Chapter 11

INVESTMENT, STRATEGY,
AND ECONOMIC RENTS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Edition
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
11-1 LOOK FIRST TO MARKET VALUES

• Smart investment decisions make more

money than smart financing decisions
• Smart investments are worth more than
they cost
• Positive NPVs

• Firms calculate NPVs by discounting

forecast cash flows

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11-1 LOOK FIRST TO MARKET VALUES

• Projects may appear to have positive NPVs

due to forecasting errors
• Some acquisitions result from error in a
discounted cash flow (DCF) analysis
• Positive NPVs stem from a comparative
advantage
• Strategic decision making identifies this
comparative advantage; it does not identify
growth areas
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11-1 LOOK FIRST TO MARKET VALUES

• Don’t make investment decisions on the

basis of errors in DCF analysis
• Start with the market price of the asset and
ask whether it is worth more to you than to
others

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11-1 LOOK FIRST TO MARKET VALUES

• Don’t assume 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?

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11-1 LOOK FIRST TO MARKET VALUES

• Department Store Rents

8 8 8  134
NPV  100   2
... 
1.10 1.10 1.1010
 $1,000,000
• [assumes price of property appreciates by 3% a year]

• Rental yield = 10 - 3 = 7%

8  7 8  7.21 8  8.87 8  9.13

NPV   2
 ...  9
 10
 $1,000,000
1.10 1.10 1.10 1.10

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FIGURE 11.1 DEPARTMENT STORE RENTS

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11-1 LOOK FIRST TO 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%

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11-1 LOOK FIRST TO MARKET VALUES

• Example, continued
• If the gold price is forecasted to rise by 5%
p.a.:
.10(840  480) .10(882  480)
NPV  400    .....  $70 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
.1 480
10
 400  800   t
 $105 million
t 1 1.10

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11-1 LOOK FIRST TO MARKET VALUES

• Does Project 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

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11-1 LOOK FIRST TO MARKET VALUES

• 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?

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TABLE 11.1 NPV CALCULATION, U.S. COMPANY

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TABLE 11.2 NPV CALCULATION, EUROPEAN
COMPANY

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TABLE 11.3 NPV CALCULATION, U.S. COMPANY
WITH EUROPEAN COMPETITION

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TABLE 11.4 GARGLE BLASTER INDUSTRY

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FIGURE 11.2 DEMAND FOR GARGLE BLASTERS

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11-3 MARVIN ENTERPRISES DECIDES TO EXPLOIT
A NEW TECHNOLOGY—AN EXAMPLE
• Value of Gargle Blaster Investment

 6  3  10
NPV new plant  100   10   t 

 1.2  1.25
 $299 million
1
Change PV existing plant  24   t
 $72 million
1.2
Net benefit  299  72  $227 million

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11-3 MARVIN ENTERPRISES DECIDES TO EXPLOIT
A NEW TECHNOLOGY—AN EXAMPLE
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

TOTAL VALUE: 551

CURRENT MARKET PRICE: 460

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FIGURE 11.3 ALTERNATIVE EXPANSION PLANS

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