Principles of Corporate Finance

Transcription

1 Principles of Corporate Finance Chapter 12. Investment, Strategy, and Economic Rents Ciclo Profissional 2 o Semestre / 2009 Graduação em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

2 Topics covered 1 Look first to market values 2 Economic rents and competitive advantage 3 Case study V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

3 Look first to market values The arithmetic of DCF is simple The difficulties come from the correct evaluation of opportunity cost cash flows When market values are already available, there is no need to forecast cash flows and apply DCF V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

4 Example: Investing in a New Department Store A department store chain is estimating the present value of expected cash flows from a new store Suppose that the new store costs $120 million (real estate) The manager forecasts that it will generate after-tax cash flow of $8 million a year for 10 years Real estate prices are estimated to grow by 3% a year The expected value of real estate at the end of 10 years is $100 ( ) 10 = $134 million According to the manager s forecast, discounting at 10% provides the following NPV 8 NPV = = 1 million ( ) 2 ( ) 10 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

5 Example: Investing in a New Department Store The NPV is highly sensible to the ending value of the real estate An ending value of $120 million implies a NPV of $5 million One could split the project in two parts Real estate part Retailing part The manager does not need to forecast the expected ending value of the store There is a competitive market of real estate that already forecasted the ending value and the correct discount factor If the market fairly prices real estate, it is equivalent for the manager to rent the store for 10 years V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

6 Example: Investing in a New Department Store Assume that similar retail space recently rented for $10 million a year In that case the project is not worthy since the store only generates $8 million per year Suppose the property could be rented for $7 million In that case the project is worthy since it earns a net operating cash flow of 8 7 = $1 million per year Assume now that the real estate prices and rents are expected to increase by 3% per year V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

7 Example: Investing in a New Department Store The store has only a five-year economic life V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

8 General point When making a capital investment decision, one should think what bets we are placing In the department store example, two bets were involve one on real estate another on the firm s ability to run a successful department store One should not make the store investment because we are optimistic about real estate prices It would be better to buy real estate and rent it One should not reject a profitable store project because we are pessimistic about real estate One should separate the two bets V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

9 Example: Opening a gold mine A firm is considering a proposal to open a new gold mine The manager estimates that the mine will cost $200 million to develop in each of the next 10 years it will produce 0.1 million ounces of gold at a cost of $200 an ounce The manager believes that the extraction costs are correctly forecasted but he is less confident about future gold prices He guesses that the price will rise by 5% per year from its current level of $400 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

10 Example: Opening a gold mine Considering a discount rate of 10%, we get the following NPV 0.1 ( ) NPV = ( ) + ( ) 10 = $10 million 0.1 ( ) ( ) According to these forecasts, the gold mine project should be rejected Is it possible to learn something from the market? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

11 Example: Opening a gold mine The less confident forecast is the PV of the price of one ounce of gold at period t Gold can be assimilated with an asset that does not pay dividends The price today of one ounce only reflects expected capital gains P 0 = P r = 1 ( ) P2 = P r 1 + r (1 + r) 2 =... = P t (1 + r) t The total production is 1 million ounces and therefore the PV of the revenue stream is 1 $400 = $400 million V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

12 Example: Opening a gold mine Assume that the appropriate discount rate for the relative certain extraction costs is 10% The NPV of the gold mine project is now NPV = initial investment + PV(revenue) PV(costs) After calculation we get NPV = = $77 million ( ) t t=1 Investing in the gold mine is not such a bad bet after all V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

13 Futures market If we replace gold by copper then today s price does not necessarily coincide with the PV of a future prices This is because copper is not only a store of value Can we find in the market an estimate of the PV of the uncertain copper s price in the future? If we succeed to estimate the certainty-equivalent of copper s price in the future, then we can discount with the risk-free rate What is the minimum fixed price at which you could agree today to sell your future production There is an active market in which firms fix today the price at which they will buy or sell copper in the future These markets are called futures markets V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

14 Economic rents and competitive advantage Definition Profits that more than cover the cost of capital are known as economic rents A firm s project provides economic rents if it is has something valuable that the competitors don t have Rarely economic rents resist to time An economic rent may come from an unexpected increase of the demand for a specific product If a firm is well-placed to expand production capacity quicker and cheaper that its competitors Economic rents are generated at least temporarily until other firms catch up the firm s production capacities V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

15 Economic rents and competitive advantage In some situations, competitive advantages are longer lived patents or proprietary technology reputation embodied in respected brand names economies of scale that competitors can t match (Boeing, Airbus, Brahma, Vale) strategic assets that competitors can t easily duplicate (railroads, soccer s players) Corporate strategy aims to find and exploit sources of competitive advantage The problem is how to do it V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

16 An example: IKEA It is suggested in the corporate strategy literature that there are three ways to secure a competitive advantage cost leadership product differentiation focus on a particular market niche An example: IKEA Its furniture is manufactured in low-cost countries and it requires costumers to collect and assemble the furniture themselves Differentiates by its distinctive Scandinavian design Has a clear focus on a group of customers: young and price-conscious V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

17 Rivals reaction When analyzing an investment opportunity, one should not assume that other firms in the industry will watch passively Positive NPV are suspect without some long-run competitive advantage One should evaluate How long the firm will have a lead over its rivals? What will happen to prices when that lead disappears? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

18 Example A U.S. Chemical producer is about to modify an existing plant to produce polyzone which is in short supply on world markets At prevailing raw material and finished-product prices the project seem to be profitable (the company s cost of capital is 8%) Production costs are $0.375 per pound after start up ($0.75 per pound in year 2, when production is only 40 million pounds) V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

19 Example Some of the project s raw materials were commodity chemicals largely imported from Europe Much of the polyzone production would be exported back to Europe The first analysis forecasted the spread at a constant $1.20 per pound of polyzone for 10 years This is too optimistic European producers who did not face the U.S. company s transportation costs would also expand capacity Increased competition would almost surely squeeze the spread We can calculate the competitive spread at which European competitor would get a zero NPV V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

20 Example The competitive spread is about $0.95 per pound It is the best long run forecast for the polyzone market V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

21 Example The manager considers that it will take five years for the spread to reach $0.95 Anticipating competitors reaction and its impact on prices, the manager concludes that the project is not viable V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

22 An example We consider the market of a product X in 2029 Annual sales amount to $1.68 billion 240 million units sold in the market (price per unit is $7) There exist two production processes for the product First generation process (2017) Second generation process (2025) Marvin is a company that came late into the business (second generation), controlling 10% of the market V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

23 An example The demand response to prices is assumed to be linear V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

24 An example Marvin called a press conference in January 2030 to announce another technological breakthrough According to management, this third-generation process will enable the firm to reduce capital costs to $10 per unit to reduce manufacturing costs to $3 per unit Marvin proposes a huge $1 billion expansion program that would add 100 million units to capacity It should take 12 months to be full in operation for Marvin s firm It will be five years before any competitor has access to the new technology V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

25 Question to the financial manager Would do you agree with the decision to expand? Do you think it would have been better to go for a larger or smaller expansion? How do you think Marvin s announcement is likely to affect the price of its stock? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

26 Forecasting prices Marvin s venture will increase industry capacity to 340 million units To sell 340 million units in the market, the price should decline to $5.75 demand = 80 (10 price) = 340 If the price falls to $5.75 what will happen to companies with the first-generation technology? Should they stay in business? Should they sell their equipment for its salvage value of $2.50 per unit? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

27 Companies with the first-generation process Assume that the opportunity cost is 20% The NPV of staying in business is NPV = = $1.25 per unit It seems that for companies with 2017 equipment, it is better to sell off capacity for $2.50 per unit than to operate it and lose $1.25 per unit As capacity is sold off, the supply of product will decline and the price will rise V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

28 New equilibrium price An equilibrium is reached when the price gets to $6 At this point, 2017 equipment has a zero NPV NPV = For this price the demand is given by = $0 per unit demand = 80 (10 price) = 80 (10 6) = 320 million units First generation producers have to withdraw 20 million units of capacity V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

29 After 5 years Marvin s competitors are also in position to build third-generation plants As long as these plants have positive NPVs, companies will increase their capacity and force the price down A new equilibrium will be reached for the price $5, at this point third-generation plants have zero NPV and there is no incentive for companies to expand further NPV = = $0 per unit With a price of $5 the industry can sell demand = 80 (10 price) = 80 (10 5) = 400 million units Companies with only first-generation equipment will no longer be able to cover its manufacturing costs and will be forced out of business V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

30 The value of Marvin s expansion The introduction of the third-generation technology forces prices to decline to $6 for the next five years and to $5 thereafter Discounting these cash flows at 20% gives us NPV = 1, t=1 ( ) 300 ( ) t ( ) 5 = $299 million 0.20 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

31 The value of Marvin s expansion There is something we should not forget Marvin s decision to expand will reduce the value of its existing 2025 plant Expansion leads to a cut of $1 in price during the first 5 years and cut of $2 dollars thereafter [ 5 ( ) ] 1 24 million ( ) t ( ) 5 = 168 million 0.20 t=1 The net present value of Marvin s venture is, therefore, = 130 or $130 million V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

32 Alternative expansion plans Would Marvin do better to build a larger or smaller plant? To check this, one needs to estimate how the additional production will affect prices then calculate the net present value of the new plan calculate the change in the net present value of the existing plant V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

33 The value of Marvin s stock If the project is not undertaken then the present value of Marvin s firm correspond to the second-generation plant PV = 24 million = $420 million With the new project, the value of existing plants declines to [ 5 ( ) ] PV = 24 + ( ) t ( ) 5 = 252 million 0.20 t=1 The new plant makes a net addition to shareholder s wealth of $299 million After Marvin s announcement, its stock will be worth = $551 million V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

34 Question 11 The manufacture of polysyllabic acid is a competitive industry Most plants have an annual output of 100,000 tons Operating costs are $0.90 a ton A 100,000-ton plant costs $100,000 and has an indefinite life What is the sales price of a ton? The industry is competitive, therefore the NPV of a plant is likely to be zero 100 (Price 0.90) NPV = and the sales price is $1 a ton V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

35 Question 11 The manufacture of polysyllabic acid is a competitive industry Most plants have an annual output of 100,000 tons Operating costs are $0.90 a ton A 100,000-ton plant costs $100,000 and has an indefinite life What is the sales price of a ton? The industry is competitive, therefore the NPV of a plant is likely to be zero 100 (Price 0.90) NPV = and the sales price is $1 a ton V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

36 Question 11 A 100,000-ton plan has current scrap value of $60,000 which is expected to decline to $57,900 over the next two years Phlogiston, Inc,. proposes to invest $100,000 in a plant that employs a new low-cost process to manufacture polysyllabic acid The plant has the same capacity as existing units, but operating costs are $0.85 a ton Phlogiston estimates that it has two years lead over each of its rivals in use of the process but is unable to build any more plants itself before year 2 You can assume that there are no taxes and that the cost of capital is 10% V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

37 Question 11 By the end of year 2, the prospective increase in acid demand will require the construction of several new plants using the Phlogiston process What is the likely NPV of such plants? The NPV of such plants is likely to be zero, because the industry is competitive and, after two years, no company will enjoy any technical advantages The PV of each of these new plants would be $100,000 because the NPV is zero and the cost is $100,000 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

38 Question 11 By the end of year 2, the prospective increase in acid demand will require the construction of several new plants using the Phlogiston process What is the likely NPV of such plants? The NPV of such plants is likely to be zero, because the industry is competitive and, after two years, no company will enjoy any technical advantages The PV of each of these new plants would be $100,000 because the NPV is zero and the cost is $100,000 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

39 Question 11 What does that imply for the price of polysyllabic acid in year 3 and beyond? The PV of revenue from such a plant is: 100 (Price 0.85) 0.10 = 100 Therefore, the price of polysyllabic acid will be $0.95 per ton Would you expect existing plant to be scrapped in year 2? How would your answer differ if scrap value were $40,000 or $80,000? At t = 2 the PV of the existing plant will be: 100 ( ) 0.10 = 50 Therefore, the price of polysyllabic acid will be $0.95 per ton V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

40 Question 11 What does that imply for the price of polysyllabic acid in year 3 and beyond? The PV of revenue from such a plant is: 100 (Price 0.85) 0.10 = 100 Therefore, the price of polysyllabic acid will be $0.95 per ton Would you expect existing plant to be scrapped in year 2? How would your answer differ if scrap value were $40,000 or $80,000? At t = 2 the PV of the existing plant will be: 100 ( ) 0.10 = 50 Therefore, the price of polysyllabic acid will be $0.95 per ton V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

41 Question 11 What does that imply for the price of polysyllabic acid in year 3 and beyond? The PV of revenue from such a plant is: 100 (Price 0.85) 0.10 = 100 Therefore, the price of polysyllabic acid will be $0.95 per ton Would you expect existing plant to be scrapped in year 2? How would your answer differ if scrap value were $40,000 or $80,000? At t = 2 the PV of the existing plant will be: 100 ( ) 0.10 = 50 Therefore, the price of polysyllabic acid will be $0.95 per ton V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

42 Question 11 What does that imply for the price of polysyllabic acid in year 3 and beyond? The PV of revenue from such a plant is: 100 (Price 0.85) 0.10 = 100 Therefore, the price of polysyllabic acid will be $0.95 per ton Would you expect existing plant to be scrapped in year 2? How would your answer differ if scrap value were $40,000 or $80,000? At t = 2 the PV of the existing plant will be: 100 ( ) 0.10 = 50 Therefore, the price of polysyllabic acid will be $0.95 per ton V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

43 Question 11 The acid plants of United Alchemists, Inc., have been fully depreciated. Can it operate them profitably after year 2? No. Book value is irrelevant. NPV of the existing plant is negative after year 2 Acidosis, Inc., purchased a new plant last year for $100,000 and is writing it down by $10,000 a year. Should it scrap this plant in year 2? Yes. Sunk costs are irrelevant. NPV of the existing plant is negative after year 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

44 Question 11 The acid plants of United Alchemists, Inc., have been fully depreciated. Can it operate them profitably after year 2? No. Book value is irrelevant. NPV of the existing plant is negative after year 2 Acidosis, Inc., purchased a new plant last year for $100,000 and is writing it down by $10,000 a year. Should it scrap this plant in year 2? Yes. Sunk costs are irrelevant. NPV of the existing plant is negative after year 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

45 Question 11 The acid plants of United Alchemists, Inc., have been fully depreciated. Can it operate them profitably after year 2? No. Book value is irrelevant. NPV of the existing plant is negative after year 2 Acidosis, Inc., purchased a new plant last year for $100,000 and is writing it down by $10,000 a year. Should it scrap this plant in year 2? Yes. Sunk costs are irrelevant. NPV of the existing plant is negative after year 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

46 Question 11 The acid plants of United Alchemists, Inc., have been fully depreciated. Can it operate them profitably after year 2? No. Book value is irrelevant. NPV of the existing plant is negative after year 2 Acidosis, Inc., purchased a new plant last year for $100,000 and is writing it down by $10,000 a year. Should it scrap this plant in year 2? Yes. Sunk costs are irrelevant. NPV of the existing plant is negative after year 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

47 Question 11 Assume that the production of the new plant of Phlogiston will yield a price for the next two years such that the existing plant s owners will be indifferent between scrapping now and scrapping at the end of year 2 Compute the price for year 1 and year (Price 0.90) (Price 0.90) 57.9 ( ) 2 + ( ) 2 = 60 Solving, we find that the price is $0.97 per ton Compute the NPV of Phlogiston s venture [ ] PV = ( ) ( ) 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

48 Question 11 Assume that the production of the new plant of Phlogiston will yield a price for the next two years such that the existing plant s owners will be indifferent between scrapping now and scrapping at the end of year 2 Compute the price for year 1 and year (Price 0.90) (Price 0.90) 57.9 ( ) 2 + ( ) 2 = 60 Solving, we find that the price is $0.97 per ton Compute the NPV of Phlogiston s venture [ ] PV = ( ) ( ) 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

49 Question 11 Assume that the production of the new plant of Phlogiston will yield a price for the next two years such that the existing plant s owners will be indifferent between scrapping now and scrapping at the end of year 2 Compute the price for year 1 and year (Price 0.90) (Price 0.90) 57.9 ( ) 2 + ( ) 2 = 60 Solving, we find that the price is $0.97 per ton Compute the NPV of Phlogiston s venture [ ] PV = ( ) ( ) 2 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

50 Question 5 Thanks to acquisition of a key patent, your company now has exclusive production rights for barkelgassers (BGs) in North America Production facilities for 200,000 BGs per year will require a $25 million immediate capital expenditure Production costs are estimated at $65 per BG The BG marketing manager is confident that all 200,000 units can be sold for $100 per unit (in real terms) until the patent runs out five years hence After that the marketing manager hasn t a clue about what the selling price will be What is the NPV of the BG project? V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

51 Question 5 Make the following assumptions The real cost of capital is 9% The technology for making BGs will not change. Capital and production costs will stay the same in real terms Competitors know the technology and can enter as soon as the patent expires, that is, in year 6 If your company invests immediately, full production begins after 12 months, that is, in year 1 There are no taxes BG production facilities last 12 years. They have no salvage value at the end of their useful life V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

52 Solution to Question 5 The sequence of events is At t = 0, the investment of $25,000,000 is made At t = 1, production begins, so the first year of revenue and expenses is recorded at t = 2 At t = 6, the patent expires and competition may enter. Since it takes one year to achieve full production, competition is not a factor until t = 7. (This assumes the competition does not begin construction until the patent expires) After t = 7, full competition will exist and thus any new entrant into the market for BGs will earn the 9% cost of capital V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

53 Solution to Question 5 We calculate the cash flows At t = 0: -$25,000,000 At t = 1: $0 At t = 2, 3..., 6: Sale of 200,000 units at $100 each, with costs of $65 each, yearly cash flow = $7,000,000 After t = 6, the NPV of the new investment must be zero. To find the selling price per unit, P, we solve 0 = 25, 000, We find P = $ , 000 (P 65) 200, 000 (P 65) ( ) ( ) 12 For years t = 7 through t = 2, the yearly cash flow will be 200, 000 ($85.02 $65) = $4, 004, 000 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44

54 Solution to Question 5 The present value in millions is: NPV = ( ) ( ) ( ) ( ) ( ) 12 and we get NPV = $10,690,000 V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance October, / 44