PowerPoint Slides © Michael R. Ward, UTA 2014

Econ 5313 The Hudsucker Proxy “Project Startup Decisions” from The Hudsucker Proxy Stop at 5:00 http://www.youtube.com/watch?v=upIMfHFgWtQ Look like the process at your company? The steps in a ‘rational’ product launch

Econ 5313 Time Value If I auctioned off a $1 today (standard auction – not ‘all pay’), how much would you be willing to pay? Darn close to $1 If I auctioned off a $1 to be paid to you in a year, how much would you be willing to pay? Something less than the first auction What does the difference represent? The cost to you of delayed gratification In general, this is the source of discounting future income flows

Econ 5313 The Discount Rate Often the rate at which we discount the future is the same per period. We call this the discount rate or “r”. Formally, we discount some future value “X”: Xt = Xt+1/(1+r) for one year. Xt = Xt+2/(1+r)2 for two years. Xt = Xt+s/(1+r)s for “s” years. We can also take current values into the future. If we lend X to someone, how much do they have to pay in the future to make us indifferent? Xt+1 = Xt×(1+r) for one year. Xt+2 = Xt×(1+r)2 for two years. Xt+s = Xt×(1+r)s for “s” years.

Valuing an Income Stream Econ 5313 Valuing an Income Stream Usually, we are dealing with an investment cost today that will generate a flow of future benefits. We expect the investment will generate a stream of future benefits B1, B2, B3, … , BT. We want to compare that to current costs, C0. To do so, we need to calculate the present value of each benefit: PV1 = B1/(1+r) for one year. PV2 = B2/(1+r)2 for two years. PVT = BT/(1+r)T for “T” years. Now the sum of these is: PV = B1/(1+r) + B2/(1+r)2 + … + BT/(1+r)T. Xt+s = Xt×(1+r)s for “s” years.

Econ 5313 Investment Criterion Now we can compare the current costs with the present value of the benefits. If PV > C0 then the investment will return benefits greater than the costs. Fund it. Sometimes we rearrange to ask “PV - C0 > 0?” This is the “Net Present Value” or NPV. Possible complications? Do we know Bt into the future? Do we know r? Is r constant? Compound interest?

Cost of Capital Where do companies’ interest rates come from? Econ 5313 Cost of Capital Where do companies’ interest rates come from? What is the opportunity cost of these funds? Borrowing and other forgone investment opportunities. Finance department calculates a Weighted Average Cost of Capital (WACC). What are typical values? How often are these updated?

Without Discounting Two very simple projects Econ 5313 Without Discounting Two very simple projects What is the sum of the benefits for project 1? What is the sum of the benefits for project 2? Which would you choose? C0 B1 B2 Project 1 $100 $115 $0 Project 2 $60

With Disounting But if the WACC was 14% then present values are: Econ 5313 With Disounting But if the WACC was 14% then present values are: Why does the timing matter? C0 B1 B2 PV Project 1 $100 $100.88 $0.00 Project 2 $52.63 $46.17 $98.80

Discounting and Price Changes Econ 5313 Discounting and Price Changes Should Prof. Ward’s new car be a V6 or a 4 cylinder? He likes the power of the V6 but they burn more gas making the operating costs higher. We need to be able to forecast the price of gasoline over the life of the new car Look ahead at the counter-party’s decision process Oil companies are have potential barrels of oil in the ground and have decided on how much to pull out each year. If MC rises with current production, spread out production over time. So set MRt = MCt in each period Across periods?

Discounting and Price Changes Econ 5313 Discounting and Price Changes They should equate PV of profits from pulling a barrel out across periods. Why? (P1-MC1)/(1+r)1 = (P2-MC2)/(1+r)2 = (P3-MC3)/(1+r)3 = … Suppose they expect that (P7-MC7)/(1+r)7 is higher than other years. What can they do to increase profits? Shift more production toward this period until equal again Or, (Pt-MCt)/(1+r)t = (P0-MC0) for each period t Suppose MCt = 0 for all t. Then, Pt = P0(1+r)t or prices just rise with the interest rate Aha, a price prediction Do we think MC of extracting oil and refining it into gasoline is falling or rising?

Discounting and Price Changes Econ 5313 Discounting and Price Changes Historically, inflation adjusted prices have been roughly constant, so if r > 0, MC must have been falling. Whoopee, I am getting a V6

Other Investment Criteria Econ 5313 Other Investment Criteria NPV versus “internal rate of return” versus “payback period” What is “internal rate of return” IRR? Defined by asking “What r will make NPV = 0?” Decision is “Is this more than WACC?” Problems with IRR? What is payback period? Defined by asking “For how many periods do we have to go out for the sum of benefits to exceed costs?” Decision is “Is this less than the life of the project?” Problems with payback period?

Econ 5313 Break-Even Analysis You can print bootleg Cowboy's Tee-shirts and sell them on game day for $9. Your costs are $6 per unit with a setup cost of $600. How many do you have to sell to break even? You just break-even when profits are zero. So we need: Revenues = Costs $9×Q = $6×Q + $600 $3×Q = $600 Q = 200 You just break-even when you sell 200 shirts. If you expect sales of >200 shirts, should you invest?

Break-Even Quantities Econ 5313 Break-Even Quantities General formula is QBE = FC/(P-MC). Use this to see how the forecast for Q compares with QBE. If you do not expect to sell QBE units, don’t invest FC. Problems with Break-Even Analysis? If Q < QBE, tempted to raise price to get a smaller value. But usually the forecast for Q is based on the lower price. EX Chicago Skyway

Alternative Investments Econ 5313 Alternative Investments In 1983, John Deere was in the midst of building a Henry-Ford-style production line factory for large 4WD tractors. Unexpectedly, wheat prices fell dramatically reducing demand for large tractors. Deere’s competitor, Versatile, assembled tractors in a garage using off-the-shelf components. A discrete investment decision – the factory had big FC and small MC, Versatile had small FC but bigger MC. High Tech: Fixed Cost = $100K and MC = $10K Low Tech: Fixed Cost = $60K and MC = $15K Which is cheaper?

Alternative Investments Econ 5313 Alternative Investments Even if you do not know Q, you might be able to determine how big or small it would have to be to justify one decision or another

Econ 5313 Break-Even Prices A toy manufacturer introduced a successful new toy truck. It invested $2.5 million for a plastic injection molding machine (which can be sold for $2.0 million) and $100,000 in plastic injection molds specifically for the toy (not valuable to anyone else). Labor and the cost of materials for each truck are $3. This year, a competitor has developed a similar toy that has cut into demand. The manufacturer is deciding whether they should continue production of the toy truck. If the estimated demand is 100,000 trucks, what is the break-even price for the toy truck? At a price of $20, should you shut down? $100,000 is sunk but $2 million is avoidable and so relevant to this decision. Breakeven price is $3 + $2 million/100,000 = $23.

Sunk versus Avoidable Costs Econ 5313 Sunk versus Avoidable Costs For shutdown decisions, it is important to only consider those costs that are marginal to the decision. Of course, marginal production costs are relevant. But the fixed costs can be divided into those that are sunk and those that are avoidable. Sunk costs are gone and are no longer relevant to decisions on how to operate into the future. But avoidable costs mean that you are foregoing some other opportunity. If you shut down the toy factory, you can redeploy the $2million elsewhere. The opportunity cost of the toy factory is a return on the $2million elsewhere. This factory has to make it worth your while to not redeploy the funds. $100,000 is sunk but $2 million is avoidable and so relevant to this decision. Breakeven price is $3 + $2 million/100,000 = $23.

Econ 5313 Hold-up National Geographic can reduce costs by printing with regional printers. To print a high quality magazine, the printer must buy a $12 million printing press. Each magazine has a MC of $1 and the printer would print 12 million copies over two years. The break-even cost/average cost is $7 = ($12M / 2M copies) + $1/copy. The printer wins the contract with a bid slightly over $7/copy. After a year, National Geographic wants to renegotiate the terms down to $2/copy. What should the printer do?

Econ 5313 Hold-up This is an example of the “hold-up problem” or “ex post opportunism.” It arises because some costs involved in a project are marginal before the contract but are sunk during the contract. These costs have to be “relationship specific” i.e., no scrap value. You have to anticipate holdup and protect yourself from it. How could the printer have protected himself?

Econ 5313 Bidding on Contract Suppose you work for an original equipment manufacturer (OEM) who makes component pieces for a telecommunications company. The telecom company asks you for a price quote for 2,000,000 units that will require a $1,000,000 investment with marginal costs of $1. What is your bottom line in negotiations with the telecom? Suppose you agree on a price slightly above your bottom line. Immediately after quoting this price to the telecom company, you receive a purchase order for one million units. What should you do?

Econ 5313 Solutions to Holdup If possible, condition prices on quantities purchased If possible, protect yourself with a strong enough contract Always some contract imperfection Sometimes, the only solution is to vertically integrate so that there is no conflict Ex power company Sometimes, there is no solution and value-creating relationship-specific investments cannot be made Is marriage a “value creating relationship-specific investment?”

Econ 5313 Selling an Idea Fargo Once the idea is revealed, can you negotiate over it? http://movieclips.com/fb6gc-fargo-movie-a-finders-fee/

From the Blog Chapter 5 Health Investments Pension Investments Econ 5313 From the Blog Chapter 5 Health Investments Pension Investments Prices and R&D Italian Employment Protection Chinese Divorces

Econ 5313 Main Points Investments usually involve cash flows at different times, i.e., costs first & revenues later To make them comparable, need to discount future values to the present value Companies’ discount rates are from cost-of-capital NPV rule – economic profit if NPV > 0 Compare IRR and payout period Breakeven quantity is quantity needed for contribution margin to cover FC Breakeven price is average avoidable costs and excludes sunk costs The different timing of costs and revenues leads to holdup 5