1. Investment, Strategy, and Economic Rents
Principles of
Corporate Finance
Tenth Edition
Chapter 11
Investment, Strategy, and Economic Rents
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. 1 1 1 1 1 2

2. Topics Covered Look First To Market Values
Economic Rents and Competitive Advantage
Example - Marvin Enterprises 2 2 2 2 3 2

3. Market Values
Smart investment decisions make MORE money than smart financing decisions
Smart investments are worth more than they cost:
they have positive NPVs
Firms calculate project NPVs by discounting forecast cash flows, but

4. Market Values
Projects may appear to have positive NPVs because of forecasting errors e.g. some acquisitions result from errors in a DCF analysis
Positive NPVs stem from a comparative advantage
Strategic decision-making identifies this comparative advantage; it does not identify growth areas

5. 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.

6. 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?

7. Department Store Rents
[assumes price of property appreciates by 3% a year]
Rental yield = = 7%

8. Department Store Rents

9. Using 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%

10. Using Market Values EXAMPLE: KING SOLOMON’S MINE - 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

11. 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

12. 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?

13. Polyzone Production NPV
U.S. Company (figures in millions)

14. Polyzone Production NPV
European Company (figures in millions)

15. Polyzone Production NPV
U.S. Company w/ European Competition (figures in millions)

16. Marvin Enterprises

17. Demand for Garbage Blasters
Marvin Enterprises
Demand for Garbage Blasters
Demand = 80 ( Price)
Price = 10 x quantity/80

18. Value of Garbage Blaster Investment
Marvin Enterprises
Value of Garbage Blaster Investment

19. Marvin Enterprises 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 = 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 = x 1 for 5 years = - 72
TOTAL VALUE:
CURRENT MARKET PRICE:

20. Alternative Expansion Plans
Marvin Enterprises
Alternative Expansion Plans

21. Web Resources Click to access web sites Internet connection required