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