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Case of Dorchester Ltd:

NPV= PV of the Cash Flows Initial Investment


NPV = 2,549,341.78 - 4,666,666.667
= -2,117,324.89

The project would generate cash flows that have a present value much lower than the
investment it requires. Thus, the project has a negative NPV so Dorchester should not
invest in US as it would actually destroy the value of the firm. This project would not add
value to the company rather it would destroy the companys value by -2,117,324.89.
However, the case does not illustrate the value that the project would have at the point
of termination i.e. the value of liquidating all the assets. If the value is large enough to
make the NPV of this project positive only then Dorchester should go ahead with the
decision of investing in US.

Year Adjusted Cash PV Factor PV Of Cash Flows ()


Flows ()
0 -4,666,666.67 1
1 27,212.986 0.899699565 24,483.51
2 257,010.417 0.809459307 208,039.47
3 509,067.085 0.728270186 370,738.38
4 785,121.980 0.655224369 514,431.05
5 1,087,045.153 0.589505079 640,818.64
6 1,200,012.228 0.530377463 636,459.44
7 323,507.175 0.477180373 154,371.27
Total 2,549,341.78
Assumptions & Reasoning for Calculations:

Year 5% Increase In Fall In Exports ($) Realized Sales


Market ($) For The Parent
($)
0 390,000.000
1 409,500.000 232,000.000 177,500.000
2 429,975.000 174,000.000 255,975.000
3 451,473.750 116,000.000 335,473.750
4 474,047.438 58,000.000 416,047.438
5 497,749.809 0.000 497,749.809
6 522,637.300 0.000 522,637.300
7 548,769.165 0.000 548,769.165

The case suggests that Dorchester would be able to recover the exports that were
previously made to US in 5 years that would be lost due to this new facility there.
However, there is no information about at what rate it would recover thus it is assumed
that it is recovered evenly over 5 years. So, at the end of year 5, 100% is recovered and
the value for lost exports is 0.

Exchange Rate:

UK inflation= 4.5% (average)


US inflation= 3%
According to PPP:
Change in ER= (0.045- 0.03)/(1+0.03) = 0.0146 = 1.46%
The ER increases by 1.46% every year.
Year ER
0 0.6667
1 0.6764
2 0.6863
3 0.6963
4 0.7065
5 0.7168
6 0.7272
7 0.7379

Whether to borrow from home or US:

According to International Fisher Effect:


1+0.1075 = 1.1075..Home interest rate
(1+ 0.095) * (1+0.0146) = 1.1109.US interest rate
US interest rate > UK interest rate

Based on this, as home interest rate is lower than the US, Dorchester should borrow
1,000,000 pound sterling at 10.75% rather than borrowing from US at 9.5%.

Bond Valuation:
Since it is not mentioned if it is a premium or discount bond, the RRR for the bond is
assumed to be 10.75% i.e. similar to the coupon rate.

It is also assumed that the coupon payments are made from the cash flows generated
from this facility and the principal is paid at the end of 7 years. Coupon payment is
converted into dollars to state the interest payment since it should be paid from the
income generated by the subsidiary. However, the principal amount is deducted at the
end of seventh year from the cash flows. Since the bond is issued to finance the new
facility it is logical to assume that it is repaid at the end of the lifetime of the project.

Year Interest ER Interest


Payment ($) Payment ($)
0 0.00 1.5000 0
1 107500 1.5219 163604.25
2 107500 1.5441 165992.8721
3 107500 1.5667 168416.368
4 107500 1.5895 170875.247
5 107500 1.6127 173370.0256
6 107500 1.6363 175901.2279

7 107500 1.6602 178469.3859

WACC:
Since the facility itself is the project, the RRR is the cost of capital in this case.

Amount () Weight WACC


Equity
2,666,666.67 57.14% 8.57%
Bond 1,000,000.00 21.43% 1.50%
Loan 1,000,000.00 21.43% 1.08%
Total 4,666,666.67 11.15%
Financing Strategy:

To choose a specific financial mix Dorchester can follow few theories developed over
time.
Trade off theory:
Trade off theory indicates a balance between interest tax shields against cost of
financial distress. It is a way of choosing debt levels by which a company can benefit
from interest payments by recognizing tax.

Option 1 Option 2 Option 3 Option 4


Equity 2,866,666.67 2,166,666.67 2,666,666.67 2,666,666.67
Bond 800,000.00 1,500,000.00 1,200,000.00 1,500,000.00
Loan 1,000,000.00 1,000,000.00 800,000.00 500,000.00
Total 4,666,666.67 4,666,666.67 4,666,666.67 4,666,666.67
Weight
Equity 0.614285714 0.464285714 0.571428571 0.571428571
Bond 0.171428571 0.321428571 0.257142857 0.321428571
Loan 0.214285714 0.214285714 0.171428571 0.107142857
Weight (1-T)
Equity 0.092142857 0.069642857 0.085714286 0.085714286
Bond 0.011978571 0.022459821 0.017967857 0.022459821
Loan 0.010794643 0.010794643 0.008635714 0.005397321

WACC 0.114916071 0.102897321 0.112317857 0.113571429

WACC 11.49% 10.29% 11.23% 11.36%


The previously chosen financial strategy estimates a WACC of 11.15%. However, if we
manipulate the level of debt by some amount the cost of capital changes.

Option 1:
It suggests that the company can reduce the level of debt by 2000000 by reducing the
debt in terms of bonds and taking same amount of loan. This would give a higher cost of
capital since the equity level increases that has the highest RRR i.e.15%.

Option 2:
It implies what happens if the company takes more debt than the increased capacity.
Though this would exhaust their debt capacity it would further reduce the cost of
capital. Since any firms objective is to maximize its value, a low cost of capital would
enhance the firms value by providing higher PV for the cash flows. By taking 2.5 million
debts the cost of capital reduces to 10.29%. Taking more debt would also mean
increasing chances of getting bankrupted i.e. bankruptcy probability goes up thus the
risk of the business would also go up leading to a rise in the cost of capital. Since the
case does not suggest the rate of increase in the risk premium, the actual cost of capital
is hard to estimate.

Option 3 and 4:
Here, the fund raised through bond is relaxed and the fund acquired by community loan
is lowered. Since the bond has a higher cost compared to the loan the WACC is higher
than the original one.
Pecking order theory:
This suggests that a company uses its retained earnings for the expansion of the firm. If
it does not have any form of retained earnings it issues debt to obtain funds. After this,
when the debt capacity is exhausted and the company is unable to issue more debt to
raise fund, it issues equity security to have access to further funds. Though Dorchester is
not using any retained earnings for the expansion it is taking the maximum debt that is
relaxed for this new subsidiary and the rest of the fund is acquired through equity.

Real life scenario:


If the real life scenario is considered i.e. factor that influences the choice of capital
structure is that how the other firms in the same industry that have been operating in
the market for a significant time. Since Dorchester is an old firm it is definitely aware of
the structure that is suitable for this particular industry. Another aspect that is
important to consider is that Dorchester does not have any subsidiary in the US so it can
identify the capital structure of other chocolate producing firms that is of similar size.
This would give them a good idea of choosing an effective capital structure. While
deciding based on this, Dorchester should also consider that there would be some
differences in the capital structure of a well established firm and a new firm in the US
market. Though Dorchester, being an exporter has the advantage of being a known
brand.

Suggested financial mix:


Dorchester should take as much debt as possible. To minimize the WACC, it should take
the total loan available i.e. $1,500,000 as the cost of loan is the lowest. It can borrow
more debt by relaxing the constraint on bonds. It can borrow more than 1 million pound
in terms of bonds as the cost of bond is lower than the cost of equity. It would help to
reduce the cost of capital but it should be raised to an amount where it will not highly
threaten the Dorchesters ability to pay its debt holders on time.
The financial strategy is based on the knowledge of FIN440.