1. Lecture 03.2 Strategy and The Capital Investment Decision Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

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

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

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

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

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 6 McGraw-Hill/Irwin Market Values  Positive NPVs stem from a comparative advantage  Strategic decision-making identifies this comparative advantage;

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

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

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

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 11 McGraw-Hill/Irwin Department Store Rents NPV = -100 + +... + = ??? [assumes price of property appreciates by 3% a year] 8 8 + 134 1.10 1.10 10

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

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

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 100103 106 109 116 119 Rent 7 7.21 7.42 7.88 8.11 Note 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.

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 = ???!!!

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

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

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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)/1.10 2 +... (652-200)/1.10 10 ])= - $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

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

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

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

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

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 23 McGraw-Hill/Irwin Polyzone Production NPV U.S. Company (figures in millions)

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 24 McGraw-Hill/Irwin Polyzone Production NPV European Company Break Even (figures in millions)

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 25 McGraw-Hill/Irwin Polyzone Production NPV U.S. Company w/ European Competition (figures in millions)

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

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 27 McGraw-Hill/Irwin Marvin Enterprises

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 28 McGraw-Hill/Irwin Marvin Enterprises

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

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

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

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

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

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

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

36. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 11- 36 McGraw-Hill/Irwin Marvin Enterprises

37. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 = $5.00 It is assumed that the long run price equilibrium will be established in 5 years so:

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

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

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

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

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