Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. PowerPoint Slides © Luke M. Froeb, Vanderbilt 2014

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Chapter 5 Investment Decisions: Look Ahead and Reason Back 2

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary of Main Points Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates (rate at which they value future vs. current dollars) lend to those with high discount rates. Companies, like individuals, have different discount rates, determined by their cost of capital. They invest only in projects that earn a return higher than the cost of capital. The NPV rule states that if the present value of the net cash flow of a project is larger than zero, the project earns economic profit (i.e., the investment earns more than the cost of capital). Although NPV is the correct way to analyze investments, not all companies use it. Instead, they use break-even analysis because it is easier and more intuitive. 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 your investment is profitable.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Summary (cont.) 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 post-investment hold-up. Anticipate hold-up and choose contracts or organizational forms that minimize the costs of hold-up. Once relationship-specific investments are made, parties are locked into a trading relationship with each other, and can be held up by their trading partners. Anticipate hold-up and choose organizational or contractual forms to give each party both the incentive to make relationship- specific investments and to trade after these investments are made.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Introductory Anecdote In summer 2007, Bert Matthews was contemplating purchasing a 48-unit apartment building. The building was 95% occupied and generated $550,000 in annual profit. Investors expected a 15% return on their capital The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of 5.5% Mr. Matthews computed the cost of capital as a weighted average of equity and debt..2*(15%) +.8*(5.5%) = 7.4% Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even. Mr. Matthews decided not to buy the building. A good decision – one year later, the cost of capital was % and Mr. Matthews could offer only $5.4 million for the building. This story illustrates both the effect of the bursting credit bubble on real estate valuations and, more importantly, the relevant costs and benefits of investment decisions.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Background: Investment Profitability All investments represent a trade-off between possible future gain and current sacrifice. Willingness to invest in projects with a low rate of return, indicates a willingness to trade current dollars for future dollars at a relatively low rate. This is also known as having a low discount rate (r). Individuals with low discount rates would willingly lend to those with higher discount rates. Discounting helps you figure out if future gains are larger than current sacrifice.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Compounding To understand discounting, let’s first look at compounding: (future value, k periods in the future) = (present value) x (1 + r) K Example: If you invest $1 (present value) today at a 10% (r), then you would expect to have $1.10 in one year. In two years, $1 becomes $1.21 = $1.10 x (1+.1) A good compounding rule of thumb: “Rule of 72”: If you invest at a rate of return r, divide 72 by r to get the number of years it takes to double your money

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Discounting Discounting (the inverse of compounding): Present value = (future value, k periods in the future) (1 + r) k Example: At a 10% r, $1 is worth: Next year: ($1)/1.1 = $0.91 Two years: ($0.91)/1.1 =$0.83 Discussion: If my discount rate is 10%, would I lend to or borrow from someone with a discount rate of 15%? What does this say about behavior?

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Example: Nashville Pension Obligations ▮ The city of Nashville uses discounting to decide how much to save for future pension obligations. ▮ For a pension that pays out $100,000 in 20 years, with a discount rate of 8.25% Nashville must save: $100,000/(1.0825) 20 =$20,485 If the city invests the $20,485 and earns 8.25%, then the savings will compound in 20 years – unrealistic! Somewhat of high savings rate that may not be returned; however, a high savings rate means less current spending, which is politically popular A more realistic (but less popular) discount rate would be 6.5%, which would lead to saving $28,380 now. 9

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Determining the Profitability of Investments Remember the simple rule: discount the future benefits of an investment, and compare them to the current cost. Companies use discount rates, which are determined by cost of capital. A company’s cost of capital is a blend of debt and equity, its “weighted average cost of capital” or WACC 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, then the project earns more than the cost of capital.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The NPV Rule In Action Consider two projects that each require an initial investment of $100 Project 1 returns $115 at the end of the first year Project 2 returns $60 at the end of the first, and $60 at the end of the second The company’s cost of capital is 14% Project 1 earns more than the cost of capital. Project 2 does not.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. NPV and Economic Profit Projects with a 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.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Another Method: Break-Even Quantities The 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) FC: fixed costs P: price MC:marginal cost (P-MC) is the “contribution margin” – what’s left after marginal cost to “contribute” to covering fixed costs

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Example: Nissan Truck Nissan’s popular truck model, the Titan, had only two years remaining on its production cycle. Redesigning the “Titan” would cost $400M. Cost of capital was 12%, implying annual fixed cost of $48M Contribution margin on each truck is $1,500 Break-even quantity is 32,000 trucks The decision to redesign or not came down to a break-even analysis Nissan had a 3% share of the market, implying only 12,000 Titan sales per year – not enough to break even. Instead they decided to license the Dodge Ram Truck, which would reduce the fixed cost of redesign, and a lower break- even point. After the Government took over Chrysler, Nissan reconsidered

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Deciding Between Two Technologies 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 decided to abandon the new factory and instead purchased Versatile, a company that assembled tractors in a garage using off-the-shelf components Deere chose one manufacturing technology over another A discrete investment decision – the factory had big FC and small MC, Versatile had small FC but bigger MC

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. John Deere: Right Decision? ▮ Was purchasing Versatile the right choice? ▮ It depends… on how much John Deere expected to sell. Suppose the capital-intensive technology would involve $100 FC and $10 MC Suppose Versatile’s technology had $50 FC and $20 MC To determine break-even quantity (point of indifference), solve for the quantity that equates the costs: $150 for 5 units If you expect to sell less than 5 units, choose the low-MC technology If you expect to sell more than 5 units, choose the low-FC technology 16

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. John Deere Lesson ▮ John Deere made the right decision by acquiring Versatile; however, the Antitrust Division of he U.S. Department of Justice challenged the acquisition as anticompetitive. ▮ John Deere and Versatile were only two of 4 firms selling 4WD tractors in North America. 17

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Break-Even Advice ▮ Remember this advice: Do not invoke break-even analysis to justify higher prices or greater output. ▮ Managers sometimes believe they must raise prices to cover fixed costs or they must sell as much as possible to make average costs lower ▮ These are extent decisions though! They require marginal analysis, not break-even 18

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. The Decision to Shut-Down Shut-down decisions are made using break-even prices rather than quantities. The break-even price is the average avoidable cost per unit Profit = (Rev-Cost)= (P-AC)(Q) If you shut down, you lose your revenue, but you get back your avoidable cost. If average avoidable cost is less than price, shut down. Determining avoidable costs can be difficult. To identify avoidable costs firms use Cost Taxonomy

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Taxonomy ▮ Example: FC=$100, MC=$5, and you produce 100 units/year ▮ How low of a price before you shut down? IT DEPENDS ▮ It depends on which costs are avoidable Long-run: fixed costs become avoidable so they are included in the shutdown price Short run: they are unavoidable and should not be included in the shutdown price

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sunk Costs and Post-Investment Hold Up Always remember the business maxim “look ahead and reason back.” This can help you avoid potential hold up. Before making a sunk cost investment, ask what you will do if you are held up. What would you do to address hold up?

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Sunk Costs and Post-Investment Hold Up Example National Geographic can reduce shipping 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 BUT once the press is purchased, the cost is sunk and the break-even price changes. Because of this the magazine can hold up the printer by renegotiating the terms of the deal – because the price of the press is unavoidable, and sunk, the break-even price falls to $1, the marginal cost.

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Vertical Integration One possible solution to post-investment hold-up is vertical integration. Example: Bauxite mine and alumina refinery Refineries are tailored to specific qualities of ore The transaction options are: Spot-market transactions Long-term contracts 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 Discussion: How is vertical integration a solution to hold up? Contractual view of marriage Long-term contracts induce higher levels of relationship-specific investment