Investment, Strategy, and Economic Rents. Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

Transcription

1 Investment, Strategy, and Economic Rents Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved

2 Topics Covered Look First To Market Values Economic Rents and Competitive Advantage Example - Marvin Enterprises

3 Market Values Smart investment decisions make MORE money than smart financing decisions Smart investments are worth more than they cost: they have positive NPVs Firms calculate project NPVs by discounting forecast cash flows, but...

4 Market Values Projects may appear to have positive NPVs because of forecasting errors e.g. some acquisitions result from errors in a DCF analysis Positive NPVs stem from a comparative advantage Strategic decision-making identifies this comparative advantage; it does not identify growth areas

5 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.

6 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?

7 Department Store Rents If you own the store NPV = = $1,000,000 If you rent the store: 8 million revenue 7 million rent =1 million Is it profitable?

8 Department Store Rents Lets see if it is profitable: Real estate prices and therefore rents increase by 3%: NPV =

9 Department Store Rents

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%

11 Using Market Values EXAMPLE: KING SOLOMON S MINE - continued If the gold price is forecasted to rise by 5% p.a.:.10( ).10( ) NPV = = $10 million But if gold is fairly priced, you do not need to forecast future gold prices: NPV = -investment + PV revenues - PV costs = ,1 10 = $77 million t 1.10

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

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?

14 Polyzone Production NPV U.S. Company (figures in millions) Year 0 Year 1 Year 2 Year 3-10 Investment 100 Production, Millions of pounds per year Spread, dollars per pound Net revenues Production costs Transport Other costs Cash flow NPV (at r=8%) = $63.6 million

15 Polyzone Production NPV European Company (figures in millions) Year 0 Year 1 Year 2 Year 3-10 Investment 100 Production, Millions of pounds per year Spread, dollars per pound Net revenues Production costs Transport Other costs Cash flow NPV (at r=8%) = 0

16 Polyzone Production NPV U.S. Company w/ European Competition (figures in millions) Year Investment 100 Production, Millions of pounds per year Spread, dollars per pound Net revenues Production costs Transport Other costs Cash flow NPV (at r= 8%)= -9.8

17 Marvin Enterprises Capacity, Millions of Units Technology Industry Marvin Capital Cost per Unit ($) Manufacturing Cost per Unit ($) Salvage Value per Unit ($) First generation (2017) 120 _ Second generation (2025)

18 Marvin Enterprises Demand for Gargle Blasters Demand = 80 (10 - Price) Price = 10 x quantity/80

19 Gargle Blasters Market With the third generation, the equilibrium point of the market is where the NPV=0 NPV= -investment+pv(price-man.cost) = -2,5 + (P.eq-5,50)/0,2 = 0 P.eq = 6 After some time, the market growth made another eq point of price $ 5.

20 Marvin Enterprises Value of Garbage Blaster Investment NPV New Plant = t = $299 million Change PVexisting plant Net benefit 1 = 24 = $72 million t 1.2 = = $227 million

21 Marvin Enterprises VALUE OF CURRENT BUSINESS: VALUE At price of $7 PV = 24 x (7-3.5)/ WINDFALL LOSS: Since price falls to $5 after 5 years, Loss = - 24 x ((5-3) /.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 = TOTAL VALUE: 551 CURRENT MARKET PRICE: 460