Last Study Topics Avoiding $100 M Mistake Competitive Spread Analysis Case: Marvin Enterprises Conclusion 1st

Today’s Study Topics Marvin Enterprises Lessons of Marvin Enterprises Conclusion 2nd Conclusion 3rd Conclusion 4th Conclusion 5th Lessons of Marvin Enterprises

Continue How much capacity will have to be sold off before the price reaches $6? You can check that by going back to the demand curve: Demand = 80 x (10 - price) = 80 x (10 - 6) = 320 M units

Demand for Gargle Blasters Marvin Enterprises Demand for Gargle Blasters 5 6 7 10 Price 800 400 320 240 Demand Demand = 80 (10 - Price) Price = 10 x quantity/80

2nd Conclusion Marvin’s expansion will cause the price to settle down at $6 a unit and will induce first-generation producers to withdraw 20 M units of capacity.

Marvin Enterprises After five years Marvin’s competitors will also be in a position to build third generation plants. A new equilibrium will be reached when the price reaches $5. NPV = - 10 + 5.00 - 3.00 = $0 per unit .20

3rd Conclusion At this point, the NPV of new third-generation plants is zero, and there is no incentive for companies to expand further

Continue Looking back once more at our demand curve, you can see that with a price of $5 the industry can sell a total of 400 million gargle blasters: Demand = 80 x (10 – price) = 80 x (10 - 5) = 400 million units

4th Conclusion The effect of the third-generation technology is, therefore, to cause industry sales to expand from 240 million units in 2023 to 400 million five years later.

Value of Marvin’s New Expansion Introduction of third-generation technology is likely to cause gargle blaster prices to decline to $6 for the next five years and to $5 thereafter. What would become the expected cash flows from Marvin’s new plant then?

Continue Table below shows the expected cash flows;

Value of Gargle Blaster Investment Marvin Enterprises Value of Gargle Blaster Investment NPV = -1000 + S(300)/(1.20)t + 1/(1.20)5(200/.20) = $299 million It looks as if Marvin’s decision to go ahead was correct, consider all incremental cash flows. One effect of Marvin’s decision to expand is to reduce the value of its existing 2019 plant.

5th Conclusion If Marvin decided not to go ahead with the new technology, the $7 price of gargle blasters would hold until Marvin’s competitors started to cut prices in five years’ time.

Continue Marvin’s decision, therefore, leads to an immediate $1 cut in price. Change PV existing plant = 24 x S (1/1.2t ) = $72 million Considered in isolation, Marvin’s decision has an NPV of $299 million. Net benefit = 299 - 72 = $227 million

Alternative Expansion Plans Marvin’s expansion has a positive NPV, but perhaps Marvin could do better to build a larger or smaller plant. First you need to estimate how the additional capacity will affect gargle blaster prices. Then you can calculate the net present value of the new plant and the change in the present value of the existing plant.

Continue Total NPV = NPV of new plant + change in PV of existing plant We have undertaken these calculations and plotted the results in Figure 3. When the new technology becomes generally available in 2029, what happen when firms will construct a total of 280 million units of new capacity? But Figure 3 shows that it would be foolish for Marvin to go that far.

Alternative Expansion Plans Marvin Enterprises Alternative Expansion Plans NPV $m. 600 NPV new plant 400 200 Total NPV of investment Addition to capacity millions 100 200 280 -200 Change in PV existing plant

Understanding If Marvin added 280 million units of new capacity in 2024, the discounted value of the cash flows from the new plant would be zero and the company would have reduced the value of its old plant by $144 million. To maximize NPV, Marvin should construct 200 million units of new capacity and set the price just below $6 to drive out the 2011 manufacturers.

Alternative Expansion Plans Marvin Enterprises Alternative Expansion Plans NPV $m. 600 NPV new plant 400 200 Total NPV of investment Addition to capacity millions 100 200 280 -200 Change in PV existing plant

The Value of Marvin Stock Marvin has 24 million units of second-generation capacity. In the absence of any third-generation technology, gargle blaster prices would hold at $7 and Marvin’s existing plant would be worth PV = 24 M x 7.00 – 3.50 .20 = $420 M

Continue Marvin’s new technology reduces the price of gargle blasters initially to $6 and after five years to $5. Therefore the value of existing plant declines to; PV = 24 M x [ ∑ 6.00-3.50 + 5.00 – 3.50 ] (1.20)t=1 .20 x (1.20)5 = $ 252 M

Marvin’s Growth Opportunity Before the announcement, Marvin’s stock was valued in the market at $460 million. The difference between this figure and the value of the existing plant represented the present value of Marvin’s growth opportunities (PVGO). After the announcement PVGO rose to $299 million.

Continue New plant makes a net addition to shareholders’ wealth of $299 million. So after Marvin’s announcement its stock will be worth; 252 + 299 = $551 million

The Lessons of Marvin Enterprises No economic model is going to predict the future with accuracy. Perhaps Marvin can hold the price above $6. Perhaps competitors will not appreciate the rich pickings to be had in the year 2029.

Continue In that case, Marvin’s expansion would be even more profitable. But would you want to bet $1 billion on such possibilities?

Continue Investments often turn out to earn far more than the cost of capital because of a favorable surprise. This surprise may in turn create a temporary opportunity for further investments earning more than the cost of capital. Anticipated and more prolonged rents will naturally lead to the entry of rival producers.

Continue Try to estimate when competition will drive the NPV down to zero, and think what that implies for the price of your product. Many companies try to identify the major growth areas in the economy and then concentrate their investment in these areas.

The views!!! The optimists argued that the information revolution was opening up opportunities for companies to grow at unprecedented rates. The pessimists pointed out that competi-tion in e-commerce was likely to be intense and that competition would ensure that the benefits of the information revolution would go largely to consumers.

Continue The Finance in the News box, which contains an extract from an article by Warren Buffett, emphasizes the point that rapid growth is no guarantee of superior profits.

Continue Marvin also reminded us of project interactions, When you estimate the incremental cash flows from a project, you must remember to include the project’s impact on the rest of the business. By introducing the new technology immediately, Marvin reduced the value of its existing plant by $72 million.

Continue Notice that Marvin’s economic rents were equal to the difference between its costs and those of the marginal producer. Therefore, if the salvage value of the 2011 equipment were higher, Marvin’s competitors would incur higher costs and Marvin could earn higher rents.

Summary Marvin Enterprises Lessons of Marvin Enterprises Conclusion 2nd Conclusion 3rd Conclusion 4th Conclusion 5th Lessons of Marvin Enterprises