1. Where Positive Net Present Values Come From Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 11 McGraw Hill/Irwin

2. 11- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  Look First To Market Values  Forecasting Economic Rents  Marvin Enterprises

3. 11- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Market Values  Smart investment decisions make MORE money than smart financing decisions

4. 11- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Market Values  Smart investments are worth more than they cost: they have positive NPVs  Firms calculate project NPVs by discounting forecast cash flows, but...

5. 11- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Market Values  Projects may appear to have positive NPVs because of forecasting errors e.g. some acquisitions result from errors in a DCF analysis

6. 11- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Market Values  Positive NPVs stem from a comparative advantage  Strategic decision-making identifies this comparative advantage; it does not identify growth areas

7. 11- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

8. 11- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

9. 11- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Department Store Rents NPV = -100 + +... + = $ 1 million [assumes price of property appreciates by 3% a year] Rental yield = 10 - 3 = 7% NPV + +... + + = $1 million 8 8 + 134 1.10 1.10 10 8 - 7 8 - 7.21 8 - 8.87 8 - 9.13 1.10 1.10 2 1.10 9 1.10 10

10. 11- 10 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved EXAMPLE: KING SOLOMON’S MINE Investment= $200 million Life= 10 years Production=.1 million oz. a year Production cost= $200 per oz. Current gold price= $400 per oz. Discount rate= 10% Using Market Values

11. 11- 11 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved EXAMPLE: KING SOLOMON’S MINE - continued If the gold price is forecasted to rise by 5% p.a.: NPV = -200 + (.1(420 - 200))/1.10 + (.1(441 - 200))/1.10 2 +... = - $10 m. But if gold is fairly priced, you do not need to forecast future gold prices: NPV = -investment + PV revenues - PV costs = 200 + 400 -  ((.1 x 200)/1.10 t ) = $77 million Using Market Values

12. 11- 12 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

13. 11- 13 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

14. 11- 14 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Marvin Enterprises

15. 11- 15 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Marvin Enterprises

16. 11- 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Marvin Enterprises 5 6 7 10 Price 800 400 320 240 Demand Demand = 80 (10 - Price) Price = 10 x quantity/80 Demand for Garbage Blasters

17. 11- 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Marvin Enterprises NPV new plant = 100 x [-10 +  ((6 - 3)/1.2 t ) + 10/1.25 = $299 million Change PV existing plant = 24 x  (1/1.2 t ) = $72 million Net benefit = 299 - 72 = $227 million Value of Garbage Blaster Investment

18. 11- 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Marvin Enterprises VALUE OF CURRENT BUSINESS:VALUE At price of $7 PV = 24 x 3.5/.20 420 WINDFALL LOSS: Since price falls to $5 after 5 years, Loss = - 24 x (2 /.20) x (1 / 1.20) 5 - 96 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 = - 72 227 227 TOTAL VALUE: 551 CURRENT MARKET PRICE: 460

19. 11- 19 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Marvin Enterprises 100 200 280 NPV new plant Change in PV existing plant Total NPV of investment 400 600 200 -200 NPV $m. Addition to capacity millions Alternative Expansion Plans

20. 11- 20 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter 12, P315-341