Any Questions from Last
Class?
Chapter 5
Investment Decisions: Look
Ahead and Reason Back
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the
Star logo, and South-Western are trademarks used herein under license.
Chapter 5 – Take Aways
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Break-even quantity is equal to fixed cost divided by the contribution margin. If
you expect to sell more than the break-even quantity, then incur the fixed costs
to enter the industry.
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Avoidable costs can be recovered by shutting down. If the benefits of shutting
down (you recover your avoidable costs) are larger than the costs (you forgo
revenue), then shut down. The break-even price is average avoidable cost.
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If you incur sunk costs, you are vulnerable to postinvestment hold-up.
Unless the parties are convinced they won’t be held up, they will be reluctant to
make sunk-cost investments.
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Relationship-specific investments are largely sunk. Once relationship-specific
investments are made, parties are locked into a bargaining relationship with
each other. If transactions are frequent and transaction costs are high, then
organizational forms like vertical integration or long-term contracts reduce
transactions costs and encourage relationship-specific investments.
Chapter 5 – Take Aways
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Investments imply willingness to trade dollars in the present
for dollars in the future. Wealth-creating transactions occur
when individuals with low discount rates lend to those with
high discount rates.
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Companies, like individuals, have different discount rates.
Invest only in projects with a positive NPV because they
earn a return higher than the company’s cost of capital.
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The NPV rule states that if the present value of the net
cash flows of a project is larger than zero, the project is
profitable.
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Projects with positive NPV create economic profit.
Review of Chapter 4
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Do not confuse marginal and average costs
MR and MC are relevant benefits and costs
of an extent decision
If MR>MC, do more of it
Incentive compensation increases MR or
decreases MC.
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Fixed fees have no effect on effort
Link compensation to measures that reflect
effort
Introductory Anecdote
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In 2000, Mobil Oil was the leading supplier of industrial lubricants in
the US, bundling engineering services with their high-quality
lubricants
One of their largest customers was a regional producer of electric
power (CBA)
In early 2000, Mobil invested in a three-month engineering audit of
CBA
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Included employee training and equipment inspections
For each piece of CBA equipment, Mobil provided repair,
service, and lubricant recommendations.
CBA made the recommended repairs but shopped the
recommendation list to Mobil’s competitors, who offered lower prices
When Mobil failed to match the lower prices, they lost the contract
and their three-month “investment”
In this section, we study investment decisions like the one by Mobil
that involve costs that cannot be recovered
Background: Break-Even Quantities
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Break-even quantity is the amount you need
to sell to just cover your costs
At this sales level, profit is zero
The break-even quantity is Q=FC/(P-MC),
where FC are fixed costs, P is price, and MC
is marginal cost
P-MC is the “contribution margin” – what’s left
after marginal cost to “contribute” to covering
fixed costs
Discrete (All-Or-Nothing) Decisions
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Should I enter this industry?
Should I exit this industry?
Should I purchase a new plant?
Should I sell to a competitor?
Total costs=F + MC*Q
 Fixed cost to enter, constant mc per unit.
 Definition: Fixed costs (F) are costs that do not vary with the
level of production.
Proposition: For short-run decisions, consider only marginal
costs
Proposition: in the long run, you should consider all costs,
marginal and fixed.
Entry Decision
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Two investment options
 Capital intensive production has higher fixed cost but
lower marginal cost
 More flexible production has lower fixed cost but
higher marginal cost
Find the quantity level at which the costs of the two
options are the same. Say, Cost1=100+10q and
Cost2=50+20q
 Costs are same at q=5
 If you expect to sell more than five, choose high fixed
cost and lower marginal cost. If less than five, choose
the other
Shut Down Decisions: Break-Even Price
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If you shut down
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RULE: shut down if
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Get back avoidable cost
But lose revenue
Opportunity cost of operation is the benefit of
shutting down
revenue is less than avoidable cost; or
price is less than average avoidable cost
Break-even price is the average avoidable
cost
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Profit =Rev-Cost=(P-AC)*Q
Avoidable Costs
Costs
Avoidable
Costs
Fixed Costs
(avoidable in long run)
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Variable Costs
(avoidable in short run)
Discussion: F=$100/year; MC=$5/unit;
Q=100/year
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Unavoidable
or "sunk" Costs
What is break-even price?
Discussion: what if F is sunk, not fixed?
Discussion: post-investment hold-up
Sunk Costs and Postinvestment Hold-Up
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Printer and Magazine
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Break-even price is $2
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2 year contract
2 million copies
$2 million for printer
MC=$1/copy
Post-investment hold-up
One Lesson of Business: how to consummate this
transaction?
Discussion: after bidding the contract you get a PO
for half the quantity you quoted? Should you accept
it?
Vertical Integration as Solution to
Hold-Up
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Bauxite mine and alumina refinery
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Refineries are tailored to specific qualities of ore
Transaction options
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Spot-market transactions
Long-term contract
Vertical integration
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Vertical integration refers to the common ownership of two
firms in separate stages of the vertical supply chain that
connects raw materials to finished goods
Contractual view of marriage
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What is hold-up problem?
Determining Investment Profitability
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Money today is worth more than money tomorrow
Compounding
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Discounting
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Xt+1=(1+r) Xt
Xt+s=(1+r)s Xt
Xt+1/(1+r)= Xt
Xt+s/(1+r)s= Xt
Discussion: trade between individual with different
discount rates
What does this say about behavior?
Present Value and Investment Decisions
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Companies also have discount rates,
determined by cost of capital
Time is a critical element in investment
decisions – cash flows to be received in the
future need to be discounted to present
value using the cost of capital
The NPV Rule: if the present value of the net
cash flows is larger than zero, the project if
profitable
The NPV Rule in Action
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Two Projects
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Project 2 is the better project, right?
Not when you consider present value
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Note: assuming cost of capital of 14%
NPV and Economic Profit
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Projects with positive NPV create economic
profit.
Only positive NPV projects earn a return
higher than the company’s cost of capital.
Projects with negative NPV may create
accounting profits, but not economic profit.
In making investment decisions, choose only
projects with a positive NPV.
Alternate Introductory Anecdote
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1983: John Deere in midst of building HenryFord-style production line for large 4WD tractors
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Abandoned factory and purchased Versatile;
assembled tractors in a garage using off-theshelf components
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Wheat prices fell dramatically reducing demand for
large tractors
Discrete investment decision
This is an example of a discrete or “all-ornothing” decision