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Chapter 5 Investment Decisions: Look Ahead and Reason Back COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 5 – Take Aways Break-even quantity is equal to fixed cost divided by the contribution margin. If you expect to sell more than the break-even quantity, then incur the fixed costs to enter the industry. Avoidable costs can be recovered by shutting down. If the benefits of shutting down (you recover your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The break-even price is average avoidable cost. If you incur sunk costs, you are vulnerable to postinvestment hold-up. Unless the parties are convinced they won’t be held up, they will be reluctant to make sunk-cost investments. Relationship-specific investments are largely sunk. Once relationship-specific investments are made, parties are locked into a bargaining relationship with each other. If transactions are frequent and transaction costs are high, then organizational forms like vertical integration or long-term contracts reduce transactions costs and encourage relationship-specific investments.

Chapter 5 – Take Aways Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates lend to those with high discount rates. Companies, like individuals, have different discount rates. Invest only in projects with a positive NPV because they earn a return higher than the company’s cost of capital. The NPV rule states that if the present value of the net cash flows of a project is larger than zero, the project is profitable. Projects with positive NPV create economic profit.

Review of Chapter 4 Do not confuse marginal and average costs MR and MC are relevant benefits and costs of an extent decision If MR>MC, do more of it Incentive compensation increases MR or decreases MC.  Fixed fees have no effect on effort Link compensation to measures that reflect effort

Introductory Anecdote In 2000, Mobil Oil was the leading supplier of industrial lubricants in the US, bundling engineering services with their high-quality lubricants One of their largest customers was a regional producer of electric power (CBA) In early 2000, Mobil invested in a three-month engineering audit of CBA  Included employee training and equipment inspections  For each piece of CBA equipment, Mobil provided repair, service, and lubricant recommendations. CBA made the recommended repairs but shopped the recommendation list to Mobil’s competitors, who offered lower prices When Mobil failed to match the lower prices, they lost the contract and their three-month “investment” In this section, we study investment decisions like the one by Mobil that involve costs that cannot be recovered

Background: Break-Even Quantities Break-even quantity is the amount you need to sell to just cover your costs At this sales level, profit is zero The break-even quantity is Q=FC/(P-MC), where FC are fixed costs, P is price, and MC is marginal cost P-MC is the “contribution margin” – what’s left after marginal cost to “contribute” to covering fixed costs

Discrete (All-Or-Nothing) Decisions Should I enter this industry? Should I exit this industry? Should I purchase a new plant? Should I sell to a competitor? Total costs=F + MC*Q  Fixed cost to enter, constant mc per unit.  Definition: Fixed costs (F) are costs that do not vary with the level of production. Proposition: For short-run decisions, consider only marginal costs Proposition: in the long run, you should consider all costs, marginal and fixed.

Entry Decision Two investment options  Capital intensive production has higher fixed cost but lower marginal cost  More flexible production has lower fixed cost but higher marginal cost Find the quantity level at which the costs of the two options are the same. Say, Cost 1 =100+10q and Cost 2 =50+20q  Costs are same at q=5  If you expect to sell more than five, choose high fixed cost and lower marginal cost. If less than five, choose the other

Shut Down Decisions: Break-Even Price If you shut down  Get back avoidable cost  But lose revenue  Opportunity cost of operation is the benefit of shutting down RULE: shut down if  revenue is less than avoidable cost; or  price is less than average avoidable cost Break-even price is the average avoidable cost  Profit =Rev-Cost=(P-AC)*Q

Avoidable Costs Discussion: F=$100/year; MC=$5/unit; Q=100/year  What is break-even price? Discussion: what if F is sunk, not fixed? Discussion: post-investment hold-up

Sunk Costs and Postinvestment Hold-Up Printer and Magazine  2 year contract  2 million copies  $2 million for printer  MC=$1/copy Break-even price is $2  Post-investment hold-up  One Lesson of Business: how to consummate this transaction? Discussion: after bidding the contract you get a PO for half the quantity you quoted? Should you accept it?

Vertical Integration as Solution to Hold-Up Bauxite mine and alumina refinery  Refineries are tailored to specific qualities of ore  Transaction options Spot-market transactions Long-term contract Vertical integration  Vertical integration refers to the common ownership of two firms in separate stages of the vertical supply chain that connects raw materials to finished goods Contractual view of marriage  What is hold-up problem?

Determining Investment Profitability Money today is worth more than money tomorrow Compounding  X t+1 =(1+r) X t  X t+s =(1+r) s X t Discounting  X t+1 /(1+r)= X t  X t+s /(1+r) s = X t Discussion: trade between individual with different discount rates What does this say about behavior?

Present Value and Investment Decisions Companies also have discount rates, determined by cost of capital Time is a critical element in investment decisions – cash flows to be received in the future need to be discounted to present value using the cost of capital The NPV Rule: if the present value of the net cash flows is larger than zero, the project if profitable

The NPV Rule in Action Two Projects Project 2 is the better project, right? Not when you consider present value Note: assuming cost of capital of 14%

NPV and Economic Profit Projects with positive NPV create economic profit. Only positive NPV projects earn a return higher than the company’s cost of capital. Projects with negative NPV may create accounting profits, but not economic profit. In making investment decisions, choose only projects with a positive NPV.

Alternate Introductory Anecdote 1983: John Deere in midst of building Henry- Ford-style production line for large 4WD tractors  Wheat prices fell dramatically reducing demand for large tractors Abandoned factory and purchased Versatile; assembled tractors in a garage using off-the- shelf components  Discrete investment decision This is an example of a discrete or “all-or- nothing” decision