic service one follows. The current spot

exchange rate is $1.50/l.00. Dorchester explicitly believes in PPP as the best means to forecast

future exchange rates.

The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this

amount by a combination of equity capital and debt. The plant will increase Dorchester's borrowing

capacity by 2,000,000 (therefore the firms optimal debt ratio is 0.429), and it plans to borrow

only that amount. The local community in which Dorchester has decided to build will provide

$1,500,000 of debt financing for a period of seven years at 7.75 percent. The principal is to be

repaid in equal installments over the life of the loan. At this point, Dorchester is uncertain whether

to raise the remaining debt it desires through a domestic bond issue or a Eurodollar bond issue. It

believes it can borrow pounds sterling at 10.75 percent per annum and dollars at 9.5 percent. The

principal of the remaining debt is also to be repaid in equal installments over the life of the debt.

Dorchester estimates its all-equity cost of capital to be 15 percent.

The U.S. Internal Revenue Service will allow Dorchester to fully depreciate the new

facility over a seven-year period. On the book, the facility will be worth nothing at the end of the

seventh year. However, the management estimates that the confectionery equipment, which

accounts for the bulk of the investment, can still be sold at US$2 million (terminal value). The

capital gain tax rate is 35%.

Dorchester does not expect to receive any special tax concessions. Further, because the

corporate tax rates in the two countries are the same-35 percent in the U.K. and in the United

States-transfer pricing strategies are ruled out.

Please prepare your case analysis by addressing the following questions:

1. Estimate the following components of IAPV and calculate the IAPV with the formula of Donald Lessard:

a) after-tax operating cash flows;

b) depreciation tax shields;

c) government subsidy of concessionary loan;

d) interest tax shields;

e) terminal value.

2. What is the overall IAPV? Should Dorchester build the new manufacturing plant in the United

States?

3. Using some sensitivity analysis, discuss if the IAPV is robustly positive.

Hint: Effective interest rate if a firm borrows from a foreign country:

[ ( 1 + If ) ( 1 + e ) 1 ] * 100%