Finance Part V Homework Many Experts Think Surprises May Await Disney

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Part V Case Studies

Case V.1 The International Machine Corporation

The International Machine Corporation (IMC) is a

large, well-established manufacturer of a wide

variety of food processing and packaging equip-

ment. Total revenue for last year was $12 billion,

of which 45% was generated outside of the

United States. IMC has subsidiaries in 23 coun-

tries, with licensing arrangements in eight others.

The management of IMC is currently contem-

plating the establishment of a subsidiary

in Mexico. IMC has been exporting products

to Mexico for several years, and its international

division believes there is sufficient demand for

the product and that a Mexican investment

might be appropriate at this time. More impor-

tant, management believes that the Mexican mar-

ket 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 inflation is projected to be 20%

annually, and the U.S. inflation rate is expected to

be 10% annually. The current exchange rate is

$1 Ps 7.2 and is expected to remain fixed 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

equity. The remaining 40% is to be distrib-

uted widely among Mexican financial insti-

tutions 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 first year is estimated

to be 200 units.

2. Selling price in the first year will be Ps

458,000 per unit.

3. Unit sales growth of 10% is expected dur-

ing 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

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expected to rise on an average of 10%

annually, in line with the projected U.S.

3. Manufacturing overhead (without deprecia-

tion) is expected to be Ps 9.2 million the

first year of operation. An average rate of

E. Selling and administrative costs

1. The variable portion of selling and admin-

istrative costs are expected to equal 10% of

annual sales revenue.

2. Semifixed selling costs are expected to

equal 5% of the first year’s sales. These

costs will then rise at 15% annually.

H. Income taxes

1. Corporate income taxes in Mexico are 42%

of taxable income.

2. Withholding taxes on licensing and over-

head allocation fees are 20%.

3. The parent company’s effective U.S. tax rate

is 35%, which is the rate used in analyzing

I. Dividend payments

1. No dividends will be paid for the first three

years.

J. Terminal payment

It is assumed that, at the end of the tenth

year of operation, IMC’s share of net worth

in the Mexican subsidiary will be remitted in

the form of a terminal payment.

K. Parent company’s capital structure

1. Domestic debt equals U.S. $1 billion with

an average before-tax cost of 12%. The cost

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 after–

tax effects on income due to the lost exports

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sales would be $648,000, $742,000, and

$930,000 in the first 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?

2. What is IMC’s required rate of return for this

project?

3. What factors and assumptions are critical to

your project analysis?

It is 1987, and in a muddy sugar-beet field 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 park’s success. Two million Europeans

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

Chunnel, the tunnel under the English Channel)

are in place.

But there is risk nonetheless. The most critical

variable is attendance. Many experts think sur-

prises may await Disney. They doubt that atten-

dance will meet Disney’s expectations. Others

Financing

In March 1987, Disney and the French govern-

ment sign a “Master Agreement” for Euro

Disneyland. In accordance with that agreement,

Case V.2 •Euro Disneyland 605

Case V.2 Euro Disneyland

Disney forms a holding company to control

development of the entire site. It pays $145 mil-

lion for 49% of the holding company’s shares

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 induce-

ment for Disney to bring Euro Disneyland to

●EDL can use accelerated depreciation to

write off the construction costs of its extravagan-

za over a 10-year period.

●The French government will invest

Disney will structure the $2.5 billion Euro

Disneyland project so that the operating losses

created during construction can be used, along

1992 –

1996 1997 1998 1999 2000 2001

0 FF 960 FF 960 FF 960 FF 960 FF 960

Euro Disneyland will also require about $115

Financial Projections

Disney’s 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

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These estimates are based on 1989 francs.

French inflation is expected to increase these

figures 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. inflation is expect-

ed to average about 4% annually, about 1% below

the expected French inflation rate.

Euro Disneyland will also collect “participa-

tion fees” from various corporate sponsors, such

as Kodak and Renault. These fees are payment

for the privilege of sponsoring specific attractions

in return for promotional considerations (e.g.,

Kraft’s “The Land”) and are expected to approxi-

mate $35 million in 1992.

EDL’s pretax operating margin is expected to

be about 35%. That money will not all flow 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 mer-

chandise. Disney also can collect significantly

higher fees from EDL if the park exceeds certain

operating cash flow (OCF) targets. Specifically,

Disney will collect 30% of the park’s 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 park’s OCF is less than

FF 1.4 billion. In this case, the operating cash

flow will equal operating income as Disney has

Questions

1. These questions are related to the $800 million

(FF 4.8 billion at FF 6 $1) in French govern-

ment-subsidized loans.

a. What is the value to Disney of the French

government’s loan subsidies?

b. What exchange risk is this project subject to

from the standpoint of Disney? How can

financing be used to mitigate this exchange

risk?

c. Suppose it turns out that having $800 mil-

lion in franc financing actually adds to

Disney’s economic exposure. How should

this affect Disney’s willingness to accept

the full amount of financing 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

Case V.2 •Euro Disneyland 607

Exhibit v.2.1

Projected Number of

Visitor Days at Euro

Disneyland (Millions)

1992 1993 1994 1995 1996

11 11.3 11.7 12.0 12.4

12 12.4 12.7 13.1 13.5

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 Disney’s

investment in Euro Disneyland?

6. Should Walt Disney go ahead with this project?

What other factors might you consider in esti-

mating the value of Euro Disneyland to Walt

Disney?

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