Investment, Strategy, and Economic Rents

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

 Topics Covered
Look First To Market Values
Economic Rents and Competitive
Advantage
Example - Marvin Enterprises
 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 . . .
 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
 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.
 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?
 Department Store Rents

If you own the store

8 8 + 134
NPV = −100 + + ... + 10
= $1,000,000
1.10 1.10

If you rent the store:

8 million revenue – 7 million rent =1 million

Is it profitable?
 Department Store Rents
Lets see if it is profitable:

Real estate prices and therefore rents increase by 3%:

8 − 7 8 − 7.21 8 − 8.87 8 − 9.13

NPV = + 2
+ ... + 9
+
1.10 1.10 1.10 1.1010
Department Store Rents
 Using Market Values

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%
 Using Market Values
EXAMPLE: KING SOLOMON’S MINE - continued

If the gold price is forecasted to rise by 5% p.a.:

.10(420 − 200) .10(441 − 200)
NPV = −200 + + + ... = −$10 million
1.10 1.10 2

But if gold is fairly priced, you do not need to forecast future gold prices:
NPV = -investment + PV revenues - PV costs
.10 × 200
= −200 + 400 × 0,1×10 − ∑ t
= $77 million
1.10
 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
 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?
 Polyzone Production NPV
U.S. Company (figures in millions)

Year 0 Year 1 Year 2 Year 3-10

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

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

 Polyzone Production NPV
European Company (figures in millions)

Year 0 Year 1 Year 2 Year 3-10

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

NPV (at r=8%) = 0

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

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

Cash flow -100 -20 -6 38 30 18

NPV (at r= 8%)= -9.8
 Marvin Enterprises

Capacity, Millions of Units

Capital Cost per Manufacturing Salvage Value per
Technology Industry Marvin Unit ($) Cost per Unit ($) Unit ($)
First generation
(2017) 120 _ 17.5 5.5 2.5

Second generation
(2025) 120 24 17.5 3.5 2.5
 Marvin Enterprises

Demand for Gargle Blasters

Demand = 80 (10 - Price)

Price = 10 x quantity/80
 Gargle Blasters Market
With the third generation, the equilibrium
point of the market is where the NPV=0

NPV= -investment+PV(price-man.cost)
= -2,5 + (P.eq-5,50)/0,2 = 0
P.eq = 6
After some time, the market growth made
another eq point of price $ 5.
 Marvin Enterprises

Value of Garbage Blaster Investment

 6 − 3  1  200 
NPV New Plant = −1000 + 100 × − 10 + ∑ t  + 5  
 1.2  1.2  0.2 
= $299 million
1
Change PVexisting plant = 24 × ∑ t = $72 million
1.2
Net benefit = 299 − 72 = $227 million
 Marvin Enterprises

•VALUE OF CURRENT BUSINESS: VALUE

At price of $7 PV = 24 x (7-3.5)/.20 420
•WINDFALL LOSS:
Since price falls to $5 after 5 years,
Loss = - 24 x ((5-3) / .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