Principles
of
Corporate
Finance
Chapter 11
Investment, Strategy, and
Economic Rents
Tenth Edition
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
12- 2
Topics Covered
Look First To Market Values
Economic Rents and Competitive
Advantage
Example - Marvin Enterprises
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 3
Department Store Rents
8
8
NPV  100 
 ... 
 $1,000 ,000
10
1.10
1.10
[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 

 ... 

 $1,000 ,000
2
9
10
1.10
1.10
1.10
1.10
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 4
Department Store Rents
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 5
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
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 6
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?
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 7
Polyzone Production NPV
U.S. Company (figures in millions)
Investment
Production, Millions of pounds per
year
Spread, dollars per pound
Net revenues
Production costs
Transport
Other costs
Cash flow
Year 0
100
Year 1
Year 2
Year 3-10
0
1.2
0
0
0
0
-100
0
1.2
0
0
0
20
-20
40
1.2
48
30
4
20
-6
80
1.2
96
30
8
20
38
NPV (at r=8%) = $63.6 million
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 8
Polyzone Production NPV
European Company (figures in millions)
Investment
Production, Millions of pounds per
year
Spread, dollars per pound
Net revenues
Production costs
Transport
Other costs
Cash flow
Year 0
100
0
0.95
0
0
0
0
-100
Year 1
0
0.95
0
0
0
20
-20
Year 2
40
0.95
38
30
0
20
-12
Year 3-10
80
0.95
76
30
0
20
26
NPV (at r=8%) = 0
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 9
Polyzone Production NPV
U.S. Company w/ European Competition (figures in millions)
Year
0
Investment
Production, Millions of pounds per
year
Spread, dollars per pound
Net revenues
Production costs
Transport
Other costs
Cash flow
NPV (at r= 8%)= -9.8
McGraw Hill/Irwin
1
2
4
3
5 - 10
100
0
1.2
0
0
0
0
0
1.2
0
0
0
20
40
1.2
48
30
4
20
80
1.2
96
30
8
20
80
1.1
88
30
8
20
80
0.95
76
30
8
20
-100
-20
-6
38
30
18
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 10
Marvin Enterprises
Capacity, Millions of Units
Technology
Industry
Marvin
Capital Cost per
Unit ($)
First generation
(2017)
120
_
17.5
5.5
2.5
Second generation
(2025)
120
24
17.5
3.5
2.5
McGraw Hill/Irwin
Manufacturing
Cost per Unit ($)
Salvage Value per
Unit ($)
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 11
Marvin Enterprises
Demand for Garbage Blasters
Demand = 80 (10 - Price)
Price = 10 x quantity/80
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 12
Marvin Enterprises
Value of Garbage Blaster Investment
6  3  10

NP V New P lant 100  10  

t 
1.2  1.25

 $299 m illion
1
Change P Vexist ingplant  24 
 $72 m illion
t
1.2
Net benefit  299 72  $227 m illion
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 13
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
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
12- 14
Marvin Enterprises
Alternative Expansion Plans
NPV $m.
600
NPV new plant
400
Total NPV of
investment
200
100
200
-200
Addition to
280 capacity
millions
Change in PV existing plant
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved