1. Investment, strategy, and economic rents11
Investment, strategy, and economic rents
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 11-1 look first to market values
Smart investment decisions make more money than smart financing decisions
Smart investments are worth more than they cost
Positive NPVs
Firms calculate NPVs by discounting forecast cash flows
Positive NPV projects are more likely to be found in the product markets than in the financial markets. Generally, investment projects with positive NPVs can be found more often with positive NPVs.

3. 11-1 look first to market values
Projects may appear to have positive NPVs due to forecasting errors
Some acquisitions result from error in a discounted cash flow (DCF) analysis
Positive NPVs stem from a comparative advantage
Strategic decision making identifies this comparative advantage; it does not identify growth areas
Good investments are those with positive NPVs, but the NPV analysis is based on forecasts of future cash flows that are error prone. Generally, positive NPVs stem from a comparative advantage. Strategy analysis enables managers to identify this comparative advantage. It does not necessarily identify growth areas. Hence, strategic decision making and capital budgeting should complement each other.

4. 11-1 look first to market values
Don’t make investment decisions on the basis of errors in DCF analysis
Start with the market price of the asset and ask whether it is worth more to you than to others
Projects may also appear to have negative NPV values because of forecasting errors. For example, some acquisitions may not provide the increase in value because of erroneous DCF analysis.
Market prices, if available, provide a basis for determining the validity of cash-flow forecasts. Generally, the market price of the asset is a good indicator of its worth. Always verify forecasts and the assumptions behind those forecasts. Many of these assumptions are implicit.

5. 11-1 look first to market values
Don’t assume 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?
Do not underestimate the competition. Even smaller firms might pose a big threat.

6. 11-1 look first to market values
Department Store Rents
[assumes price of property appreciates by 3% a year]
Rental yield = = 7%
NPV = – / /(1.1)2 + ……..+ ( )/(1.1)10 = $1,000,000
100(1.03)10 = $134 = selling price at the end of 10 years. Assumes property value increases by 3% and the rental yield will increase by 7%.

7. Figure 11.1 department store rents
Department store income will not cover the rent after year 5. The department store is not a good investment. This is shown graphically.

8. 11-1 look first to 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%
The example shows how to utilize the market value in NPV analysis. King Solomon’s mine is a very good example of using market price to evaluate a project.

9. 11-1 look first to market values
Example, 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
Forecasting error might mask a good project. In this case there is no need to forecast gold prices. When forward rates are used for estimating future cash flows, they are certainty-equivalent cash flows and are discounted at the risk-free rate.

10. 11-1 look first to market values
Does Project 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
By identifying the source and the value of economic rents, one can verify NPV forecasts. Competitive advantages are sources of economic rents. Economic rents are profits that more than cover the capital costs. NPV can be thought of as the present value of rents. Rents are a result of better product, lower cost, or some form of competitive advantage. Competition generally erodes economic rents over time. Under pure competition, there is no economic rent and NPV is equal to zero.

11. 11-1 look first to market values
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’s (specialty chemicals) high positive NPV is due to a failure to take competition into account. This is an interesting example to show various pitfalls associated with the introduction of new technology. This is for the U.S. company. It is important to note that new technology will make the current technology obsolete. Personal computers are a good example of this.

12. Table 11.1 npv calculation, U.S. Company
This is the forecast for the U.S. company.

13. Table 11.2 npv calculation, European company
This is the forecast for the European company.

14. Table 11.3 npv calculation, u.s. company with European competition
This is the forecast for the U.S. company when competition from the European company is taken into consideration. This shows that the project has a negative NPV.

15. Table 11.4 gargle blaster industry
This frame shows the data for Marvin Enterprises.

16. Figure 11.2 demand for gargle blasters
The demand equation shows that for each dollar cut in price, the demand increases by 80 million units.

17. 11-3 marvin enterprises decides to exploit a new technology—an example
Value of Gargle Blaster Investment
The NPV for the project is calculated considering the incidental effect on the existing plant.

18. 11-3 marvin enterprises decides to exploit a new technology—an example
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
This frame shows how to value the business. Cash flows are assumed to be perpetuities to simplify the calculations. Students should focus on the concepts and methodology and not on the actual calculations.

19. Figure 11.3 alternative expansion plans
Total NPV is maximized if Marvin builds 200 million units of new capacity. If Marvin builds 280 million units of new capacity, total NPV is –144 million. The value of the existing plant drops dramatically if the capacity of the new plant is greater than 200 million. There is an optimal expansion capacity in this case.