MSDI - Alcala de Henares, Spain Case

Part 1

1. Conduct an NPV analysis of this project by discounting in the foreign currency and converting to the domestic currency at today?s spot exchange rate. Assume that Merck is using 8% as their estimate of peseta inflation and 4% as the estimate for inflation in the U.S. for purposes of computing cash flows. Use these relative inflation rates to forecast both expected future spot rates and the foreign cost of capital. Now convert foreign cash flows into domestic currency at expected future spot rates and then discount in the domestic currency. Are the NPVs the same?

Part 2

1. Suppose the inflation rate is expected to be 4% in each currency. Inflate the cost projections in Exhibit 2 at these rates and repeat the valuation in 1. How much is the increase in value under the two approaches? Where does it come from?
2. Consider the last paragraph of the case (before the exhibits). Instead of the peseta appreciating against the dollar as some experts think, suppose a different currency expert thinks the peseta is going to lose value against the dollar due to a crisis associated with upcoming Spanish elections. In particular, he believes the peseta will fall from its current value of Pts127/$ to Pts150/$ next year, Pts170/$ in the second year, and will then remain at Pts170/$ indefinitely. This represents a possible (and serious for Merck) deviation from UIP. Repeat the valuation in 1a and 1b. What do you find?
3. Suppose real interest rates in Spain and the U.S. are not in equilibrium, and that the weighted average cost of capital on projects of this risk in Spain is 25% rather than the rate suggested by the inflation differential. Expected future spot rates are still generated assuming PPP holds: E[StPts/$]/S0Pts/$ = [(1+E[pPts])/(1+E[p$])]t.
4. What does Section 13-3 of the text say about whether you want to hedge the project?s cash flows against currency risk in each of the above scenarios?

Attached is the answer (I'm pretty sure to Part 1), but I need help completing Part 2. Thank you in advance!

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MSDI Input & data section MV(new eqpt) BV(old eqpt) MV(old eqpt) Loss on sale of old Tax on sale of old Worksheet Ampule volume Cost w old eqpt Cost w new eqpt Old cost per ampule Cost w old eqpt New cost per ampule Cost w new eqpt 61,525 1,605 950 655 229 E[pPts] E[p$] Tax % 8% 4% 35% Dollar WACC Peseta WACC 13.00% 17.35% today 4590 4258 4166 4020 3854 3702 3566 3443 88,496 88,663 93,687 97,636 101,092 104,874 109,103 113,766 69,676 69,807 73,763 76,872 79,593 82,571 85,900 89,572 17.85 19.28 20.82 22.49 24.29 26.23 28.33 30.60 33.04 88,496 88,663 93,687 97,636 101,092 104,874 109,103 113,766 15.18 16.39 17.71 19.12 20.65 22.30 24.09 26.02 69,676 69,807 73,763 76,872 79,593 82,571 85,900 89,572 14.06 Old depreciation New depreciation MSDI's local (foreign) peseta analysis Buy new machine Sell old machine Tax savings on loss (Revenue) (operating expense) (depreciation) (Taxable income) (Taxes) (Net income) (depreciation) (Net cash flow) PV(Peseta CFs) NPV(Pesetas) NPV$ = 1 2 3 88,663 69,807 5,618 13,237 4,633 8,604 5,618 14,222 15,360 93,687 73,763 5,618 14,306 5,007 9,299 5,618 14,917 16,110 4 5 6 7 8 (61,525) 950 229 (60,346) 88,496 69,676 5,618 13,202 4,621 8,581 5,618 14,199 15,335 97,636 101,092 104,874 109,103 113,766 76,872 79,593 82,571 85,900 89,572 6,153 6,153 6,153 6,153 6,153 14,611 15,346 16,150 17,049 18,041 5,114 5,371 5,652 5,967 6,314 9,497 9,975 10,497 11,082 11,727 6,153 6,153 6,153 6,153 6,153 15,650 16,128 16,650 17,235 17,880 16,902 17,418 17,982 18,614 19,310 12,122.28 95.45 Merck's (parent's) dollar analysis - Equilibrium case E[St$/P] E[CFt$] = E[CFtP]E[St$/P] PV(E[CFt$]) NPV$ Merck's (parent's) dollar analysis - Disequilibrium case (Case question #3) E[St$/Pts] = 127 150.00 170.00 170.00 170.00 170.00 E[CFt$] = E[CFtP]E[St$/P] PV(E[CFt$]) NPV$ = 170.00 170.00 170.00 0.173462 3335 3240 119,014 124,873 93,704 98,317 35.69 38.54 119,014 124,873 28.10 30.34 93,704 98,317 9 10 119,014 124,873 93,704 98,317 6,153 6,153 19,157 20,403 6,705 7,141 12,452 13,262 6,153 6,153 18,605 19,415 20,093 20,968 170.00 170.00 Possible Running head: INFLATION 1 Inflation Student's Name Institution INFLATION 2 Governments by issuing cash as well as managing inflation, they do put floor on how low the interest rates can always go as well as how high the asset prices can always rise and that is hardly a free market. Like any other government interference, that always causes inefficiencies. Preventing future prices of the goods as well as services from rising very far above current prices, it always constrains the demand for the current goods as well as services. The weak demand then leads the firms to hire less as well as to invest less in development of any new technologies, thus, leaving work force to be underutilized and the productivity to be very low. Hence, it is good to abolish currency and then move completely to the electronic cash, for the reason that the electronic cash can always have any kind of yield, interest rates will be in a position to go as far into the negative territory as market required. If cash were to be abolished, then I would support adoption of two measures. First of all, is that instead of targeting positive inflation rate, the central banks can target true price stability, that is by aiming to always keep level of the prices constant over a given period of time. Secondly, currency do provide service beyond just being store of the value and also a medium of exchange. The deficit government spending during the recession is always a good debt. That is because it always meets all the conditions of a good debt. There is a crucial need for the governments to get out of the recession. The resulting debt can always be repaid by the successful individuals as well as corporations through their taxes with relatively a bit less pain, that is because of the income as well as profits and also risen considerably. The increase in the tax rates may not always be necessary (Arrow & Kruz, 2013). On the other hand, the government is not supposed to always give in to the pressures of reducing taxes so as to cause the deficits in cases where there is no recession. That is considered to be a bad as well as an unnecessary debt, hence it will make the government to be less capable of reacting to an impending recession. INFLATION 3 Being able to interpret financial results is an important factor in maintaining positive cash flow and helps prevent the agency from going into debt. In this Paper I will choose 4 different financial ratios that I have learned in the previous week and will summarize my findings. The four ratios I choose for this assignment is the current ratio, the inventory turnover ratio, the Quick Ratio, and the Asset Turnover ratio. With these four different ratios I will compare and contrast how Spain and U.S.A has either improved or declined over the past three years (Borio & Zhu, 2012). The first Ratio I will use is the Current Ratio. The Current Ratio is a form of liquidity ratio that will show how the company will be able to pay its short term debts. If the ratio is less than 1 then it will show that Apple Inc. does not have enough short term assets to pay off its short term Liabilities. Analyzing the Balance Sheet provided. In 2012 U.S.A had. Total assets = 57, 653 Current liabilities = 38, 542 57,653 /38542= 1.50 So in the Year of 2012 U.S.A had Current Ratio of 1.50 (rounding to the nearest Hundreds) In the year of 2013 U.S had Current Assets of = 73,286 Current liabilities = 43, 658 73,286 /43,658= 1.68 INFLATION 4 So in the year of 2013 U.S.A. had a current ratio of 1.68 and since the ratio is higher than 1. U.S.A had no problem paying all of its short terms debt with the positive cash flow. In the year 2012 the current ratio was at 1.50 and in 2013 the current ratio was at 1.68 showing a small increase in its current assets over its current liabilities for the year of 2013. The Next Ratio I would like to use is the Inventory Turnover Ratio. This ratio will show how effectively U.S.A goods are being sold or the turnover rate of the product. The ratio shows how many times a product is sold over a period of time. The Formula for Inventory Turnover ratio is Cost of goods sold and divide that number by the amount of inventories. In 2012 U.S.A Had cost of goods sold at 87,846 and in 2012 the inventories was set at 791. 87,846 / 791 = 111.06 In the year of 2012 U.S.A Had an Inventory turnover ratio of 111.06 In 2013 U.S.A Had cost of goods sold of 106,606 and inventories was 1,764 106,606 / 1,764 = 60.43 In 2012, the turnover ratio was 111.05 and in 2013 the turnover ratio dropped to 60.43. This means that in 2012 U.S.A has sold its total inventory over 100 times over. This could deem a possible problem as it may seem that U.S did not have enough inventories to keep up with the demand. In 2013 the ratio dropped drastically to almost half at 60.43 in which U.S.A was able to solve the problem of not having enough inventories to keep up with the demand. INFLATION 5 I will now use the Quick Ratio. The Quick Ratio is similar to the current ratio but with the subtraction of inventories to the ratio because at times inventory can be viewed as liquid and inventory is the most difficult to be converted to cash so the quick ratio takes it entirely out of the equation. In 2012 Spain Had 57,653 Total current assets Current Liabilities = 38,542 Inventories of = 791 57,653 - 791 / 38,542 = 1.48 In 2013 Spain had Current assets = 73, 286 Current liabilities = 43,658 Inventories of = 1,764 73,286- 1,764 / 43,658 = 1.64 So between the years of 2012 and 2013 there was an increase of .15 of the ratio and with inventories removed there still a development of a positive quick ratio in which Spain will be able to pay off its short term debts. The Final Ratio I will analyze is the Asset Turnover Ratio. The Asset turnover Ratio displays the dollar amount of sales that is made through each dollar of Spain total assets. IF the Asset turnover is higher that means that the total assets are effectively managed and utilized to crease money for Spain INFLATION In 2012 Spain had Net sales of = 156,508 Total assets of = 176,064 156,508 / 176,064 = $0.89 Implying that in 2012 for every dollar Spain had in assets they made $0.89 in sales. In 2013 Spain had Net sales of = 170,910 Total assets of = 207,000 170,910 / 207,000 = $0.83 The difference between 2012 and 2013 shows that there was a decrease in the amount of sales U.S.A made per dollar of assets same to Spain. 6 INFLATION 7 Reference Arrow, K. J., & Kruz, M. (2013). Public investment, the rate of return, and optimal fiscal policy (Vol. 1). Routledge. Bartels, L. M. (2014). Ideology and retrospection in electoral responses to the Great Recession. Mass politics in tough times: Opinion, votes, and protest in the great recession, 185-223. Borio, C., & Zhu, H. (2012). Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?. Journal of Financial Stability, 8(4), 236-251. Burda, M., & Wyplosz, C. (2012). Macroeconomics: a European text. Oxford university press. DeLong, J. B., & Summers, L. H. (2012). Fiscal policy in a depressed economy. Brookings Papers on Economic Activity, 2012(1), 233-297. Pollin, R. (2012). US government deficits and debt amid the great recession: what the evidence shows. Cambridge Journal of Economics, 36(1), 161-187. Wiles, W. W. (2015 June 25). Federal Reserve System. System