Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Where Net Present Values
Come From
Slides by
Matthew Will
Irwin/McGraw Hill
Chapter 11
©The McGraw-Hill Companies, Inc., 2000
11- 2
Topics Covered
 Look First To Market Values
 Forecasting Economic Rents
 Marvin Enterprises
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 3
Market Values
Smart investment decisions make
MORE money than smart
financing decisions
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 4
Market Values
 Smart investments are worth more than
they cost: they have positive NPVs
 Firms calculate project NPVs by
discounting forecast cash flows, but . . .
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 5
Market Values
 Projects may appear to have positive NPVs
because of forecasting errors.
e.g. some acquisitions result from errors in
a DCF analysis.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 6
Market Values
 Positive NPVs stem from a comparative
advantage.
 Strategic decision-making identifies this
comparative advantage; it does not
identify growth areas.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 7
Market Values
 Don’t make investment decisions on the
basis of errors in your DCF analysis.
 Start with the market price of the asset and
ask whether it is worth more to you than to
others.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 8
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?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 9
Department Store Rents
NPV = -100 + 8
1.10
+ ... +
8 + 134
= $ 1 million
1.1010
[assumes price of property appreciates by 3% a year]
Rental yield = 10 - 3 = 7%
NPV
8-7
1.10
Irwin/McGraw Hill
+
8 - 7.21
1.102
+...+
8 - 8.87
1.109
+
8 - 9.13
= $1 million
1.1010
©The McGraw-Hill Companies, Inc., 2000
11- 10
Using Market Values
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%
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 11
Using Market Values
EXAMPLE: KING SOLOMON’S MINE - continued
If the gold price is forecasted to rise by 5% p.a.:
NPV = -200 + (.1(420 - 200))/1.10 + (.1(441 - 200))/1.102 + ... = - $10 m.
But if gold is fairly priced, you do not need to forecast future gold prices:
NPV = -investment + PV revenues - PV costs
= 200 + 400 - S ((.1 x 200)/1.10t) = $77 million
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 12
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.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 13
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?
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 14
Marvin Enterprises
Capacity
Unit cost
Technology Industry Marvin Capital Prodn. Salvage
value
1. 2011
120
17.5
5
2.5
2. 2019
120
24
17.5
5
2.5
* Proposed
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 15
Marvin Enterprises
Prices
Technology Production Interest Interest Invest Scrap
cost
on
on
above below
capital salvage
1. 2011
5.5
3.5
.5
9
6
2. 2019
3.5
3,5
.5
7
4
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 16
Marvin Enterprises
Demand for Garbage Blasters
Demand
800
Demand = 80 (10 - Price)
Price = 10 x quantity/80
400
320
240
5
Irwin/McGraw Hill
6 7
10
Price
©The McGraw-Hill Companies, Inc., 2000
11- 17
Marvin Enterprises
Value of Garbage Blaster Investment
NPV new plant = 100 x [-10 + S ((6 - 3)/1.2t ) + 10/1.25
= $299 million
Change PV existing plant = 24 x S (1/1.2t ) = $72 million
Net benefit = 299 - 72 = $227 million
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 18
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
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
11- 19
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
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000