1. Chapter 5 Investment Decisions: Look Ahead and Reason Back
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Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb,
Brian T. McCann,
Website, managerialecon.com
COPYRIGHT © 2008
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2. Chapter 5 – 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.

3. Chapter 5 – 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.

4. 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.

5. 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.

6. Determining investment profitability
The current/future trade-off can be calculated by,
Compounding
Xt+1=(1+r) Xt
Xt+s=(1+r)s Xt
Discounting (the opposite of compounding)
Xt+1/(1+r)= Xt
Xt+s/(1+r)s= Xt
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?
Discussion note: A high-discount-rate individual would willingly borrow from a low-discount-rate individual.

7. Present value and investment decisions
Companies also have 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, the project if profitable.
Calculating a company’s cost of capital is not a simple matter. Proper methods are the subject of much debate in the field of finance. Many companies satisfy themselves with rough estimates.
Note: NPV – net present value

8. The NPV rule in action
By calculating the returns of Projects 1 and 2, we find that Project 1’s return is higher than 14%, and Project 2’s is lower than 14%.
For this example the company’s cost of capital is 14%
To determine profitability, discount future inflows and outflows to compare with the initial investment – here $100

9. 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.

10. Background: 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), 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
Definition: Break-even analysis
0=Profits
0=Revenue-Total Costs
0=q*p-q*mc-F
0=(p-mc)q-F
q=F/(p-mc)

11. Decision making 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

12. 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
A discrete investment decision – the factory had big FC and small MC, Versatile had small FC but bigger MC
Remember this advice: Do not invoke break-even analysis to justify higher prices or greater output.
Discussion: Was this a good decision?
Advantage – the decision meant that the company could reach profitability sooner, with fewer sales, than if they had built their own factory.
Note on advice: Managers often reason that they must raise price to cover fixed costs. This is wrong if fixed costs do not vary with the pricing decision.
Similarly, managers sometimes reason that since average fixed costs decline with quantity, they must sell as much as they can to reduce average cost. Both lines of reasoning are flawed because pricing and production are extent decisions that require marginal analysis, not break-even analysis.

13. 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

14. Cost Taxonomy

15. Using the cost taxonomy
Example problem:
Fixed cost (FC)=$100/year
Marginal costs (MC)=$5/unit
Quantity (Q)=100/year
What is the break-even price for this scenario?
How low can prices go before shut down is profitable?
Answer: In the short run, only marginal cost is avoidable, so the shutdown price is $5.
In the long run, fixed costs become avoidable, so they become relevant to the shutdown decision. In the long run, the shutdown price includes average fixed cost and so rises to $6.
To make this concrete, present the FC as a one-year renewable lease. When the lease comes up for renewal, it is relevant to the shutdown decision because it is avoidable. However, until the lease comes up for renewal—during the period that economists call the short run—it is unavoidable, so you should ignore it when deciding whether to shut down.

16. Sunk costs and post-investment hold up
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 renogiating 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.

17. Sunk costs and post-investment hold up (cont.)
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?
One possible solution to post-investment hold-up is vertical integration.

18. 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
What is the hold-up problem?
Marriage: Parties invest time, energy, and money in a marriage, which differentiates marriages from more casual relationships (spot market transactions). These investments are valuable to the marriage parties but are largely specific, they have a lower value outside the relationship. The marriage contract penalizes post-investment hold-up (i.e., divorce) and this makes couples willing to invest more in the marriage.

19. Managerial Economics - Table of contents
1. Introduction: What this book is about
2. The one lesson of business
3. Benefits, costs and decisions
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7. Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19. The problem of adverse selection
20. The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
Managerial Economics - Table of contents