Case Study on Dorchester Ltd.
Suggested Solution to Dorchester Ltd.
Summary of Key Information
The current exchange rate in European terms is So(£/$) = 1/1.50 = .6667.
The initial cost of the project in British pounds is SoCo = £0.6667($7,000,000) =
£4,666,900.
The U.K. inflation rate is estimated at 4.5% per annum, or the mid-point of the 4%-5% range. The U.S. inflation rate is forecast at 3% per annum. Under the simplifying assumption that PPP holds [pic] = .6667(1.045)t/(1.03)t.
The before-tax nominal contribution margin per unit at t=1 is $4.40(1.03)t-1.
It is assumed that Dorchester will be able to sell one-fifth of the 290,000 pounds of candy it presently sells to North America in Eastern Europe the first year the new manufacturing facility is in operation; two-fifths the second year; etc.; and all 290,000 pounds beginning the fifth year.
The contribution margin on lost sales per pound in year t equals £3.00(1.045)t.
Terminal value will initially be assumed to equal zero.
Straight line depreciation over the seven year economic life of the project is assumed: Dt = $1,000,000 = $7,000,000/7 years.
The marginal tax rate, (, is the U.K. (or U.S.) rate of 35%.
Dorchester will borrow $1,500,000 at the concessionary loan rate of 7.75% per annum. Optimally, Dorchester should borrow the remaining funds it needs, £1,000,000, in pounds sterling because according to the Fisher equation, the real rate is less for borrowing pounds sterling than it is for borrowing dollars:
5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus
6.31% or .0631 = (1.095)/(1.03) - 1.0.
Kud = 15%.
Calculation of the Present Value of the After-Tax Operating Cash Flows
| | | | | | | | |
| | | |[pic] x Quantity | | | | |
| | | | |
Summary of Key Information
The current exchange rate in European terms is So(£/$) = 1/1.50 = .6667.
The initial cost of the project in British pounds is SoCo = £0.6667($7,000,000) =
£4,666,900.
The U.K. inflation rate is estimated at 4.5% per annum, or the mid-point of the 4%-5% range. The U.S. inflation rate is forecast at 3% per annum. Under the simplifying assumption that PPP holds [pic] = .6667(1.045)t/(1.03)t.
The before-tax nominal contribution margin per unit at t=1 is $4.40(1.03)t-1.
It is assumed that Dorchester will be able to sell one-fifth of the 290,000 pounds of candy it presently sells to North America in Eastern Europe the first year the new manufacturing facility is in operation; two-fifths the second year; etc.; and all 290,000 pounds beginning the fifth year.
The contribution margin on lost sales per pound in year t equals £3.00(1.045)t.
Terminal value will initially be assumed to equal zero.
Straight line depreciation over the seven year economic life of the project is assumed: Dt = $1,000,000 = $7,000,000/7 years.
The marginal tax rate, (, is the U.K. (or U.S.) rate of 35%.
Dorchester will borrow $1,500,000 at the concessionary loan rate of 7.75% per annum. Optimally, Dorchester should borrow the remaining funds it needs, £1,000,000, in pounds sterling because according to the Fisher equation, the real rate is less for borrowing pounds sterling than it is for borrowing dollars:
5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus
6.31% or .0631 = (1.095)/(1.03) - 1.0.
Kud = 15%.
Calculation of the Present Value of the After-Tax Operating Cash Flows
| | | | | | | | |
| | | |[pic] x Quantity | | | | |
| | | | |