Chapter 11 Where do Positive NPV Projects come from? (Capital Budgeting and Economics !

!"ip section 11#$ This chapter is concerned with answering the question: Where do positive NPV projects come from? In a competitive world, positive NPV projects should e difficult to find! Therefore, "ou should carefull" evaluate projects that purport to produce a positive NPV! We focus on using our #economic intuition# in order to criticall" evaluate the assumptions used in calculating the project NPV! In particular we will: $% &nderstand wh" 'and when% we should trust mar(et values! )% &nderstand when it is li(el" we might earn #positive economic rents,# and wh", in general, the" should not e e*pected! ++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++ In order to determine a project,s NPV, we need to determine the initial investment, e*pected future cash flows, and the discount rate's%! -stimation errors are unavoida le! .or e*ample, consider /Project 01 'from the 2hapter 3 notes% Time 4 cash flow 'initial investment% 5 67$44 Project 0 time one e*pected cash flow calculation 'from 2hapter 3 notes%: 8oom econom" cash flow 5 7$99, pro a ilit" 5 )4: Normal econom" cash flow 5 7$;9, pro a ilit" 5 <4: =ecession econom" cash flow 5 7>4, pro a ilit" 5 )4: -*pected time one cash flow 5 7$)4 8eta 5 $!?4??3 @iscount rate 5 )4!$A>9: NPV 5 67$44 B 7$)4 C $!)4$A>9 5 674!$<$? 8ased on the project NPV, the project is rejected! Now, consider the estimation error 0ssume that the econom" for the ne*t "ear ends up eing a D ooming, econom"! Eo the project,s time $ cash flow would have een 7$99! In retrospect, the project should have een accepted! Fowever, ased on the information availa le at time 4, the project was correctl" rejected! In general, the e*pected cash flows that "ou calculate for an individual project are li(el" to e an overestimate or an underestimate of actual project cash flows! In the previous e*ample, the actual cash flow would have een higher than the e*pected cash flow! Fowever, over time and over man" projects, overestimates from some projects should cancel out underestimates with other projects! Therefore, these estimation errors are diversified awa" to a certain e*tent! -ven though "ou can,t estimate with $44: accurac", the estimates of the e*pected future cash flows need to e un%iased! That is, actual cash flows should, on average, e equal to the e*pected cash flow! In the same wa", "ou need to ma(e an un iased estimate of the discount rate!

&o' do (ou "no' if a person is ma"ing un%iased estimates of future cash flo's? If "ou ma(e un iased estimates of future cash flows, then these un iased estimates should, on average, e equal to actual future cash flows 'assuming "ou have enough o servations across man" projects and man" "ears%! Evidence of un%iased estimates of future cash flo's G refer ac( to Project 0 and ignore inflation! Hver a $446"ear period of time, "ou would e*pect to see 'roughl"%: )4 ooming "ears with a 7$99 cash flow <4 normal "ears with a 7$;9 cash flow )4 recession "ears with a 7>4 cash flow Total cash flows for $44 projects 5 7$),444 0verage per project 5 7$)4 E)ample of %iased estimates of future cash flo's G an overl" optimistic manager ma(es the following estimates for the cash flows in the three different t"pes of economies! '0nother possi le error for the optimistic manager would have een to overestimate the pro a ilit" of a ooming econom"!% 8oom econom" cash flow 5 7$<4 Normal econom" cash flow 5 7$>4 =ecession econom" cash flow 5 7>9 -ffects on the NPV calculation for Project 0: &sing the un iased estimates of econom" pro a ilities 7$)4 $!?4??3 )4!$A>9: 674!$<$? &sing the iased estimates of econom" pro a ilities

-*pected cash flow 8eta @iscount rate NPV

Hnl" over time 'and man" projects% will we e a le to determine that the manager is ma(ing iased estimates! Pro%lems associated 'ith ma"ing a %iased estimate ! No pro lem e*ists if there is no change in project selection due to the ias! 0 ias towards overestimating e*pected cash flows 'or underestimating the discount rate% will ma(e a good project loo( great! 'Project is still accepted!% 0 ias towards underestimating e*pected cash flows 'or overestimating the discount rate% will ma(e a ad project loo( horri le! 'Project is still rejected!% Pro lems occur in the following two circumstances: 0 ias towards overestimating e*pected cash flows 'or underestimating the discount rate% can ma(e a ad project loo( good! 'Negative NPV project accepted!% This pro lem is compounded if a manager has an incentive to overestimate cash flows 'or underestimate the discount rate%! When would a manager have the incentive to do this? 0 ias towards underestimating e*pected cash flows 'or overestimating the discount rate% can ma(e a good project loo( ad! 'Positive NPV project rejected!% This pro lem is compounded if a manager has an incentive to underestimate cash flows 'or overestimate the discount rate%! When would a manager have the incentive to do this?

&o' do (ou prevent (or minimi*e forecast errors? 1 +se mar"et values! In other words, use the information that is availa le from the current mar(et value 'as esta lished " investors that u" and sell the asset in question% in "our anal"sis of the project! To use this approach, "ou need current mar(et values from an asset that trades in an active and competitive mar(et! Wh" do we want to use mar(et values? If "ou tr" to estimate e*pected future cash flows 'and discount rates% for an asset that trades in an active and competitive mar(et, "ou might let "our optimistic 'or pessimistic% estimates ias "our NPV calculations! This could cause "ou to accept a ad project 'or reject a good project%! We are assuming that the current mar(et value esta lished " numerous investors is a more relia le estimate of the asset,s true value than "our own estimate! ,n e)ample G Iou plan to invest in 082 stoc( and sell in one "ear! 082 stoc( does not currentl" pa" dividends 'and will not for the ne*t several "ears%! 0ssume the financial mar(et where 082 stoc( trades is perfect, efficient, and in equili rium! 2urrent stoc( price 5 7$4 -*pected sales price at time $ 5 ??? 8eta 5 ??? =is(6free rate 5 9: Jar(et ris( premium 5 ?!>: What is the NPV of the one6"ear investment? To answer, "ou need to (now: What is the e*pected time $ sale,s price? What is the discount rate? Fowever, ta(e advantage of the fact that 082 stoc( trades is perfect, efficient, and in equili rium mar(et! Thus: What is the NPV of the investment? Therefore, what is the present value of the time one stoc( price? ,nother e)ample G Koe is offering the sale of the mining rights for gold on his propert" for 7>4 million! The right to mine gold will e for $4 "ears and the purchaser must restore the propert" after the end of the $46"ear period! The e*pected e*traction and restoration costs 'and PVs of these costs% have alread" een estimated! Leologists have determined that $44,444 ounces of gold can e e*tracted from the land! Iou plan to e*tract $4,444 ounces of gold each "ear for $4 "ears! '0ssume that the gold mar(et is perfect, efficient, and in equili rium!% Present value of e*traction costs 5 7> million Present value of restoration costs 5 7) million NPV 5 67>4 million 6 7> million 6 7) million B PV of revenue Iou wor( for a potential purchaser and "our jo is to estimate the PV of revenue! To determine the PV of the revenue 'and ultimatel" the NPV of the project%, "ou need: The e*pected price of gold at the end of each of the ne*t $4 "ears The eta of the gold revenue cash flows 'and associated discount rate% 0dditional fact: the current price of gold 5

What is the NPV of the project?

@oes the present value of the e*pected cash revenue increase or decrease if "ou e*tract the gold quic(er 'i!e, )4,444 ounces of gold per "ear for 9 "ears%?

What if the mar"et is not active or competitive? Then the price is not necessar" an /equili rium1 price! E)ample G 0 house has een for sale for the last si* months for 7$94,444! Ehould "ou u" the house for the purpose of reselling at a later date? What is the e*pected future selling price? What is the discount rate? What is the NPV of this project? E)ample G 0 house just went on the mar(et for 7$94,444! Ehould "ou u" the house for the purpose of reselling at a later date? @oes it ma(e a difference that the house hasn,t een e*posed to the mar(et "et? - Economic .ents / !ummar( of this section / Wh" hasnMt an"one else thought of this idea? In a competitive industr" that has een operating for a long period of time, projects that involve entering and e*iting this industr" have a Nero NPV 'i!e!, the I== equals the opportunit" cost of capital%! Wh"? If entering the industr" really had a positive NPV, then competitors will also enter the industr"! The impact of this is: Euppl" of items to e sold will OOOOOOOOO! This will cause a OOOOOOOOO in price This will cause a OOOOOOOOO in the NPV of a project that involves entering this industr"

The opposite would occur if entering 'and sta"ing in% the industr" were a negative NPV project! In this case competitors will withdraw from the industr"! The impact of this is: Euppl" of items to e sold will OOOOOOOOO! This will cause a OOOOOOOOO in price This will cause a OOOOOOOOO in the NPV of a project that involves entering this industr"

The competitive equili rium would therefore occur when there is no advantage to entering 'or e*iting% the industr" 'NPV 5 74%! In this case, economic rents equal Nero! E)ample 6 8ased on current cotton prices and the costs of farming, land used for cotton farming should e priced such that the NPV of cotton farming is a Nero6NPV project! Therefore, there is no incentive to purchase land to farm cotton! Fowever, notice that "ou can e*pect to earn a fair rate of return ' ased on the eta ris( of farming%, therefore it would not necessaril" e ad to enter farming! Corollar(: If cotton prices increase, what should happen to the price of land used for farming cotton? 0esson 6 8e suspicious of projects that involve long6run competitive industries that purport to produce a positive 'or negative% NPV!

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, side issue G What if "ou have developed a new machine that allows "ou to plant and harvest cotton at a lower cost than "our competitors? Where are (ou li"el( to find positive NPV projects? $% Positive economic rents can e e*pected during the start6up phase of an industr" 'i!e!, the industr" has not entered its long6term equili rium%! Fowever, these positive rents should onl" e temporar" until enough competitors enter the new industr"! The oo( uses the term /economic rents1 instead of /positive economic rents! That is, /positive1 is implied! 8efore entering a #start6up# industr", "ou should carefull" evaluate how long the e*cess profit period will last! The addition of competitors to the industr" can e swift 'and the more profita le the project, the faster competitors will enter%! =ead the article " Warren 8uffett on page )A$ for some further insight! )% Positive economic rents are also li(el" for participants in an industr" if the" are a le to enforce some t"pe of monopol"! Jonopolies can occur ecause of: 0% Pegal constraints 'patents, regulator"%! 8% Jar(et power 'siNe of "our compan" in relation to the total mar(et%! E)ample: Jicrosoft 2% Eome other competitive advantage 'superior managementCpersonnel, location, etc!%! 1lip the argument around for another perspective 0ssume that "ou are the low6cost producer 'perhaps ecause of a patent, or ecause of some competitive advantage% in a growing industr"! .urther assume "our NPV anal"sis sa"s that e*pansion is a negative NPV project? What should "ou do? 2n summar(, remem er that a positive NPV project must produce positive economic rentsQ Therefore, if "our anal"sis shows that a project has a positive NPV, "ou must e a le to e*plain to "ourself 'h( the project produces positive economic rents! In addition to anal"Ning the spreadsheet for computational errors, determine if there are an" logical errorsQ If the NPV from the spreadsheet is positive 'or negative% as( if it is logical that the compan" should capture positive 'or negative% economic rents with this project!

!elected 3ui* 3uestions from the Chapter 11 of the te)t%oo" $$!$, $$!), $$!;, $$!>, $$!9 Chapter 11 .evie' 4uestions $! What is estimation error? What is an un iased estimate of future e*pected cash flows? What is a iased estimate of future e*pected cash flows? Fow would we (now if a manager were ma(ing iased or un iased estimates of future e*pected cash flows? Fow could a managerMs compensation pac(age give the incentive for a manager to ma(e iased estimates of a project,s future e*pected cash flows? What t"pe of compensation scheme would give managers the incentive to overestimate future e*pected cash flows? What t"pe of compensation scheme would give managers the incentive to underestimate future e*pected cash flows? Fow can cash6flow estimation ias cause managers to ma(e ad capital udgeting decisions 'i!e!, accept negative NPV projects or reject positive NPV projects%? Liven a tendenc" for a particular manager to overestimate 'or underestimate% future project cash flows, which of his 'or her% projects should "ou review for accurac" of the NPV calculation 6 projects which he 'she% calculates a positive NPV or a negative NPV? What does it mean to #use mar(et values#? Fow does using mar(et values reduce the chance of ma(ing an error in calculating the NPV of a project? What are #economic rents#? &nderstand and e a le to e*plain wh" "ou should e*pect to earn Nero economic rents from investing in a project in a long6run competitive industr"! Liven this assumption, what should happen to the price 'value% of assets as the future e*pected cash flows associated with the use of those assets change? .or e*ample, other things equal, what should happen to the value of cotton farmland if cotton prices increase? 'Note: .or the same reason, changes in the discount rate should also have an impact on cotton farmland prices!% Rnow the circumstances when positive economic rents should e e*pected!

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Chapter 11 Practice 4uestions $! 0ssume financial mar(ets are perfect, efficient, and in equili rium! &sing the following information, what is the e*pected price of SIT stoc( in $4 "ears? Answer: Expected stock price in 10 years = $75.89 ! What is the present value of this time $4 stoc( price? Answer: $15. )! SIT stoc( does not currentl" pa" dividends 'and will not for at least the ne*t $4 "ears%! 2urrent stoc( price 5 7$9 8eta 5 $!9 =is(6free rate 5 9: Jar(et ris( premium 5 ?!>:

Iour uncle said that he will give "ou $44 ounces of gold when "ou turn )9 'five "ears from toda"%! Iou want to calculate the present value of this gift! &sing the concept of /using mar(et values,1 a discount rate of ;: per "ear, and a current gold price of 7)39!?9 per ounce, what is the present value of this gift? 100 * $275.85 = $27 585 =efer ac( to the previous pro lem! 0ssume that the gift will e at age ;4 instead of age )9! Reeping the rest of the information the same, how does this change in assumption affect the present value of the gift? 0! The present value of the gift is now higher than the correct answer to the previous pro lem! 8! The present value of the gift is now the same as than the correct answer to the previous pro lem! '!orrect % 2! The present value of the gift is now lo'er than the correct answer to the previous pro lem!

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0ssume that "ou just started wor(ing for a gold mining compan"! 0s part of "our emplo"ment, the compan" will give "ou $4 ounces of gold at the end of each "ear that "ou wor( for the compan"! Iou plan to wor( for the compan" for onl" one "ear, get "our $4 ounces of gold, then quit! What is the present value of these $4 ounces of gold that "ou will receive in one "ear? 10 * $"85 = $"850 Hther information 2urrent gold price 5 7;?9 0ssume that the gold mar(ets are perfect, efficient, and in equili rium! 8ecause of this, the NPV of investment in gold is 74! 8eta of gold 5 64!) 20PJ discount rate 5 9: 6 4!) '?!>:% 5 ;!;):

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0ssume that "ou just started wor(ing for a gold mining compan"! 0s part of "our emplo"ment, the compan" will give "ou $4 ounces of gold at the end of each "ear that "ou wor( for the compan"! Iou plan to wor( for the compan" for onl" one "ear, get "our $4 ounces of gold, then quit! What is the e*pected value of the $4 ounces of gold that "ou will receive in one "ear? 'Fint: I am not as(ing for the present value of the gold! I am as(ing for the value in one "ear, i!e!, at the time "ou receive the gold!% #$10%$&"0'* 1.0""2 Hther information 2urrent gold price 5 7>;4 0ssume that the gold mar(et is perfect, efficient, and in equili rium! 8ecause of this, the NPV of investment in gold is 74! 8eta of gold 5 64!) 20PJ discount rate 5 9: 6 4!) '?!>:% 5 ;!;):

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Iour compan" is considering a gold mining project! It will cost 7$4 million to u" the mining rights for the propert"! The present value of the e*traction and restoration costs are 79 million, so the total present value of the mining rights, e*traction, and restoration costs is 7$9 million! 'There are no other costs or e*penses for this project!% The onl" revenue for the project will e the sale of the gold mined from the propert"! 0ssume that there are >4,444 ounces of gold on the propert"! It will ta(e four "ears to mine the gold out of the ground and all >4,444 ounces will e sold at the end of the > th "ear! 0ssume that the gold mar(et is perfect, efficient, and in equili rium! 8ecause of this, the NPV of an investment in gold is 74! 0dditional information: 8eta for gold 5 64!$ =is( free rate 5 9:, mar(et ris( premium 5 ?!>: 20PJ discount rate 5 9: B 64!$'?!>:% 5 >!$<: 2urrent price of gold 5 7><4 C ounce &sing the concept of /using mar(et values,1 what is the NPV of the gold mining project? $" &00 000

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In class, we discussed how "ou can use mar(et values to prevent 'or minimiNe% forecast errors! 0ssume "ou own one ounce of gold and plan to sell the gold either toda" or in one "ear! .urther assume that the gold mar(et is perfect, efficient, and equili rium, so "ou can use mar(et values in "our anal"sis and there is no cost associated with storing the gold for the ne*t "ear! Hther information a out gold and the financial mar(ets: 2urrent price of gold 5 7>34 per ounce 0ppreciation in gold prices over the last "ear 5 $9: 8eta of gold 5 4!) =is( free rate 5 9:, mar(et ris( premium 5 ?!>:, use the 20PJ to calculate required rates of return H viousl", if "ou sell toda", "ou would receive 7>34! What is the present value of selling in one "ear? $&70

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0ssume that "ou invest 7$,444,444 in a one6"ear project in a long6run competitive industr" and that the opportunit" cost of capital for this project is $4:! 8ased on our discussions in class, an investment in a project in a long6run competitive industr" should have a Nero net present value 'assuming the industr" is in equili rium%! If this project does have a Nero net present value, then 0! The e*pected return 'or internal rate of return% for this project is less than 4:! 8! The e*pected return 'or internal rate of return% for this project is equal to 4:! 2! The e*pected return 'or internal rate of return% for this project is greater than 4:! $!orrect%