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Problem Statement
Merk & Co., Inc was reviewing an investment proposal from MSDI, its facility in Spain. The value of this
investment has to be evaluated using discounted cash flow method. The problem which the company has to
solve is to decided among the following three options:
Case Facts
Analysis
Three possibilities
The following three cases are possible in the way Merck & Co., Inc deals with its cash flows from its
subsidiaries.
1. The cash flows which come in peseta are reinvested in the local currency (peseta). Therefore the
opportunity cost of capital(the rate at which cash flows are discounted) should be that of peseta
2. The cash flows which come in peseta are converted to USD as an when they are received.
3. The cash flows conversion to dollars does not follow a pattern.
1. Use cash flows in peseta and discount them using peseta discount rate (opportunity cost at subsidiary).
NPV that is obtained is in peseta which is converted to USD using the spot rate.
2. Convert the cash flows from peseta into USD using future exchange rates. Calculate NPV using $
discount rate.
3. Estimate the rate at which peseta cash flows are converted to dollars. Get the corresponding $ amount
and discount it using $ discount rate.
If parity condition holds in two currencies, then all the three approaches will result in the save value. Therefore
the value of the investment is independent of the approach. However in the next five years peseta is predicted
to appreciate against dollar. The reason is because of the improvements in performance of Spanish economy
in the recent years. The GDP has doubled in the past 4 years (from 1984 to 1987).
Merck & Co., Inc can reinvest their cash flows in peseta because of the following reasons:
Spanish economy is developing, and it makes more sense for Merck & Co., Inc to reinvest their cash
flows in local currency.
Operations at Alcala de Henares is into research are development and not sales. Therefore the cash
realized might not be translated readily into dollars.
Therefore valuation approach 1 can be used for the purpose of evaluating the value of the investment.