Chapter 11

INVESTMENT, STRATEGY,
AND ECONOMIC RENTS

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education 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, i.e. positive NPVs
Firms calculate NPVs by discounting
forecast cash flows
But, we know these already!

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11-1 LOOK FIRST TO MARKET VALUES
Managers must know the source of positive
NPVs
Projects may show positive NPVs due to
forecasting errors or WACC estimation errors
Generally, positive NPVs should come from a
comparative advantage of the firm
Start with the market price of the asset and ask
whether it is worth more to you than to others
Strategy analysis identifies this comparative
advantage
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11-1 LOOK FIRST TO MARKET VALUES

Dont assume other firms will watch

passively. Do not underestimate
competition, even from small firms
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?
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11-1 LOOK FIRST TO MARKET VALUES
Department Store Rents (pages 274-275)
Building cost $100, CF $8 per year for 10 yrs, real estate
prices increase 3% per year. NPV is as follows:

8 8 8 134
NPV 100 2
...
1.10 1.10 1.1010
$1,000,000
What can go wrong?
Building prices
Stores revenue

Market rental of similar building

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FIGURE 11.1 DEPARTMENT STORE RENTS

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11-1 LOOK FIRST TO MARKET VALUES

Example: King Solomons 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%

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11-1 LOOK FIRST TO MARKET VALUES

Example, continued
If the gold price is forecasted to rise by 5% p.a.:
.10(840 480) .10(882 480)
NPV 400 2
..... $70 million
1.10 1.10
But if gold is fairly priced, you do not need to
forecast future gold prices because current price =
pv of future price.

NPV = investment + PV revenues PV costs

.1 480 10
400 800 t
$105 million
t 1 1.10

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11-1 LOOK FIRST TO MARKET VALUES

Does Project Have Positive NPVs?

Economic 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

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11-1 LOOK FIRST TO MARKET VALUES

Competitive Advantage:
Proposal to manufacture specialty chemicals in
US, but raw materials were imported from
Europe. Finished product was exported to
Europe.
Due to new technology, company gets high profits in
early years, but what happens when competitors
enter?

What happens when European companies start

producing the product?

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TABLE 11.1 NPV CALCULATION, U.S. COMPANY

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TABLE 11.2 NPV CALCULATION, EUROPEAN
COMPANY

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TABLE 11.3 NPV CALCULATION, U.S. COMPANY
WITH EUROPEAN COMPETITION

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 HOMEWORK: SELF STUDY
MARVIN ENTERPRISES, Pages 281-288
(old book), pages 288-294 (new book)

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TABLE 11.4 GARGLE BLASTER INDUSTRY

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FIGURE 11.2 DEMAND FOR GARGLE BLASTERS

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11-3 MARVIN ENTERPRISES DECIDES TO EXPLOIT
A NEW TECHNOLOGYAN 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 t
$72 million
1.2
Net benefit 299 72 $227 million

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11-3 MARVIN ENTERPRISES DECIDES TO EXPLOIT
A NEW TECHNOLOGYAN EXAMPLE
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

TOTAL VALUE: 551

CURRENT MARKET PRICE: 460

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FIGURE 11.3 ALTERNATIVE EXPANSION PLANS

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