The net present value of the photoelectric

The case talks about a large producer of pharmaceuticals, Merck Sharpe & Dohme International, MSDI, focusing specifically on its operations in ALCA De HENARES, SPAIN. At Spain, one of the primary process consisted of washing, filling, inspecting and sealing the ampoules of Lidocaine. It is stated that in spring 1987, it was running at 200% of planned capacity. To sustain this level of production 10 more workers were needed, who in turn needed 2 – 3 months of training.
An alternative that was available and being considered was investing in new equipment, which had a capacity of 6 million ampules per year, i.e. , 25% more capacity than was anticipated. Decision is required to be taken on whether or not this would be a worthwhile investment or not?
Compute the net present value of the photoelectric inspection equipment in (a) pesetas, by discounting peseta cash flows at a peseta discount rate; and b) dollars, by translating future peseta cash flows into dollars at expected future spot exchange rates. Merck’s dollar hurdle rate for a project of this type was 13 percent. Assume that at the time of the analysis, annual inflation was expected to be 8 percent in Spain and 4 percent in the United States.

We get the same net present value as in case 1. However if we use the historical inflation data and interest rates to calculate the exchange rate there is a difference in the NPV. The Net Present Values are different because of the change in the macroeconomic indicators. The approach which is the most conservative one should be used i. e. considering the historical inflation data. The IRR is also quite good. Here one should try to be conservative because the demand for the product is going to decrease in the years.
So if the company decides to buy the equipment even when the demand is going to fall it should be conservative in its decision making. As the inflation decreases from 8% to 4% the values of peseta/dollar exchange rate for the corresponding years from 1987 to 1997 also decreases. This is because the expected spot rate factor is directly depended on the inflation rate. The decrease in expected spot rate leads to lesser increase in forward spot exchange rates which increases the differential cash flow in dollar whcih ultimately results in increasing NPV.