Chapter 11Principles of

Corporate FinanceTenth Edition

Investment, Strategy, and

Economic Rents

Slides by

Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

11-2

Topics Covered

Look First To Market ValuesEconomic Rents and Competitive

AdvantageExample - Marvin Enterprises

11-3

Market Values

Smart investment decisions make MORE money than smart financing decisions

Smart investments are worth more than they cost:

– they have positive NPVs

Firms calculate project NPVs by discounting forecast cash flows, but . . .

11-4

Market Values

Projects may appear to have positive NPVs because of forecasting errors

e.g. some acquisitions result from errors in a DCF analysis

Positive NPVs stem from a comparative advantage

Strategic decision-making identifies this comparative advantage; it does not identify growth areas

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Market Values

Don’t make investment decisions on the basis of errors in your DCF analysis.

Start with the market price of the asset and ask whether it is worth more to you than to others.

11-6

Market Values

Don’t assume that other firms will watch passively.

Ask --How long a lead do I have over my rivals? What will happen to prices when that lead disappears

In the meantime how will rivals react to my move? Will they cut prices or imitate my product?

11-7

Department Store Rents

[assumes price of property appreciates by 3% a year]

Rental yield = 10 - 3 = 7%

000,000,1$10.1

1348...

10.1

8

10.1

8100

102

NPV

000,000,1$10.1

13.98

10.1

87.88...

10.1

21.78

10.1

781092

NPV

11-8

Department Store Rents

11-9

EXAMPLE: KING SOLOMON’S MINE

Investment = $400 million

Life = 10 years

Production = .1 million oz. a year

Production cost = $480 per oz.

Current gold price = $800 per oz.

Discount rate = 10%

Using Market Values

11-10

EXAMPLE: KING SOLOMON’S MINE - continued

If the gold price is forecasted to rise by 5% p.a.:

But if gold is fairly priced, you do not need to forecast future gold prices:

NPV = -investment + PV revenues - PV costs

Using Market Values

millionNPV 70$.....10.1

)480882(10.

10.1

)480840(10.400

2

milliont

t105$

10.1

4801.800400

10

1

11-11

Do Projects Have Positive NPVs?

Rents = profits that more than cover the cost of capital

NPV = PV (rents)

Rents come only when you have a better product, lower costs or some other competitive edge

Sooner or later competition is likely to eliminate rents

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Competitive Advantage

Proposal to manufacture specialty chemicals

Raw materials were commodity chemicals imported from Europe

Finished product was exported to Europe

High early profits, but . . .

. . . what happens when competitors enter?

11-13

Polyzone Production NPV

Year 0 Year 1 Year 2 Year 3-10

Investment 100Production, Millions of pounds per year 0 0 40 80Spread, dollars per pound 1.2 1.2 1.2 1.2Net revenues 0 0 48 96Production costs 0 0 30 30Transport 0 0 4 8Other costs 0 20 20 20Cash flow -100 -20 -6 38

NPV (at r=8%) = $63.6 million

U.S. Company (figures in millions)

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Polyzone Production NPV

Year 0 Year 1 Year 2 Year 3-10

Investment 100Production, Millions of pounds per year 0 0 40 80Spread, dollars per pound 0.95 0.95 0.95 0.95Net revenues 0 0 38 76Production costs 0 0 30 30Transport 0 0 0 0Other costs 0 20 20 20Cash flow -100 -20 -12 26

NPV (at r=8%) = 0

European Company (figures in millions)

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Polyzone Production NPV

0 1 2 3 4 5 - 10Investment 100Production, Millions of pounds per year 0 0 40 80 80 80Spread, dollars per pound 1.2 1.2 1.2 1.2 1.1 0.95Net revenues 0 0 48 96 88 76Production costs 0 0 30 30 30 30Transport 0 0 4 8 8 8Other costs 0 20 20 20 20 20

Cash flow -100 -20 -6 38 30 18NPV (at r= 8%)= -9.8

Year

U.S. Company w/ European Competition (figures in millions)

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Marvin Enterprises

Capacity, Millions of Units

Technology Industry MarvinCapital Cost per

Unit ($)Manufacturing

Cost per Unit ($)Salvage Value per

Unit ($)

First generation (2020) 120 _ 17.5 5.5 2.5

Second generation (2028) 120 24 17.5 3.5 2.5

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Marvin Enterprises

Demand = 80 (10 - Price)

Price = 10 x quantity/80

Demand for Garbage Blasters

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Marvin Enterprises

Value of Garbage Blaster Investment

million

million

million

t

t

227$72299benefit Net

72$2.1

124plant existingPV Change

299$

25.1

10

2.1

3610100Plant New NPV

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Marvin Enterprises

VALUE OF CURRENT BUSINESS: VALUE

At price of $7 PV = 24 x 3.5/.20 420

WINDFALL LOSS:

Since price falls to $5 after 5 years,

Loss = - 24 x (2 / .20) x (1 / 1.20)5 - 96

VALUE OF NEW INVESTMENT:

Rent gained on new investment = 100 x 1 for 5 years = 299

Rent lost on old investment = - 24 x 1 for 5 years = - 72

227 227

TOTAL VALUE: 551

CURRENT MARKET PRICE: 460

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Marvin Enterprises

Alternative Expansion Plans

11-21

Web Resources

Click to access web sitesClick to access web sites

Internet connection requiredInternet connection required

www.thecorporatelibrary.com

www.towers.com

www.businessweek.com

www.forbes.com