Advanced Corporate Finance
Ronald F. Singer
Strategy and the Capital
Budgeting Decision
Lecture 3.1
Fall 2009
1
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 projects, and the Wisdom to know the
difference.
Topics Covered
• Look First To Market Values: Unless you think you
are better than the market in using assets,
assume the value of any asset to you is what the
market will pay (i.e. have a zero NPV)
• Projects having positive NPV’s are projects that
generate economic rents which come about
because of your competitive advantage relative
to the rest of the market
• If you cannot identify your competitive
advantage, it is unlikely you can generate positive
NPV from a project.
Market Values
• The reason for organizations called firms
is that they are designed to generate
and take advantage of competitive
advantage: What are these advantages:
– Special marketing advantage
– Special distribution advantage
– Special skills and patents
– Superior organization
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
Market Values
• Positive NPVs stem from a competitive
advantage
• Strategic decision-making identifies this
competitive advantage;
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 !
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?
Pizza Hut
• Include in your analysis the opportunity cost
of utilizing assets even if there is no explicit
cash flow generated by the asset.
• The economic life of an asset may not be the
same as the physical life of the asset.
Pizza Hut!!!
You are considering purchasing the Pizza Parlor on the
other side of Calhoun opposite the College (Pizza
Hut). You expect Cash Flows of $8 million per year
for 10 years. The current owner is asking for $100
million, and there will be 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?
Pizza Hut
• Clearly you need to consider 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:
Calhoun Pizza Hut
•NPV = -100 + 8
1.10
+ ... +
8 + 134
1.1010
= ???
Calhoun Pizza Hut
•NPV = -100 + 8
1.10
+ ... +
8 + 134
1.1010
= $0.819 million
Pizza Hut
• An Alternative is to lease the land to someone
else:
• In a competitive market for real estate, you
will be able to earn a return which is equal to
the appropriate discount rate (i.e. 10%)
• Since you will earn 3% as a result of the
increased land value (by assumption),
• The Rental Value will be: 7% of the value of
the land. So that the total return from holding
the land is: 3% + 7% = 10%
Pizza Hut
• Recall that 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 rent of 7%
of the value of the land over time.
• That means the first year you get $7 million,
the second year $7.21 million and so on.
• So, what should you do?
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
4
5
6
7
8
9
10
Land 100
103 106 109 113 116 119 123 127 130 134
Rent
7 7.21 7.43 7.65 7.88 8.11 8.36 8.61 8.87 9.13
Operate Pizza H. 8
8
8 8
8
8
8
8
8 8
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 (or selling) rather than operating
it after year 5.
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.
Pizza Hut
So cash flows will really be
Time 0
1 2
3
5
-100 8 8 8 8 +116
What is the NPV of this?
6
0…
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!!! Vs 0.819 if you operate for 10
years.
King Solomon’s Mine
• Whenever possible use market prices unless
you have a special reason why you are a better
judge of the value than the market as a whole
• Assume that you are not going to generate
any economic rents (excess value, or positive
NPV’s) unless you have a special expertise,
special position, special economic power
King Solomon’s Mine
• For an investment of $200 million, you believe
that you can produce 100,000 ounces of gold
a year. The production cost is $200 per ounce,
and the price of gold is $400 per ounce. You
forecast that the gold price will increase at 5%
per year over the 10 year life of the mine, but
production cost will not change. At a discount
rate of 10%, what is the NPV of the mine
production (ignore the opportunity cost of not
selling the land).
Trust Market Prices
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% per year:
NPV = -200,000,000 + (100,000[(420 - 200))/1.10 + (441 200)/1.102 +... (652-200)/1.1010])= - $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.
By forecasting 5% increase, you assume you are better at
forecasting gold prices than the market.
King Solomon’sMine
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. (discounted at 6%, then the
PV remains $400 per ounce over time.
That is, unless you have better knowledge in
forecasting gold prices than the market,
assume that the market has priced the gold
correctly so that the required and actual
returns of holding gold is the same.
King Solomon’s Mine
• NPV = -Investment + PV revenues - PV
costs
Initial Inv.
•
+
PV of revenues -
= -200,000,000 + 400 x 100,000 x 10 PV costs
• St ((100,000 x 200)/1.10t) =
•
-200,000,000 + 400,000,000 -122,891,342
= $77,102,658
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
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 cost 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.
It will take them 1 year to begin production, and 2
years to be in full production
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?
Polyzone Production NPV
U.S. Company (figures in millions)
Investment
Production, Millions of pounds
per year
Spread, dollars per pound
Net revenues
fixed Production costs
Transport (10 cents per million
pounds)
Other costs
Cash flow
NPV (at r=8%) = $63.6 million
Year 0
100
Year 1
Year 2
Year 3-10
0
0
0
0
1.2
0
0
40
1.2
48
30
80
1.2
96
30
0
0
-100
0
20
-20
4
20
-6
8
20
38
Polyzone Production
• The above analysis ignores the possibility that
competition will lead to a decrease in the
price of polyzone (i.e the “spread”) in the
future.
• The natural competition are European
chemical companies.
• Forecast the impact of these companies on
the “spread)
Polyzone Production
• We have to ask: if European companies can
compete, what will be the minimum spread
that these companies need to make the
production worthwhile.
• That is, what spread drives the NPV of the
European companies to zero?
Polyzone Production NPV
European Company Break Even (figures in millions)
Year
Investment
Production, Millions of pounds
per year
Spread, dollars per pound
Net revenues
Production costs
Transport
Other costs
Cash flow
NPV (at r= 8%)= 0
0
100
1
2
3 to 10
0
0
40
80
????
????
????
????
0
0
0
0
0
0
0
20
38
30
0
20
76
30
0
20
-100
-20
-12
26
Polyzone Production NPV
European Company Break Even (figures in millions)
Year
Investment
Production, Millions of pounds
per year
Spread, dollars per pound
Net revenues
Production costs
Transport
Other costs
Cash flow
NPV (at r= 8%)= 0
0
100
1
2
3 to 10
0
0.95
0
0
0
0
0
0.95
0
0
0
20
40
0.95
38
30
0
20
80
0.95
76
30
0
20
-100
-20
-12
26
Polyzone Production
• So eventually competition will drive the
spread per pound of polyzone to $0.95.
• So the question is when?
• Forecast that increased European competition
will drive spreads to 1.1 in 4 years, and then to
0.95 in 5 years
• Modified cash flow estimates are as follows:
Polyzone Production NPV
U.S. Company w/ European Competition (figures in millions)
0
Investment
Production, Millions of pounds
per year
Spread, dollars per pound
Net revenues
Production costs
Transport
Other costs
Cash flow
NPV (at r= 8%)= -9.8
1
2
4
3
5 - 10
100
0
1.2
0
0
0
0
0
1.2
0
0
0
20
40
1.2
48
30
4
20
80
1.2
96
30
8
20
80
1.1
88
30
8
20
80
0.95
76
30
8
20
-100
-20
-6
38
30
18
Marvin Enterprises
The best drink in existence is the Pan Galactic
Gargle Blaster. The effect of a Pan Galactic
Gargle Blaster is like having your brains
smashed out by a slice of lemon wrapped
round a large gold brick.
Source: The Hitchhiker's Guide to the Galaxy
Marvin enterprises
• Although Marvin is a really complicated case,
it is worth spending some time on doing this
by yourself so that you understand the factors
that must be considered in a dynamic setting
for an investment project.
• The project is affected by new technology,
competition and price changes which lead to
changes in production, capacity and so on.
Marvin Enterprises
Technology
Industry
Marvin
Capital Cost per
Unit ($)
First generation
(2014)
120
_
17.5
5.5
2.5
Second generation
(2022)
120
24
17.5
3.5
2.5
Hurdle Rate =
20%
Production facilities last forever
Demand Curve and Production costs the same for each technology
Fourth Generation not possible
No Income Tax
Inflation is 0
Manufacturing
Cost per Unit ($)
Salvage Value per
Unit ($)
Marvin Enterprises
Technology
Industry
Marvin
Capital Cost per
Unit ($)
First generation
(2014)
120
_
17.5
5.5
2.5
Second generation
(2022)
120
24
17.5
3.5
2.5
Third generation
(2030)
100
100
10
Hurdle Rate =
20%
Production facilities last forever
Demand Curve and Production costs the same for each technology
Fourth Generation not possible
No Income Tax
Inflation is 0
Manufacturing
Cost per Unit ($)
Salvage Value per
Unit ($)
3
Marvin Enterprises
Demand for Gargle Blasters
Demand
800
Demand = 80 (10 - Price)
Price = 10 x quantity/80
400
320
240
5
6 7
10
Price
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?
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:
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?
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 generation 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?
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
Marvin Enterprises
So the new capacity will decline from 340 units
to that capacity which will support a price of
$6.00.
From the Demand curve, that capacity is:
Quantity = 80(10-6) = 320.
Thus, 20 million units of generation 1 capacity
will drop out, leaving:
Marvin Enterprises
Technology
Industry
Marvin
Capital Cost per
Unit ($)
First generation
(2014)
100
_
17.5
5.5
2.5
Second generation
(2022)
120
24
17.5
3.5
2.5
100
20%
100
10
3
Third generation
(2030)
Hurdle Rate =
Production facilities last forever
Demand Curve and Production costs the same for each technology
Fourth Generation not possible
No Income Tax
Inflation is 0
Manufacturing
Cost per Unit ($)
Salvage Value per
Unit ($)
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 investment in 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:
Marvin Enterprise
Year
0
Equilibrium Price
Cash Flow/unit
7.00
-10
Cash Flow for
100 million units -$1,000
(million)
1-5
6
6-3=3
$300
6 and greater
5
5-3=2
$200
Marvin Enterprises
Value of Gargle Blaster Investment
In ($1,000,000)
NPV new plant = -1,000 + PVA(300, 20%, 5) +
(1/(1.2)5 ) (200/.20)
=
$299.06
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
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
Marvin Enterprises
Alternative Expansion Plans
NPV $m.
600
NPV new plant
400
Total NPV of
investment
200
100
200
-200
Change in PV existing plant
Addition to
280 capacity
millions