Risk Identification - Duke's Fuqua School of Business
Shanghai Disneyland Case Solution
The Walt Disney Company established its first theme park in 1955 in Anaheim, California. The company (also vested in Media Networks, Studio Entertainment, and Consumer Products) has since opened theme parks in Orlando, Florida, Tokyo, Japan, and Paris, France. More recently, Disney broke ground in Hong Kong with the intention of launching Hong Kong Disneyland on Lantau Island for approximately $2 Billion in hopes of reaching what has largely been an untapped Chinese market.
Given competitor Universal Vivendi’s current plans to build a theme park for less than $100 Million in Shanghai around 2006, Disney’s entry into China’s mainland has been a source of speculation. The main issues surrounding a Shanghai capital investment include financial potential of a new theme park and the potential qualitative and quantitative risks involved.
After reading and solving this case, the student should be able to:
• Forecast cash flows based upon sensitivities pertinent to a service-oriented company in an emerging market
• Evaluate effect of country risk upon discount rates to determine whether or not to enter an investment
• Understand the financial and economic effects of an emerging market government on a project
• Understand alternative ways of structuring a deal within an emerging market
An MBA student who has solved this case should be able to develop a thorough understanding of how to evaluate risk and financial return within an emerging market. In order to do this, the following solution is recommended.
MARKET SIZE ESTIMATIONS
The demographics of potential attendees not only help to size the market for Shanghai Disneyland, but also determine the required size of the park and average ticket price. This assessment is crucial since the average Shanghai resident (including both urban and rural) has an annual income of only $1,000 USD. Although setting an affordable ticket price is necessary to attract visitors, the tickets should also be priced to cover most of the operating costs, since ticket prices generate 50% of total park revenues. Determining the size of the market requires us to look at both the local Shanghai residents and its tourist market. These groups are discussed below separately.
Shanghai Residents
Rural Households
Rural households were ruled out from this market for several reasons. Most rural residents live in poverty, inhibiting them from this type of entertainment. Also, rural residents not considered peasants lack enough disposable income to attend the park after their normal expenditures have been covered. Therefore, it is very unlikely that Shanghai Disneyland will capture this market.
Urban Households
Urban Households should be considered for this market for several reasons. Shanghai is one of the wealthiest cities in China and its residents are considered the trendsetters of the country. Therefore, its view of this park will influence other Chinese visitors that may travel to Shanghai Disneyland. Attracting the urban market requires sub-segmenting this 16 million populated group based on their wealth distribution. Even though China has an income disparity and lacks a middle-income group, it is expected that Shanghai’s wealth distribution is slightly improved when compared to the overall country distribution. Therefore, estimates of the wealth distribution of Shanghai should be assessed separately. An income floor should be set for the target market to determine the potential penetration rate for the mid-to-upper income group. The income floor used in this analysis is 30,000 yuan ($3,600 USD), which reduces the urban segment to 5 million. The percentage of attendees estimated in this mid-to-upper group (80%) comprise of roughly 4 million visitors.
Tourist Market
Domestic Tourists
The tourist industry in Shanghai is very large and provides a large influx of money into the city. In 2000, 65.5 million domestic tourists visited Shanghai. Many of the tourists were visiting Shanghai to conduct business, shop, or visit family and friends. A conservative estimate of the penetration rate of this market is required. In our assessment, 12% was assumed for the mainland domestic tourists and 1% for the overseas domestic tourists, which adds roughly 7.8 million visitors to the captured market for Shanghai Disneyland.
Foreign Tourists
The same methodology applied for domestic tourists is considered for the foreign segment. However, only 5% of this market will add an additional 75,000 to the captured market.
Shanghai Disneyland’s 2010 Captured Market
Based on the demographic information provided, the key segments for Shanghai Disneyland are local mid-to-upper income urban residents, domestic tourists, and foreign tourists. The total market size for Shanghai amusement parks is estimated at roughly 72 million. Based on the above market analysis, Shanghai Disneyland is estimated to capture 15% of this market, with a 25% penetration from Shanghai urban residents and a 10% penetration from the tourist market. This puts Shanghai Disneyland with an estimated 10.64 million visitors in its first year of operation. See Exhibits 1a and 1b for more details on this analysis.
RISK ANALYSIS
The International Cost of Capital and risk calculator (ICCRC) theory was used to obtain the cost of capital. To do this, a standard 4% U.S. risk free rate and a 4% U.S. risk premium with a current U.S. Credit Rating of 93.10 was assumed. The institutional investor credit rating for China is 58.90 out of 100. These factors provided a 16.10% cost of equity. To accurately obtain the cost of equity for the Shanghai Disneyland project, adjustments were made to this implied cost of equity by accounting for project-specific risks that may differ from the overall risks of the country.
Major risks elements that would be affected by the project were identified and analyzed and compared to a typical project in China. From this analysis it was concluded that some components of the sovereign, operating, and financial risks needed to be adjusted. The details are discussed below and the results are contained in Exhibit 2.
Sovereign Risks
The principal risk in a communist country is most likely expropriation. However, this risk has been mitigated in this project since the government will have a controlling equity stake (57%) in the project. Also, the Government’s dependence on Disney to operate and market the venture mitigates any major expropriation risk.
Shanghai Disneyland’s cash flows will not be greatly affected by currency risk since the majority of the cash flows and debt service will be in the local currency.
The sensitivity of the project to wars, strikes, and terrorism is higher than the average foreign investment project in this country. The tourism industry is significantly affected by strikes, and war or terrorism would clearly have a severe and adverse impact on revenues in this sector. Having a company that is an American cultural icon as a large equity holder could further increase these risks.
China is a country with a considerable level of risk for natural disasters, but the project’s location in Shanghai reduces the overall risk of natural disasters when compared to country averages.
Operating and Financial risks
There are a number of relevant operating risks, including possible cannibalization from Hong Kong Disneyland. However, a minor amount of cannibalization can be expected given the infrastructure of the country and the relatively light travel patterns of the population between these areas.
The technology for this project would be provided by Disney, therefore there are no financial mitigating factors; rather, this project is closely tied to the government.
In summary, the adjustments for the tourism sector and the project specific risks reduce the cost of equity required by the shareholders from 16.10% to 16.09%.
CASH FLOW ANALYSIS
The assumptions and results of the cash flow analysis used in this solution are documented below.
Capital Structure
The capital structure information is summarized in Exhibit 9.
• The project was conservatively assumed to be $1.27B (based on the Hong Kong park and Universal’s investment in Shanghai), including $70M for construction of one hotel
• Structure is 60% Debt / 40% Equity with Disney holding 43% of the equity
• Investment schedule of the capital is spread over 5 year construction period from 2004-2008
• On-going capital expenditures are assumed to start at $38.52M in 2009 and grow by 3% (inflation) every year; these are for new attractions at the park and upgrades for the hotel
Revenues
Revenues were assumed to come from the following sources: park admissions, merchandise, food and beverage, main entrance fees (parking, lockers, etc.), and hotel revenues. The revenue calculations are summarized in Exhibits 5, 6, and 7.
Admissions revenues were based on attendance figures from Exhibit 1B and ticket price information from Exhibit 5. An initial attendance of 10.64M was assumed for 2008 and based on past attendance figures for other Disney venues, this number was expected to grow at a 1.5% annual rate. To keep things simple, only two ticket types were assumed – a one-day pass and an annual pass. 90% of attendance is expected from one-day passes.
Merchandise and food and beverage revenues were estimated assuming a fixed level of income ($5.03 each for merchandise and food & beverage in 2008) for each visitor to the park. This number was based on information from other Disney parks adjusted for the Shanghai market.
Main entrance fees are small and were assumed to be $0.5M in 2008. It was assumed this number would grow every year at the rate of inflation (3%).
Finally, hotel revenue assumptions are summarized in Exhibit 7. These conservative estimates were based on a moderate level hotel.
Operating Expenses
Operating expense information is summarized in Exhibits 3, 7, and 8.
• Park operating expense information (Exhibit 8) was based on data from other Disney venues – adjustments, particularly for cheaper labor and merchandise, were made for the Shanghai market
• Hotel operating expenses (Exhibit 7) were assumed to be 65% of hotel revenues
• $20M in startup costs for advertising and marketing were assumed in 2008
• 5% royalty fees that would be paid to Disney were assumed to be an expense for this project
Debt Repayment
A proposed debt repayment schedule is provided in Exhibit 10.
• Debt was taken on according to the investment schedule in Exhibit 9
• Repayment begins in 2008 with the beginning of operations
• Debt accumulates interest in years 2004-2017
• Assumed repayment horizon of 10 years with equal annual payments and an interest rate of 6%
Depreciation
A depreciation schedule is included in Exhibit 11.
• China allows straight-line depreciation over 20 years
• Assumed began depreciating assets as soon as investment was made
Taxes
The corporate tax rate in China is 30%. Deductions for interest on debt and depreciation expenses are allowable. Additionally, losses can be carried forward for five years. Note in Exhibit 3 that the losses from 2004-2007 were carried forward to 2008 and 2009.
NPV, IRR, and Cash Flows
The NPV, IRR and Cash Flow calculations are summarized in Exhibit 3. The cash flows were projected out over 25 years and discounted back using the 16.09% cost of equity discussed in the previous section. The result is a positive NPV of $19.2M and an IRR of 17% (which is greater than the 16.09% hurdle rate).
REAL OPTIONS
Finally, there are a variety of options to consider that could potentially add value to this project. For example, Disney could wait on constructing a theme park in Shanghai until Universal Studios opens their operation. This would give Disney the opportunity to observe Universal’s undertaking and apply any benchmarks to their project. However, given Universal’s relatively poor track record at opening resorts, the value of this option is likely small. More significant options probably include the following:
• Build more hotels at a later date
• Build a ‘Downtown Disney’ entertainment center with shopping, restaurants and bars after the theme park has established operations
• Eventually increase the size of the park by adding another gate, i.e. Epcot Center in Orlando
Specifically, the hotel option should increase the value of the project. With the existence of one hotel in the original project, Disney has the opportunity to gauge the market. This would certainly reduce the uncertainty and risk associated with building more hotels at a later date. Thus, there should be significant value for Disney in waiting to make a decision on further hotel construction for this project.
CONCLUSION
Based on these calculations and methodology, the students who review this case will most likely find that it is indeed a good business proposition for Disney to enter the Shanghai market. Students writing up this case should not only touch upon the points listed above, but should also delve into the unquantifiable benefits of expanding the Disney brand within China’s market. This point should be especially important should students find their calculations indicate the project would be a negative NPV or a below hurdle rate IRR. Recommendations made could also include the following:
• Begin negotiations with Chinese government
o Government equity stake and debt provisions
o Land and infrastructure provisions
• Disney must make the argument that a Shanghai Park would not substantially damage Hong Kong
• Escalating political tensions on the Korean peninsula could change the risk assessment
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