Chapter 11 INVESTMENT, STRATEGY, AND ECONOMIC RENTS Brealey, Myers, and Allen Principles of Corporate Finance 11th Edition McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. 11-1 LOOK FIRST TO MARKET VALUES • Smart investment decisions make more money than smart financing decisions • Smart investments are worth more than they cost • Positive NPVs • Firms calculate NPVs by discounting forecast cash flows 11-2 11-1 LOOK FIRST TO MARKET VALUES • Projects may appear to have positive NPVs due to forecasting errors • Some acquisitions result from error in a discounted cash flow (DCF) analysis • Positive NPVs stem from a comparative advantage • Strategic decision making identifies this comparative advantage; it does not identify growth areas 11-3 11-1 LOOK FIRST TO MARKET VALUES • Don’t make investment decisions on the basis of errors in DCF analysis • Start with the market price of the asset and ask whether it is worth more to you than to others 11-4 11-1 LOOK FIRST TO MARKET VALUES • Don’t assume 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? 11-5 11-1 LOOK FIRST TO MARKET VALUES • Department Store Rents 8 8 8 134 NPV 100 ... 2 1.10 1.10 1.1010 $1,000,000 • [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 11-6 FIGURE 11.1 DEPARTMENT STORE RENTS 11-7 11-1 LOOK FIRST TO MARKET VALUES • Example • King Solomon’s mine Investment = $400 million Life = 10 years Production = .1 million oz. a year Production cost = $480 per oz. Current gold price = $800 per oz. Discount rate = 10% 11-8 11-1 LOOK FIRST TO MARKET VALUES • Example, continued • If the gold price is forecasted to rise by 5% p.a.: NPV 400 .10(840 480) .10(882 480) ..... $70 million 1.10 1.10 2 • But if gold is fairly priced, you do not need to forecast future gold prices: • NPV = −investment + PV revenues − PV costs .1 480 400 800 $105 million t t 1 1.10 10 11-9 11-1 LOOK FIRST TO MARKET VALUES • Does Project 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 11-10 11-1 LOOK FIRST TO MARKET VALUES • 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? 11-11 TABLE 11.1 NPV CALCULATION, U.S. COMPANY 11-12 TABLE 11.2 NPV CALCULATION, EUROPEAN COMPANY 11-13 TABLE 11.3 NPV CALCULATION, U.S. COMPANY WITH EUROPEAN COMPETITION 11-14 TABLE 11.4 GARGLE BLASTER INDUSTRY 11-15 FIGURE 11.2 DEMAND FOR GARGLE BLASTERS 11-16 11-3 MARVIN ENTERPRISES DECIDES TO EXPLOIT A NEW TECHNOLOGY—AN EXAMPLE • Value of Gargle Blaster Investment 6 3 10 NPV new plant 100 10 t 1.2 1.25 $299 million 1 Change PV existing plant 24 $72 million t 1.2 Net benefit 299 72 $227 million 11-17 11-3 MARVIN ENTERPRISES DECIDES TO EXPLOIT A NEW TECHNOLOGY—AN EXAMPLE VALUE OF CURRENT BUSINESS: At price of $7 PV = 24 x 3.5/.20 VALUE 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 TOTAL VALUE: 551 CURRENT MARKET PRICE: 460 11-18 FIGURE 11.3 ALTERNATIVE EXPANSION PLANS 11-19