Investment, Strategy, and Economic Rents Principles of Corporate Finance Tenth Edition Chapter 11 Investment, Strategy, and Economic Rents Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

Topics Covered Look First To Market Values Economic Rents and Competitive Advantage Example - Marvin Enterprises 2 2 2 2 3 2

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 . . .

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

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.

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?

Department Store Rents [assumes price of property appreciates by 3% a year] Rental yield = 10 - 3 = 7%

Department Store Rents

Using Market Values 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 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

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

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?

Polyzone Production NPV U.S. Company (figures in millions)

Polyzone Production NPV European Company (figures in millions)

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

Marvin Enterprises

Demand for Garbage Blasters Marvin Enterprises Demand for Garbage Blasters Demand = 80 (10 - Price) Price = 10 x quantity/80

Value of Garbage Blaster Investment Marvin Enterprises Value of Garbage Blaster Investment

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

Alternative Expansion Plans Marvin Enterprises Alternative Expansion Plans

Web Resources Click to access web sites Internet connection required www.thecorporatelibrary.com www.towers.com www.businessweek.com www.forbes.com