PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
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The Hudsucker Proxy
“Project Startup Decisions” from The Hudsucker Proxy
Stop at 5:00
http://www.youtube.com/watch?v=upIMfHFgWtQ
Look like the process at your company?
Econ 5313
Time Value
• If I auctioned off a $1 today (standard auction – not ‘all
pay’), how much would you be willing to pay?
• Darn close to $1
• If I auctioned off a $1 to be paid to you in a year, how
much would you be willing to pay?
• Something less than the first auction
• What does the difference represent?
• The cost to you of delayed gratification
• In general, this is the source of discounting future income
flows
Econ 5313
The Discount Rate
• Often the rate at which we discount the future is the same
per period. We call this the discount rate or “r”. Formally,
we discount some future value “X”:
• Xt = Xt+1/(1+r) for one year.
• Xt = Xt+2/(1+r)2 for two years.
• Xt = Xt+s/(1+r)s for “s” years.
• We can also take current values into the future. If we lend
X to someone, how much do they have to pay in the
future to make us indifferent?
• Xt+1 = Xt×(1+r) for one year.
• Xt+2 = Xt×(1+r)2 for two years.
• Xt+s = Xt×(1+r)s for “s” years.
Econ 5313
Valuing an Income Stream
• Usually, we are dealing with an investment cost today that
will generate a flow of future benefits.
• We expect the investment will generate a stream of future
benefits B1, B2, B3, … , BT. We want to compare that to
current costs, C0.
• To do so, we need to calculate the present value of each
benefit:
• PV1 = B1/(1+r) for one year.
• PV2 = B2/(1+r)2 for two years.
• PVT = BT/(1+r)T for “T” years.
• Now the sum of these is:
• PV = B1/(1+r) + B2/(1+r)2 + … + BT/(1+r)T.
• Xt+s = Xt×(1+r)s for “s” years.
Econ 5313
Investment Criterion
• Now we can compare the current costs with the present
value of the benefits.
• If PV > C0 then the investment will return benefits greater
than the costs. Fund it.
• Sometimes we rearrange to ask “PV - C0 > 0?” This is the
“Net Present Value” or NPV.
• Possible complications?
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Do we know Bt into the future?
Do we know r?
Is r constant?
Compound interest?
Econ 5313
Cost of Capital
• Where do companies’ interest rates come from?
• What is the opportunity cost of these funds?
• Borrowing and other forgone investment opportunities.
Finance department calculates a Weighted Average Cost
of Capital (WACC).
• What are typical values?
• How often are these updated?
Econ 5313
Without Discounting
• Two very simple projects
Project 1
Project 2
C0
$100
$100
B1
$115
$60
B2
$0
$60
• What is the sum of the benefits for project 1?
• What is the sum of the benefits for project 2?
• Which would you choose?
Econ 5313
With Disounting
• But if the WACC was 14% then present values are:
Project 1
Project 2
C0
B1
B2
PV
$100 $100.88 $0.00 $100.88
$100 $52.63 $46.17 $98.80
• Why does the timing matter?
Econ 5313
Discounting and Price Changes
• Should Prof. Ward’s new car be a V6 or a 4 cylinder?
• He likes the power of the V6 but they burn more gas
making the operating costs higher. We need to be able to
forecast the price of gasoline over the life of the new car
• Look ahead at the counter-party’s decision process
• Oil companies are have potential barrels of oil in the
ground and have decided on how much to pull out each
year. If MC rises with current production, spread out
production over time.
• So set MRt = MCt in each period
• Across periods?
Econ 5313
Discounting and Price Changes
• They should equate PV of profits from pulling a barrel out
across periods. Why?
• (P1-MC1)/(1+r)1 = (P2-MC2)/(1+r)2 = (P3-MC3)/(1+r)3 = …
• Suppose they expect that (P7-MC7)/(1+r)7 is higher than
other years. What can they do to increase profits?
• Shift more production toward this period until equal again
• Or, (Pt-MCt)/(1+r)t = (P0-MC0) for each period t
• Suppose MCt = 0 for all t. Then, Pt = P0(1+r)t or prices just
rise with the interest rate
• Aha, a price prediction
• Do we think MC of extracting oil and refining it into
gasoline is falling or rising?
Econ 5313
Discounting and Price Changes
• Historically, inflation adjusted prices have been roughly
constant, so if r > 0, MC must have been falling.
• Whoopee, I am getting a V6
Econ 5313
Other Investment Criteria
• NPV versus “internal rate of return” versus “payback
period”
• What is “internal rate of return” IRR?
• Defined by asking “What r will make NPV = 0?”
• Decision is “Is this more than WACC?”
• Problems with IRR?
• What is payback period?
• Defined by asking “For how many periods do we have to go out
for the sum of benefits to exceed costs?”
• Decision is “Is this less than the life of the project?”
• Problems with payback period?
Econ 5313
Break-Even Analysis
• You can print bootleg Cowboy's Tee-shirts and sell them
on game day for $9. Your costs are $6 per unit with a
setup cost of $600.
• How many do you have to sell to break even?
• You just break-even when profits are zero. So we need:
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Revenues = Costs
$9×Q = $6×Q + $600
$3×Q = $600
Q = 200
• You just break-even when you sell 200 shirts.
• If you expect sales of >200 shirts, should you invest?
Econ 5313
Break-Even Quantities
• General formula is QBE = FC/(P-MC).
• Use this to see how the forecast for Q compares with QBE.
• If you do not expect to sell QBE units, don’t invest FC.
• Problems with Break-Even Analysis?
• If Q < QBE, tempted to raise price to get a smaller value.
• But usually the forecast for Q is based on the lower price.
• EX Chicago Skyway
Econ 5313
Alternative Investments
• In 1983, John Deere was in the midst of building a HenryFord-style production line factory for large 4WD tractors.
Unexpectedly, wheat prices fell dramatically reducing
demand for large tractors. Deere’s competitor, Versatile,
assembled tractors in a garage using off-the-shelf
components. A discrete investment decision – the factory
had big FC and small MC, Versatile had small FC but bigger
MC.
• High Tech: Fixed Cost = $100K and MC = $10K
• Low Tech: Fixed Cost = $60K and MC = $15K
• Which is cheaper?
Econ 5313
Alternative Investments
Total Costs ($1,000)
350
300
250
200
150
High Tech
100
Low Tech
50
0
0
4
8
Units
12
16
Even if you do not know Q, you might be able to determine
how big or small it would have to be to justify one decision
or another
Econ 5313
Break-Even Prices
• A toy manufacturer introduced a successful new toy truck.
It invested $2.5 million for a plastic injection molding
machine (which can be sold for $2.0 million) and $100,000
in plastic injection molds specifically for the toy (not
valuable to anyone else). Labor and the cost of materials
for each truck are $3. This year, a competitor has
developed a similar toy that has cut into demand. The
manufacturer is deciding whether they should continue
production of the toy truck.
• If the estimated demand is 100,000 trucks, what is the
break-even price for the toy truck?
• At a price of $20, should you shut down?
Econ 5313
Sunk versus Avoidable Costs
• For shutdown decisions, it is important to only consider
those costs that are marginal to the decision.
• Of course, marginal production costs are relevant.
• But the fixed costs can be divided into those that are sunk and
those that are avoidable.
• Sunk costs are gone and are no longer relevant to decisions on
how to operate into the future.
• But avoidable costs mean that you are foregoing some other
opportunity. If you shut down the toy factory, you can redeploy
the $2million elsewhere. The opportunity cost of the toy factory
is a return on the $2million elsewhere. This factory has to make it
worth your while to not redeploy the funds.
Econ 5313
Hold-up
• National Geographic can reduce costs by printing with
regional printers. To print a high quality magazine, the
printer must buy a $12 million printing press. Each
magazine has a MC of $1 and the printer would print 12
million copies over two years. The break-even
cost/average cost is $7 = ($12M / 2M copies) + $1/copy.
• The printer wins the contract with a bid slightly over
$7/copy.
• After a year, National Geographic wants to renegotiate the
terms down to $2/copy. What should the printer do?
Econ 5313
Hold-up
• This is an example of the “hold-up problem” or “ex post
opportunism.”
• It arises because some costs involved in a project are
marginal before the contract but are sunk during the
contract.
• These costs have to be “relationship specific” i.e., no scrap
value.
• You have to anticipate holdup and protect yourself from it.
• How could the printer have protected himself?
Econ 5313
Bidding on Contract
• Suppose you work for an original equipment manufacturer
(OEM) who makes component pieces for a
telecommunications company. The telecom company asks
you for a price quote for 2,000,000 units that will require a
$1,000,000 investment with marginal costs of $1. What is
your bottom line in negotiations with the telecom?
Suppose you agree on a price slightly above your bottom
line. Immediately after quoting this price to the telecom
company, you receive a purchase order for one million
units.
• What should you do?
Econ 5313
Solutions to Holdup
• If possible, condition prices on quantities purchased
• If possible, protect yourself with a strong enough contract
• Always some contract imperfection
• Sometimes, the only solution is to vertically integrate so
that there is no conflict
• Ex power company
• Sometimes, there is no solution and value-creating
relationship-specific investments cannot be made
• Is marriage a “value creating relationship-specific
investment?”
Econ 5313
Selling an Idea
• Fargo
• Once the idea is revealed, can you negotiate over it?
• http://movieclips.com/fb6gc-fargo-movie-a-finders-fee/
Econ 5313
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From the Blog
Chapter 5
Health Investments
Pension Investments
Prices and R&D
Italian Employment Protection
Chinese Divorces
Econ 5313
Main Points
• Investments usually involve cash flows at different times,
i.e., costs first & revenues later
• To make them comparable, need to discount future values
to the present value
• Companies’ discount rates are from cost-of-capital
• NPV rule – economic profit if NPV > 0
• Compare IRR and payout period
• Breakeven quantity is quantity needed for contribution
margin to cover FC
• Breakeven price is average avoidable costs and excludes
sunk costs
• The different timing of costs and revenues leads to holdup