1. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Investment Strategy April 11, 2007 (LA) or April 5, 2007 (OCC)

2. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Strategic Issues raised by NPV u Sources of NPV u Sequencing of decisions u Dealing with uncertainty u Open questions –the discount rate –affecting the market value for investors

3. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Sources of Present Values u Michael Porter’s analysis (e.g. Competitive Strategy, 1980) –Competitors –Suppliers –Customers –Substitutes –Potential entrants u No advantage lasts forever in competitive markets

4. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Sequencing of Decisions u Most investments can be developed in a sequence of stages where the investment strategy can be refined or the project abandoned u Decision trees useful Test Market Expand Close Down Good result Bad result

5. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Stewart Pharmaceuticals u The Stewart Pharmaceuticals Corporation is considering investing in developing a drug that cures the common cold. u A corporate planning group, including representatives from production, marketing, and engineering, has recommended that the firm go ahead with the test and development phase. u This preliminary phase will last one year and cost $1 billion. Furthermore, the group believes that there is a 60% chance that tests will prove successful. u If the initial tests are successful, Stewart Pharmaceuticals can go ahead with full-scale production. This investment phase will cost $1.6 billion. Production will occur over the next 4 years.

6. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Decision Tree for Stewart Pharmaceutical Do not test Test Failure Success Do not invest Invest The firm has two decisions to make: To test or not to test. To invest or not to invest. NPV = $3.4 b NPV = $0 NPV = –$91.46 m

7. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Stewart Pharmaceutical: Test? u Let’s move back to the first stage, where the decision boils down to the simple question: should we invest? u The expected payoff evaluated at date 1 is: The NPV evaluated at date 0 is: So we should test.

8. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Dealing with Uncertainty u We have implicitly been dealing with expected cash flows - each cash flow represents a probability-weighted average of likely outcomes u Alternatives methods are to deal with several alternatives (scenario analysis) or to identify critical assumptions (sensitivity analysis) u Break-even points may assist evaluation

9. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Break-Even Analysis u Accounting break-even analysis u Present-value break-even analysis u Example

10. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Examples of PV vs Real Options u Value of motel is costing $9.7 million expected worth $10 million at 10% yields NPV of $300,000 u $10 million is expected value of two equally likely outcomes, $11 and $9 million, future will reveal information about true value of motel u Management could wait one year to take advantage of this information u This value of project with option to postpone is.5*($1.3)/1.1 = $.591 million (since no bad outcome) so option value is $.591 - $.300 = $.291 million

11. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Management options AbandonContractSwitchWaitExpandGrowth Currently Invested: React to Good News Currently Invested: React to Bad News Not Currently Invested

12. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Real Options and Investment u Growth options –May increase size of investment later u Timing options –Delay and learn more about opportunities u Switching options –Change nature or use of invested assets u Option to expand or contract (scale) u Abandonment options

13. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Open Questions u How do we actually choose the discount rates? u If we make positive net present value decisions, how will they affect our share price? u Can the market understand every possible strategy -- should we play out a strategy even though our share price suffers?

14. J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 For Class 11 and Following Week u Read Chapters 9 and 10 and work problems for next week u Work on Part 3 of group project (due April 25 (LA) or April 24 (OCC)) and identify any questions or problems requiring assistance from instructor u Read handout on Sheet 2 “Continuing Values” assumptions for PVFIRM05