Lecture 03.2 Strategy and The Capital Investment Decision Copyright © 2006 by The McGraw-Hill...

Lecture 03.2

Strategy and The Capital Investment

Decision

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

McGraw-Hill/Irwin


11- 2

McGraw-Hill/Irwin

Financial Serenity Prayer

Grant me the Serenity to accept the things I cannot change,the Courage to change the things I canand the Wisdom to know the difference

Grant me the Serenity to accept projects with positive NPV’s, the Courage to reject negative NPV porjects, and the Wisdom to know the difference.


11- 3

McGraw-Hill/Irwin

Topics Covered

Look First To Market Values: Unless you think you are better than the market in using assets, assume there value to you is what the market will pay

Projects having positive NPV’s are projects that generate economic rents which come about because of your advantage relative to the rest of the market

Example - Marvin Enterprises


11- 4

McGraw-Hill/Irwin

Market Values

The reason for organizations called firms is that they are designed to generate and take advantage of comparative advantage: What are these advantages:– Special marketing advantage – Special distribution advantage – Special skills and patents– Superior organization


11- 5

McGraw-Hill/Irwin

Market Values Firms calculate project NPVs by discounting forecasted

cash flows, and ask:

Are the (PV of) the benefits greater than the (PV of) the costs?

But one must be careful not to generate positive NPV’s simply because of errors in judgment, overly optimistic expectations, etc.

Projects may appear to have positive NPVs because of forecasting errors


11- 6

McGraw-Hill/Irwin

Market Values

Positive NPVs stem from a comparative advantage

Strategic decision-making identifies this comparative advantage;


11- 7

McGraw-Hill/Irwin

Market Values

Consider alternatives as an on going decision.

Start with the market price of the asset and ask whether it is worth more to you than to others.

If you can’t identify why it would be worth more to you than others: Fahgettaboudit !


11- 8

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?


11- 9

McGraw-Hill/Irwin

Pizza Hut!!!

You are considering putting up a Pizza Parlor on the other side of Calhoun opposite the College (Pizza Hut). You project Cash Flows of $8 million per year for 10 years. It will require the purchase of the land of $100 million, and for simplicity, assume there is no other additional investments in Buildings, etc. You expect that the value of the land will appreciate at 3% per year, and real estate, as well as the Pizza Hut Project has a required return of 10%.

Is this a desirable project?


11- 10

McGraw-Hill/Irwin

Pizza Hut

Clearly you need to consider the cost of purchasing the land, and how much you could sell it for at the end of ten years.

If the value of the land increases @ 3% per year, it will be worth ????? at the end of 10 years.

So Cash Flows look like:


11- 11

McGraw-Hill/Irwin

Department Store Rents

NPV = -100 + + . . . + = ???

[assumes price of property appreciates by 3% a year]

8 8 + 134

1.10 1.1010


11- 12

McGraw-Hill/Irwin

Pizza Hut

An Alternative is to lease the land: The Rental Value will be: The Payment per year that will give the landowner a 10% return: That is: ?????

So you can get a payment of $8 million per year if you owned the land, and operated the Pizza Hut, but if you rented the land to someone else you could get ?????

So, what should you do?


11- 13

McGraw-Hill/Irwin

Pizza Hut

The problem is, you are not acting strategically. You have assumed that the Economic Life of the project is 10 years. This may be the physical life of the building, but not necessarily the economic life.

Remember, that you will be able to sell the asset sometime in the future, or rent it out to someone else. These are the alternatives and it is an ongoing problem.


11- 14

McGraw-Hill/Irwin

Pizza Hut Land and rental values: Remember that the land is

increasing in value by 3% per year, and the implicit (opportunity) rent is 7%. So the land as a separate “enterprise” will look as follows:

Time 0 1 2 3 … 5 6 Land 100 103 106 109 116 119Rent 7 7.21 7.42 7.88 8.11Note that the implicit rent is $8.11 million in 6 years, whereas

the project generates only $8 million. So the idea is that you are better off leasing the land to someone else rather than operating it after year 5.


11- 15

McGraw-Hill/Irwin

Pizza Hut

So cash flows will really be

Time 0 1 2 3 … 5 6

-100 8 8 8 … (8 +116) 0…

What is the NPV of this?

NPV = ???!!!


11- 16

McGraw-Hill/Irwin

Pizza Hut

So cash flows will really be

Time 0 1 2 3 … 5 6

-100 8 8 8 … (8 +116) 0…

What is the NPV of this?

NPV = 2.35!!!


11- 17

McGraw-Hill/Irwin

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%

Trust Market Prices


11- 18

McGraw-Hill/Irwin

EXAMPLE: KING SOLOMON’S MINE - continued

If the gold price is forecasted to rise by 5% per year:

NPV = -200,000,000 + (100,000[(420 - 200))/1.10 + (441 - 200)/1.102 +... (652-200)/1.1010])= - $10 m.

But if gold is fairly priced, you do not need to forecast future gold prices: Since gold pays no cash flow, the current price is simply what the market thinks the present value of selling it in the future will be. That is:

Current Price of Gold = Present Value of the Price of Gold at any time t in the future.

Using Market Values


11- 19

McGraw-Hill/Irwin

For example, if the price of gold is $400 per ounce, then if the required return for holding gold is 6%, the price one year from today is expected to be $424; to years from today = $449 and so on.

NPV = -Investment + PV revenues - PV costs

= -200,000,000 + 400 x 100,000 x 10 - t ((1 x 200)/1.10t) = $77 million


11- 20

McGraw-Hill/Irwin

Do Projects Have Positive NPVs?

Economic Rents = profits that more than cover the cost of capital

NPV = PV (economic 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


11- 21

McGraw-Hill/Irwin

Polyzone Production

There is a shortage in the European Polyzone market, driving prices up to market historical highs, and production at prevailing prices are highly profitable. The current spread between the selling price and the cots of raw materials is $1.20. At this spread, production is highly profitable.

Chemfile Inc, a US based chemical company is considering expanding production. They intend to import the raw materials from Europe, manufacture the poyzone, and ship it to Europe for sale.


11- 22

McGraw-Hill/Irwin

Polyzone Production

Raw materials were commodity chemicals imported from Europe

Finished product was exported to Europe

Does this sound like a good idea to you?


11- 23

McGraw-Hill/Irwin

Polyzone Production NPV

Year 0 Year 1 Year 2 Year 3-10

Investment 100Production, Millions of pounds per year 0 0 40 80Spread, dollars per pound 1.2 1.2 1.2 1.2Net revenues 0 0 48 96Production costs 0 0 30 30Transport 0 0 4 8Other costs 0 20 20 20Cash flow -100 -20 -6 38

NPV (at r=8%) = $63.6 million

U.S. Company (figures in millions)


11- 24

McGraw-Hill/Irwin


European Company Break Even (figures in millions)

Year 0 Year 1 Year 2 Year 3-10Investment 100Production, Millions of pounds per year 0 0 40 80Spread, dollars per pound 0.95 0.95 0.95 0.95Net revenues 0 0 38 76Production costs 0 0 30 30Transport 0 0 0 0Other costs 0 20 20 20Cash flow -100 -20 -12 26

NPV (at r=8%) = 0


11- 25

McGraw-Hill/Irwin


U.S. Company w/ European Competition (figures in millions)

0 1 2 3 4 5 - 10Investment 100Production, Millions of pounds per year 0 0 40 80 80 80Spread, dollars per pound 1.2 1.2 1.2 1.2 1.1 0.95Net revenues 0 0 48 96 88 76Production costs 0 0 30 30 30 30Transport 0 0 4 8 8 8Other costs 0 20 20 20 20 20

Cash flow -100 -20 -6 38 30 18NPV (at r= 8%)= -9.8

Year


11- 26

McGraw-Hill/Irwin

Marvin Enterprises

The best drink in existence is the Pan Galactic Gargle Blaster. The effect of a Pan Galactic Gargle Blaster is like having your brains smashed out by a slice of lemon wrapped round a large gold brick.

Source: The Hitchhiker's Guide to the Galaxy


11- 27

McGraw-Hill/Irwin

Marvin Enterprises

Technology Industry MarvinCapital Cost per

Unit ($)Manufacturing

Cost per Unit ($)Salvage Value per

Unit ($)

First generation (2014) 120 _ 17.5 5.5 2.5

Second generation (2022) 120 24 17.5 3.5 2.5

Hurdle Rate = 20%Production facilities last foreverDemand Curve and Production costs the same for each technologyFourth Generation not possible No Income TaxInflation is 0


11- 28

McGraw-Hill/Irwin

Marvin Enterprises




Unit ($)



Third generation (2030) 100 100 10 3

Hurdle Rate = 20%Production facilities last foreverDemand Curve and Production costs the same for each technologyFourth Generation not possible No Income TaxInflation is 0


11- 29

McGraw-Hill/Irwin

Marvin Enterprises

5 6 7 10 Price

800

400 320 240

Demand

Demand = 80 (10 - Price)

Price = 10 x quantity/80

Demand for Gargle Blasters


11- 30

McGraw-Hill/Irwin

Marvin Enterprises

Steps in Analysis – What is the impact of the new technology on

the Current Price – What will this change in price do to the existing

(older) technologies?– Immediate (equilibrium) Price Impact– What and when will be the impact on newer

technologies?– What will be the impact on the profitability of

Marvin’s older technology?


11- 31

McGraw-Hill/Irwin

Marvin Enterprise

Impact of New technology on current Price – Capacity increases immediately from 240 to

340 million units. – Given the demand curve, that means to price

will go down to:


11- 32

McGraw-Hill/Irwin

Marvin Enterprise

Impact of New technology on current Price – Capacity increases immediately from 240 to

340 million units. – Given the demand curve, that means to price

will go down to:– Price = 10-Quantity/80 = $5.75.– Is this an Equilibrium Price – Answer: NO, why not?


11- 33

McGraw-Hill/Irwin

Marvin Enterprise

Impact of New technology on current Price – Capacity increases immediately from 240 to 340

million units. – Given the demand curve, that means to price will go

down to:– Price = 10-Quantity/80 = $5.75.– Is this an Equilibrium Price – At this price the gen. 1 technology has a present value

of (5.75-5.5)/.20 = $1.25 per unit – Salvage Value = $2.50– So some of the generation 1 capacity will be sold. – How much?


11- 34

McGraw-Hill/Irwin

Marvin Enterprises

Impact on older technologies

The Generation 1 technology has a breakeven when the present value of the cash flows is $2.50 per unit. So solve for

(Price -5.50)/.2 = 2.50

Equilibrium Price must be $6.00


11- 35

McGraw-Hill/Irwin

Marvin Enterprises

So the new capacity will decline from 340 units to that capacity which will support a price of $6.00.

From the Demand curve, that capacity is:

Quantity = 80(10-6) = 320.

Thus, 20 million units of generation 1 capacity will drop out, leaving:


11- 36

McGraw-Hill/Irwin

Marvin Enterprises




Unit ($)



Third generation (2030) 100 100 10 3

Hurdle Rate = 20%

Production facilities last foreverDemand Curve and Production costs the same for each technologyFourth Generation not possible No Income TaxInflation is 0


11- 37

McGraw-Hill/Irwin

Marvin Enterprises

This “equilibrium” price of $6.00 is the short run adjustment to the new capacity. In the long run, the price will be driven down to where the NEW technology has a zero NPV. That will be where:

NPV = (P-3)/.20 – 10 = 0,Or

P = $5.00It is assumed that the long run price equilibrium will

be established in 5 years so:


11- 38

McGraw-Hill/Irwin

Marvin Enterprise

Year

0 1-5 6 and greater

Equilibrium Price 7.00 6 5

Cash Flow/unit -10 6-3=3 5-3=2

Cash Flow for

100 million units $1,000 $300 $200

(million)


11- 39

McGraw-Hill/Irwin

Marvin Enterprises

NPV new plant = -1,000 + PVA(300, 20%, 5) +

(1/(1.2)5 ) (200/.20)

= $299.06

Value of Gargle Blaster Investment


11- 40

McGraw-Hill/Irwin

Marvin Enterprise

Impact on Marvin’s Existing Plant

Assume that the new technology will be introduced by competitors regardless of what Marvin does. So the Change in PV of Marvin’s generation 2 technology is ;

Change PV existing plant =24 x PVA (-1, 20%, 5) = -$71.77 million

Net value of introduction = 299.06- 71.77 =

$227.29 million


11- 41

McGraw-Hill/Irwin

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


11- 42

McGraw-Hill/Irwin

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

Lecture 03.2 Strategy and The Capital Investment Decision Copyright © 2006 by The McGraw-Hill...

Documents

Transcript of Lecture 03.2 Strategy and The Capital Investment Decision Copyright © 2006 by The McGraw-Hill...