Powerpoint Slides © Luke M. Froeb, Vanderbilt 2014

PowerPoint Slides © Luke M.
Froeb, Vanderbilt 2014

Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 5
Investment
11
Decisions: Look
Ahead and
Reason Back
2
Summary of Main Points
• Investments imply willingness to trade dollars in the present for
dollars in the future. Wealth-creating transactions occur when
individuals with low discount rates (rate at which they value future vs.
current dollars) lend to those with high discount rates.
• Companies, like individuals, have different discount rates,
determined by their cost of capital. They invest only in projects that
earn a return higher than the cost of capital.
• The NPV rule states that if the present value of the net cash flow of a
project is larger than zero, the project earns economic profit (i.e.,
the investment earns more than the cost of capital).
• Although NPV is the correct way to analyze investments, not all
companies use it. Instead, they use break-even analysis because it is
easier and more intuitive.
• Break-even quantity is equal to fixed cost divided by the contribution
margin. If you expect to sell more than the break-even quantity, then
your investment is profitable.
Summary (cont.)
• Avoidable costs can be recovered by shutting
down. If the benefits of shutting down (you
recover your avoidable costs) are larger than the
costs (you forgo revenue), then shut down. The
break-even price is average avoidable cost.
• If you incur sunk costs, you are vulnerable to
post-investment hold-up. Anticipate hold-up and
choose contracts or organizational forms that
minimize the costs of hold-up.
• Once relationship-specific investments are made,
parties are locked into a trading relationship
with each other, and can be held up by their
trading partners. Anticipate hold-up and choose
organizational or contractual forms to give each
party both the incentive to make relationship-
specific investments and to trade after these
investments are made.
Introductory Anecdote
• In summer 2007, Bert Matthews was contemplating purchasing a 48-unit
apartment building.
• The building was 95% occupied and generated $550,000 in annual profit.
• Investors expected a 15% return on their capital
• The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of
5.5%
• Mr. Matthews computed the cost of capital as a weighted average of equity
and debt.
• .2*(15%) + .8*(5.5%) = 7.4%
• Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break
even.
• Mr. Matthews decided not to buy the building. A good decision – one year
later, the cost of capital was 10.125% and Mr. Matthews could offer only
$5.4 million for the building.
• This story illustrates both the effect of the bursting credit bubble on real
estate valuations and, more importantly, the relevant costs and benefits of
investment decisions.
Background: Investment Profitability
• All investments represent a trade-off between
possible future gain and current sacrifice.
• Willingness to invest in projects with a low rate of
return, indicates a willingness to trade current
dollars for future dollars at a relatively low rate.
• This is also known as having a low discount rate
(r).
• Individuals with low discount rates would
willingly lend to those with higher discount
rates.
• Discounting helps you figure out if future gains
are larger than current sacrifice.
Compounding
• To understand discounting, let’s first look at
compounding:
(future value, k periods in the future) = (present value) x (1 + r)K
• Example: If you invest $1 (present value) today at
a 10% (r), then you would expect to have $1.10 in
one year.
• In two years, $1 becomes $1.21 = $1.10 x (1+.1)
• A good compounding rule of thumb:
• “Rule of 72”: If you invest at a rate of return r, divide
72 by r to get the number of years it takes to double
your money
Discounting
• Discounting (the inverse of compounding):
Present value = (future value, k periods in the future)
(1 + r)k
• Example: At a 10% r, $1 is worth:
• Next year: ($1)/1.1 = $0.91
• Two years: ($0.91)/1.1 =$0.83
• Discussion: If my discount rate is 10%, would I lend
to or borrow from someone with a discount rate of
15%?
• What does this say about behavior?
Example: Nashville Pension Obligations
▮ The city of Nashville uses discounting to decide how
much to save for future pension obligations.
▮ For a pension that pays out $100,000 in 20 years, with
a discount rate of 8.25% Nashville must save:
• $100,000/(1.0825)20 =$20,485
• If the city invests the $20,485 and earns 8.25%, then the
savings will compound in 20 years – unrealistic!
• Somewhat of high savings rate that may not be returned;
however, a high savings rate means less current spending,
which is politically popular
• A more realistic (but less popular) discount rate would be
6.5%, which would lead to saving $28,380 now.
Copyright ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9
Determining the Profitability of Investments
• Remember the simple rule: discount the future
benefits of an investment, and compare them to the
current cost.
• Companies use discount rates, which are determined
by cost of capital.
• A company’s cost of capital is a blend of debt and
equity, its “weighted average cost of capital” or WACC
• Time is a critical element in investment decisions
• Cash flows to be received in the future need to be
discounted to present value using the cost of capital
• The NPV Rule: if the present value of the net cash
flows is larger than zero, then the project earns more
than the cost of capital.
The NPV Rule In Action
• Consider two projects that each require an initial
investment of $100
• Project 1 returns $115 at the end of the first year
• Project 2 returns $60 at the end of the first, and $60 at the end of
the second
• The company’s cost of capital is 14%
• Project 1 earns more than the cost of capital. Project 2 does not.
NPV and Economic Profit
• Projects with a positive NPV create economic
profit.
• Only positive NPV projects earn a return
higher than the company’s cost of capital.
• Projects with negative NPV may create
accounting profits, but not economic profit.
• In making investment decisions, choose only
projects with a positive NPV.
Another Method: Break-Even Quantities
• The break-even quantity is the amount you need
to sell to just cover your costs
• At this sales level, profit is zero.
• The break-even quantity is:
Q=FC/(P-MC)
FC: fixed costs P: price MC:marginal cost
• (P-MC) is the “contribution margin” – what’s left
after marginal cost to “contribute” to covering fixed
costs
Break-Even Example: Nissan Truck
• Nissan’s popular truck model, the Titan, had only two years
remaining on its production cycle. Redesigning the “Titan”
would cost $400M.
• Cost of capital was 12%, implying annual fixed cost of $48M
• Contribution margin on each truck is $1,500
• Break-even quantity is 32,000 trucks
• The decision to redesign or not came down to a break-even analysis
• Nissan had a 3% share of the market, implying only 12,000
Titan sales per year – not enough to break even.
• Instead they decided to license the Dodge Ram Truck, which
would reduce the fixed cost of redesign, and a lower break-
even point.
• After the Government took over Chrysler, Nissan reconsidered
Deciding Between Two Technologies
• In 1983, John Deere was in the midst of building a
Henry-Ford-style production line factory for large 4WD
tractors
• Unexpectedly, wheat prices fell dramatically reducing
demand for large tractors
• Deere decided to abandon the new factory and instead
purchased Versatile, a company that assembled
tractors in a garage using off-the-shelf components
• Deere chose one manufacturing technology over
another
• A discrete investment decision – the factory had big FC
and small MC, Versatile had small FC but bigger MC
John Deere: Right Decision?
▮ Was purchasing Versatile the right choice?
▮ It depends… on how much John Deere expected
to sell.
• Suppose the capital-intensive technology would involve
$100 FC and $10 MC
• Suppose Versatile’s technology had $50 FC and $20 MC
• To determine break-even quantity (point of indifference),
solve for the quantity that equates the costs: $150 for 5
units
• If you expect to sell less than 5 units, choose the low-MC
technology
• If you expect to sell more than 5 units, choose the low-FC
technology
John Deere Lesson
▮ John Deere made the right decision by
acquiring Versatile; however, the Antitrust
Division of he U.S. Department of Justice
challenged the acquisition as anticompetitive.
▮ John Deere and Versatile were only two of 4
firms selling 4WD tractors in North America.
Break-Even Advice
▮ Remember this advice: Do not invoke
break-even analysis to justify higher prices
or greater output.
▮ Managers sometimes believe they must raise
prices to cover fixed costs or they must sell as
much as possible to make average costs lower
▮ These are extent decisions though!
• They require marginal analysis, not break-even
The Decision to Shut-Down
• Shut-down decisions are made using break-even
prices rather than quantities.
• The break-even price is the average avoidable cost
per unit
• Profit = (Rev-Cost)= (P-AC)(Q)
• If you shut down, you lose your revenue, but you
get back your avoidable cost.
• If average avoidable cost is less than
price, shut down.
• Determining avoidable costs can be difficult.
• To identify avoidable costs firms use Cost Taxonomy
Cost Taxonomy
▮ Example: FC=$100, MC=$5, and you produce 100 units/year
▮ How low of a price before you shut down? IT DEPENDS
▮ It depends on which costs are avoidable
• Long-run: fixed costs become avoidable so they are included in the
shutdown price
• Short run: they are unavoidable and should not be included in the
shutdown price
Sunk Costs and Post-Investment Hold Up
• Always remember the business maxim
“look ahead and reason back.” This can
help you avoid potential hold up.
• Before making a sunk cost investment, ask
what you will do if you are held up.
• What would you do to address hold up?
Sunk Costs and Post-Investment Hold Up
Example
• National Geographic can reduce shipping costs by printing
with regional printers.
• To print a high quality magazine, the printer must buy a
$12 million printing press.
• Each magazine has a MC of $1 and the printer would print
12 million copies over two years.
• The break-even cost/average cost is $7 = ($12M / 2M
copies) + $1/copy
• BUT once the press is purchased, the cost is sunk and the
break-even price changes.
• Because of this the magazine can hold up the printer by
renegotiating the terms of the deal – because the price of
the press is unavoidable, and sunk, the break-even price
falls to $1, the marginal cost.
Vertical Integration
• One possible solution to post-investment hold-up is vertical
integration.
• Example: Bauxite mine and alumina refinery
• Refineries are tailored to specific qualities of ore
• The transaction options are:
• Spot-market transactions
• Long-term contracts
• Vertical integration
• Vertical integration refers to the common ownership of two
firms in separate stages of the vertical supply chain that
connects raw materials to finished goods
• Discussion: How is vertical integration a solution to hold up?
• Contractual view of marriage
• Long-term contracts induce higher levels of relationship-specific
investment

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