 Where Net Present Values Come From Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 11 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Topics Covered  Look First To Market Values  Forecasting Economic Rents  Marvin Enterprises

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Market Values  Smart investment decisions make MORE money than smart financing decisions

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Market Values  Smart investments are worth more than they cost: they have positive NPVs  Firms calculate project NPVs by discounting forecast cash flows, but...

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Market Values  Projects may appear to have positive NPVs because of forecasting errors. e.g. some acquisitions result from errors in a DCF analysis.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Market Values  Positive NPVs stem from a comparative advantage.  Strategic decision-making identifies this comparative advantage; it does not identify growth areas.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Department Store Rents NPV = = $ 1 million [assumes price of property appreciates by 3% a year] Rental yield = = 7% NPV = $1 million

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill EXAMPLE: KING SOLOMON’S MINE Investment= $200 million Life= 10 years Production=.1 million oz. a year Production cost= $200 per oz. Current gold price= $400 per oz. Discount rate= 10% Using Market Values

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill EXAMPLE: KING SOLOMON’S MINE - continued If the gold price is forecasted to rise by 5% p.a.: NPV = (.1( ))/ (.1( ))/ = - $10 m. But if gold is fairly priced, you do not need to forecast future gold prices: NPV = -investment + PV revenues - PV costs =  ((.1 x 200)/1.10 t ) = $77 million Using Market Values

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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.

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 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?

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Marvin Enterprises

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Marvin Enterprises

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Marvin Enterprises Price Demand Demand = 80 (10 - Price) Price = 10 x quantity/80 Demand for Garbage Blasters

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Marvin Enterprises NPV new plant = 100 x [-10 +  ((6 - 3)/1.2 t ) + 10/1.25 = $299 million Change PV existing plant = 24 x  (1/1.2 t ) = $72 million Net benefit = = $227 million Value of Garbage Blaster Investment

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Marvin Enterprises VALUE OF CURRENT BUSINESS:VALUE At price of $7 PV = 24 x 3.5/ WINDFALL LOSS: Since price falls to $5 after 5 years, Loss = - 24 x (2 /.20) x (1 / 1.20) 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 = TOTAL VALUE: 551 CURRENT MARKET PRICE: 460

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill Marvin Enterprises NPV new plant Change in PV existing plant Total NPV of investment NPV $m. Addition to capacity millions Alternative Expansion Plans