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Part V Case Studies

Case V.1
The International Machine Corporation
equity. The remaining 40% is to be distributed widely among Mexican nancial institutions and private investors. Accordingly. IMC needs to invest U.S. $6 million in the project. B. Working capital 1. The company plans to maintain 5% of annual sales as a minimum cash balance. 2. Accounts receivable are estimated to be 73 days of annual sales. 3. Inventory is estimated to be 20% of annual sales. 4. Accounts payable are estimated to be 10% of annual sales. 5. Other payables are estimated to be 5% of annual sales. 6. Licensing and overhead allocation fees are paid annually at the end of the year. C. Sales volume 1. Sales volume for the rst year is estimated to be 200 units. 2. Selling price in the rst year will be Ps 458,000 per unit. 3. Unit sales growth of 10% is expected during the project life. 4. An annual price increase of 20% is expected. D. Cost of goods sold 1. The U.S. parent company is expected to provide parts and components adding up to Ps 59,000 per unit in the rst year of operation. These costs (in U.S. dollars) are
Source: This is an edited version of The International Machine Corporation: An Analysis of Investment in Mexico, by Vinod B. Bavish, University of Connecticut, and Haney A. Shawkey, State University of New York at Albany. Permission to use this case was provided by Professors Bavishi and Shawkey.

The International Machine Corporation (IMC) is a large, well-established manufacturer of a wide variety of food processing and packaging equipment. Total revenue for last year was $12 billion, of which 45% was generated outside of the United States. IMC has subsidiaries in 23 countries, with licensing arrangements in eight others. The management of IMC is currently contemplating the establishment of a subsidiary in Mexico. IMC has been exporting products to Mexico for several years, and its international division believes there is sufcient demand for the product and that a Mexican investment might be appropriate at this time. More important, management believes that the Mexican market is expanding, that the economy is growing, and that producing such products locally appears to be consistent with the national aspirations of the Mexican government. Mexican ination is projected to be 20% annually, and the U.S. ination rate is expected to be 10% annually. The current exchange rate is $1 Ps 7.2 and is expected to remain xed in real terms over the life of the investment. The following list contains details of the contemplated investment. A. Initial investment 1. It is estimated that it would take one year to purchase and install plant and equipment. 2. Imported machinery and equipment will cost $9 million. No import duties will be levied by the Mexican government. With a small allowance for banking fees, the bill will come to Ps 65.5 million. 3. The plant would be set up on government-owned land that will be sold to the project for Ps 6.5 million. 4. IMC plans to maintain effective control of the subsidiary with ownership of 60% of

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expected to rise on an average of 10% annually, in line with the projected U.S. ination rate. 2. Local material and labor costs are expected to be Ps 137,000 per unit, with an annual rate of increase of 20%. 3. Manufacturing overhead (without depreciation) is expected to be Ps 9.2 million the rst year of operation. An average rate of increase of 15% is expected. 4. Depreciation of manufacturing equipment is to be computed on a straightline basis, with a projected life of 10 years and zero salvage value to be assumed. E. Selling and administrative costs 1. The variable portion of selling and administrative costs are expected to equal 10% of annual sales revenue. 2. Semixed selling costs are expected to equal 5% of the rst years sales. These costs will then rise at 15% annually. F Licensing and overhead allocation fees . 1. The parent company will levy Ps 23,000 per unit as licensing and overhead allocation fees, payable at year end in U.S. dollars. 2. This fee will increase 20% per year to compensate for Mexican ination. G. Interest expense 1. Local borrowings can be obtained for working capital purposes at 15%. Borrowing will occur at the end of the year with the full years interest budgeted in the following year. 2. Any excess funds can be invested in Mexican marketable securities with an annual rate of return of 15%. Investment will be made at the end of the year, with the full years interest to be received in the following year. H. Income taxes 1. Corporate income taxes in Mexico are 42% of taxable income. 2. Withholding taxes on licensing and overhead allocation fees are 20%.

Part V Case Studies

3. The parent companys effective U.S. tax rate is 35%, which is the rate used in analyzing investment projects. It can be assumed that the parent company can take appropriate credits for taxes paid to, or withheld by, the Mexican government. I. Dividend payments 1. No dividends will be paid for the rst three years. 2. Dividends equal to 70% of earnings will be paid to the shareholders, beginning in the fourth year. J. Terminal payment It is assumed that, at the end of the tenth year of operation, IMCs share of net worth in the Mexican subsidiary will be remitted in the form of a terminal payment. K. Parent companys capital structure 1. Domestic debt equals U.S. $1 billion with an average before-tax cost of 12%. The cost of new long-term debt is estimated at 14% before tax. 2. An amount equivalent to $600 million of parent debt is denominated in various foreign currencies, and after adjusting for previous exchange gains/losses the cost (or effective cost) of this debt has averaged 16%. 3. Shareholder equity (capital, surplus, and retained earnings) equals U.S. $1.5 billion. The company plans to pay U.S. $3.20 in dividends per share during the coming year. Over the last 10 years, earnings and dividends have grown at a compounded rate of 7%. The market price of common stock was $40, and number of shares outstanding were 60 million as of last December 31. L. Exports lost At present IMC is exporting about 25 units per year to Mexico. If IMC decides to establish the Mexican subsidiary, it is expected that the aftertax effects on income due to the lost exports

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Case V.2 Euro Disneyland

sales would be $648,000, $742,000, and $930,000 in the rst three years of operation, respectively. IMC assumes it cannot count on these export sales for more than three years because the Mexican government is determined to see that such machinery is manufactured locally in the near future.
Questions
1. Should IMC make this investment?

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2. What is IMCs required rate of return for this

project?
3. What factors and assumptions are critical to

your project analysis?

Case V.2

Euro Disneyland
Chunnel, the tunnel under the English Channel) are in place. But there is risk nonetheless. The most critical variable is attendance. Many experts think surprises may await Disney. They doubt that attendance will meet Disneys expectations. Others think that the crowds will come but will spend less than Disney projects. Disney faces other unknowns as well. MCA/Universal, which will be bought by Matsushita in 1990, is thinking of building a park in London, which would cannibalize Euro Disneylands attendance. Theres also the grim winter weather, which prompts European parks to close until spring. Then theres the challenge of training 12,000 Europeans, half of them French, to be Disney cast members. Bowing to French individualism, Disney will relax its personal grooming code a bit. Disney may also decide to change its ban on booze if customers call loudly enough for wine and beer. Disney claims that its experience with Tokyo Disneyland, its last major development project, shows that it can deal with non-American culture and bad weather. Tokyo Disneyland was completed on time and within 1% of budget. It has also been a huge commercial success.
Financing

It is 1987, and in a muddy sugar-beet eld 20 miles east of Paris, Walt Disney Co. is creating Euro Disneyland. By the time of its scheduled opening in 1992, Euro Disneyland (EDL) is expected to cost FF 15 billion ($2.5 billion based on an exchange rate of FF 6 $1). Most signs point to the parks success. Two million Europeans already visit its American parks every year. And Paris demographics look great: In two hours, 17 million people could drive to the park and 310 million people could y to the park. Disneys risk appears to be modest. It has invested $350 million in planning the park but has put up just $145 million for 49% of EDLs equity. Public investors will pay $1 billion for the other 51% in a stock offering in October 1989. The public company, through its traded shares, will give Europeans a chance to participate in the success of the project once the gates open in 1992. (When the stock begins trading on the Paris Bourse in October 1989, Disneys stake will be valued at $1 billion an $855 million gain in value.) Even if prots are weak, Disney will rake in fat management fees. And it could clean up just on the land: It has rights to buy 4,800 acres from the government at just $7,500 an acre compared with $750,000 an acre for similar land in the area. Disney can resell chunks to other developers for any price it can get. The acreage should jump in value once high-speed rail lines from Paris and London (via the

In March 1987, Disney and the French government sign a Master Agreement for Euro Disneyland. In accordance with that agreement,

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Disney forms a holding company to control development of the entire site. It pays $145 million for 49% of the holding companys shares and sells 51% of EDL to European investors for a little over $1 billion; of the latter shares, around half are sold to the French. The holding company set up as an SCA (Societ Commandite par Actions), a unique French corporate form that is very similar to an American limited partnership. Disney is the gerant, or general partner. The SCA structure allows Disney to control management, even with a minority shareholding. Thus, even though the holding company owns EDL, Disney will manage it and collect an estimated $35 million a year in royalties on sales of admission tickets, food, and souvenirs. The master agreement is basically an inducement for Disney to bring Euro Disneyland to Paris rather than to Spains Mediterranean coast. The inducements include the following:
G Loans of up to FF 4.8 billion are available from a French government agency. The loans carry a xed interest rate of 7.85%, in contrast to a normal commercial rate of 9.25%. G EDL can use accelerated depreciation to write off the construction costs of its extravaganza over a 10-year period. G The French government will invest $350 million in park-related infrastructure. This includes sewer and telephone trunk lines, subway and road links to Paris, and a new line of its 156-mile-per-hour train a grande vitesse (TGV) that will link EDL to the Chunnel (and thence to London), Brussels, and Lyons. G Disney is allowed to buy 4,800 acreas of land at 1971 prices. The average cost is FF 11.1 per square meter compared with FF 1,000 per square meter for development land in the Paris suburbs. G The French government agrees to cut the value-added tax (VAT) on ticket sales to just 7% instead of the usual 18.5%.

Part V Case Studies

Disney will structure the $2.5 billion Euro Disneyland project so that the operating losses created during construction can be used, along with the accelerated depreciation benets, as tax shelters. These tax benets will be sold to a group of French companies for $200 million. Equity contributions include the $1.15 billion stock sale plus Disneys $350 million investment in project planning. The remaining $800 million of project nancing will come from loans subsidized by the French government. The repayment schedule on these loans is as follows (in FF millions):
1992 1996 1997
0

1998

1999

2000

2001

FF 960 FF 960 FF 960 FF 960 FF 960

Euro Disneyland will also require about $115 million in working capital initially, and this amount is expected to grow at the rate of sales revenue. The working capital will be nanced by French franc bank loans carrying an interest rate expected to average about 9.5% annually.
Financial Projections

Disneys projections assume a minimum 1992 attendance rate at Euro Disneyland of 11 million visitor-days and maximum of 16 million. These numbers compare with 1988 attendance at the domestic U.S. parks of 25.1 million for Orlandos Disney World and 13 million for Anaheims Disneyland. In projections of future years attendance, a conservative 3% annual growth rate is reasonable. The range of EDL attendance gures based on these assumptions is shown in Exhibit V 2.1. The next step is to forecast individual expenditures at the park on a daily basis, for admission as well as for food and merchandise. Disneys projections assume that each visitor will spend FF 78.6 on merchandise, FF 59.5 on food and beverages, and FF 5.5 on parking and other items (e.g., stroller rentals). Admission fees are estimated at FF 144.4 apiece.

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Case V.2 Euro Disneyland

Exhibit v.2.1 1992
11 12 13 14 15 16 Projected Number of Visitor Days at Euro Disneyland (Millions)

607
Disney will collect 30% of the parks OCF in the range of FF 1.4 2.1 billion; 40% of all OCF between FF 2.1 and 2.8 billion; and 50% of all OCF above FF 2.8 billion. Disney will receive no incentive fee if the parks OCF is less than FF 1.4 billion. In this case, the operating cash ow will equal operating income as Disney has sold its depreciation tax benets. In November 1989, Walt Disney Co. announced plans to add a movie studio theme park as the second gated attraction to Euro Disneyland. The movie studio theme park is expected to open in 1996. In addition to strengthening Disneys lm production capabilities in Europe (where the movement to enforce geographic quotas continues to gain momentum), the second attraction could add as much as FF 3.3 billion to 1996 operating revenues.
Questions
1. These questions are related to the $800 million

1993
11.3 12.4 13.4 14.4 15.5 16.5

1994
11.7 12.7 13.8 14.9 15.9 17.0

1995
12.0 13.1 14.2 15.3 16.4 17.5

1996
12.4 13.5 14.6 15.8 16.9 18.0

Source: Liz Buyer, EuroDisney: As Close to Risk Free as a Deal Can Get, The Journal of European Business, March/April 1992, p. 27. Reprinted with permission of Journal of European Business and Faulkner and Gray.

These estimates are based on 1989 francs. French ination is expected to increase these gures by 5% each year. As of late 1989, the French franc:dollar exchange rate was about FF 6 $1, but this rate could obviously vary considerably. For example, U.S. ination is expected to average about 4% annually, about 1% below the expected French ination rate. Euro Disneyland will also collect participation fees from various corporate sponsors, such as Kodak and Renault. These fees are payment for the privilege of sponsoring specic attractions in return for promotional considerations (e.g., Krafts The Land) and are expected to approximate $35 million in 1992. EDLs pretax operating margin is expected to be about 35%. That money will not all ow into the hands of EDL shareholders. EDL must pay interest on its debt and French tax. The effective tax rate is estimated at 55%. In addition, EDL must pay Disney royalties, a base management fee, and an incentive-based bonus fee. Under the master agreement, Disney will collect 10% of the revenues generated by ticket sales and 5% of all expenditures on food, beverage, and merchandise. Disney also can collect signicantly higher fees from EDL if the park exceeds certain operating cash ow (OCF) targets. Specically,

(FF 4.8 billion at FF 6 $1) in French government-subsidized loans. a. What is the value to Disney of the French governments loan subsidies? b. What exchange risk is this project subject to from the standpoint of Disney? How can nancing be used to mitigate this exchange risk? c. Suppose it turns out that having $800 million in franc nancing actually adds to Disneys economic exposure. How should this affect Disneys willingness to accept the full amount of nancing offered by the French government? 2. Based on purchasing power parity, project the dollar:franc exchange rate from 1989 through 1996. 3. What is the range of projected dollar net income for Euro Disneyland for the years 1992 1996? 4. Suppose the terminal value at the end of 1996 is estimated at seven times net income for 1996. Using a 15% cost of capital, what is the

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range of net present values of Euro Disneyland as a stand-alone project? 5. Using the same 15% cost of capital, what is the range of net present values of Walt Disneys investment in Euro Disneyland?

Part V Case Studies

6. Should Walt Disney go ahead with this project?

What other factors might you consider in estimating the value of Euro Disneyland to Walt Disney?