Lecture 3.2 Principles of Corporate Finance Eighth Edition Strategy and The Capital Investment Decision Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Topics Covered  Look First To Market Values  Economic Rents and Competitive Advantage  Example - Marvin Enterprises

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Market Values  Smart investment decisions make MORE money than smart financing decisions

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Market Values  Smart investments are worth more than they cost: –they have positive NPVs  Firms calculate project NPVs by discounting forecast cash flows, but...

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Market Values  Projects may appear to have positive NPVs because of forecasting errors e.g. some acquisitions result from errors in a DCF analysis

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Market Values  Positive NPVs stem from a comparative advantage  Strategic decision-making identifies this comparative advantage; it does not identify growth areas

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Department Store Rents NPV = = $ 1 million [assumes price of property appreciates by 3% a year] Rental yield = = 7% NPV = $1 million

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Polyzone Production NPV U.S. Company (figures in millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin But you need to expect that competition will enter at some time causing prices to decline. In this case: European producers can avoid the transportation costs, so they are in fact the least cost producer. Your advantage is that you are the “first mover”

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Polyzone Production NPV European Company (figures in millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Polyzone Production NPV European Company (figures in millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Polyzone Production NPV U.S. Company w/ European Competition (figures in millions)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Marvin Enterprises

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Marvin Enterprises Price Demand Demand = 80 (10 - Price) Price = 10 x quantity/80 Demand for Garbage Blasters

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Marvin Enterprises First find breakeven price for old technologies Generation NPV Price (P-5.50) (P-3.50) (P-3.00)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin  So we build the plant, capacity will now be 340 million units, so price will decline from $7 to $5.75. But at that price, Generation 1 capital will be driven out, causing the price to increase. When will this process stop?  When the price rises to $6.00. That will be when total capacity is: 320. That is when 20 million units of old technology capacity leaves  Finally, after 5 years, competition drives the price to $5.00

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Marvin Enterprises NPV new plant = 100 x [-10 +  ((6 - 3)/1.2 t ) + 10/(1.20) 5 = $299 million Change PV existing plant = 24 x  (1/1.2 t ) = $72 million Net benefit = = $227 million Value of Garbage Blaster Investment

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Marvin Enterprises NPV new plant Change in PV existing plant Total NPV of investment NPV $m. Addition to capacity millions Alternative Expansion Plans

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