Why is a manager who has learned about discounted cash flow (DCF) like a baby with a hammer? Answer: Because to a baby with a hammer, everything looks like a nail. Our point is that you should not blindly apply DCF without thinking about the reasons that a project may add value. You also need to ensure that the investment process is designed to produce well-researched investment proposals that will add value for shareholders.
We start with the second issue. Investment proposals may emerge from many different parts of the organization. So companies need procedures to ensure that every project is assessed consistently. We review how firms develop budgets for capital investments, how they authorize specific projects, and how they check whether projects perform as promised.
We then ask how managers can distinguish projects that truly have positive NPVs from those that appear worthwhile merely because of forecasting errors? We suggest that they should ask some probing questions about the possible sources of economic gain.
To make good investment decisions, you need to understand your firm’s competitive advantages. This is where corporate strategy and finance come together. Good strategy positions the firm to generate the most value from its assets and growth opportunities. The search for good strategy starts with understanding how your firm stacks up versus your competitors and how they will respond to your initiatives. Are your cash-flow forecasts realistic in your competitive environment? What effects will your competitors’ actions have on the NPVs of your investments?
The first section in this chapter is concerned with the organization of the investment process. We then review certain common pitfalls in capital budgeting, notably the tendency to apply DCF when market values are already available and no DCF calculations are needed. The third section covers the economic rents that underlie all positive-NPV investments. The final section presents a case study describing how Marvin Enterprises, the gargle blaster company, analyzed the introduction of a radically new product.
11-1How Firms Organize the Investment Process
The Capital Budget
Senior management needs some forewarning of future investment outlays. So for most large firms, the investment process starts with the preparation of an annual capital budget, which is a list of investment projects planned for the coming year. Smaller investments are not itemized separately in the budget. For example, they may be grouped into the broad category of “machine replacement.” Larger investments that significantly affect the company’s future will receive greater attention.
Many of the investment proposals that are included in the budget bubble up from the bottom of the organization. But ideas are also likely to come from higher up. For example, the managers of plants A and B cannot be expected to see the potential benefits of closing their plants and consolidating production at a new plant C. We expect divisional managers to propose plant C. Similarly, divisions 1 and 2 may not be eager to give up their own data processing operations to a large central computer. That proposal would come from senior management.
Inconsistent assumptions can creep into these expenditure plans. For example, suppose the manager of your furniture division is bullish on housing starts, but the manager of your appliance division is bearish. The furniture division may push for a major investment in new facilities, while the appliance division may propose a plan for retrenchment. It would be better if both managers could agree on a common estimate of housing starts and base their investment proposals on it. Therefore, many firms begin the capital budgeting process by establishing consensus forecasts of economic indicators, such as inflation and growth in national income, as well as forecasts of particular items that are important to the firm’s business, such as housing starts or the prices of raw materials. These forecasts are then used as the basis for the capital budget.
Preparation of the capital budget is not a rigid, bureaucratic exercise. There is plenty of give-and-take and back-and-forth. Divisional managers negotiate with plant managers and fine-tune the division’s list of projects. The budget is then reviewed and pruned by senior management and staff that specialize in planning and financial analysis. Usually, there are negotiations between senior management and divisional management, and there may also be special analyses of major outlays or ventures into new areas.
The final capital budget needs to reflect the corporation’s strategic plans. These plans take a top-down view of the company. They attempt to identify businesses where the company has a competitive advantage. They also seek to identify businesses that should be sold or allowed to run down. A firm’s capital investment choices should reflect both bottom-up and top-down views of the business. Plant and division managers, who do most of the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic planners may have a mistaken view of the forest because they do not look at the trees one by one.
Project Authorizations—and the Problem of Biased Forecasts
Once the budget has been approved, it generally remains the basis for planning over the ensuing year. However, it is not the final sign-off for specific projects. Most companies require appropriation requests for each proposal. Before each investment gets the final go-ahead, it will need to be supported by a more detailed analysis setting out particulars of the project, cash-flow forecasts, and present value calculations.
Many investment projects carry a high price tag and may determine the shape of the firm’s business 10 or 20 years in the future. Hence, final approval of appropriation requests tends to be reserved for top management. Companies set ceilings on the size of projects that divisional managers can authorize. Often these ceilings are surprisingly low. For example, a large company, investing $400 million per year, might require top management to approve all projects over $500,000.
The result is that the head office may receive several hundred investment proposals each year. As each proposal travels up the organization, alliances are formed. Thus, once a division has screened its own plants’ proposals, the plants in that division unite in competing against outsiders. The final proposal may be silent on the questions and doubts that were raised during the project’s travel up the organization.
Project sponsors are liable to be both overconfident and overoptimistic about their pet projects, and these two traits make it particularly difficult for others to judge the merits of a proposal. Most people tend to be overconfident when they forecast. Events they think are almost certain to occur may actually happen only 80% of the time, and events they believe are impossible may happen 20% of the time.1 Therefore. project risks are understated.
Furthermore, anyone who is keen to get a project accepted is likely to look on the bright side when forecasting the project’s cash flows. Such overoptimism seems to be a common feature in financial forecasts. Overoptimism afflicts governments too, probably more than private businesses. How often have you heard of a new dam, highway, or military aircraft that actually cost less than was originally forecasted?
Overoptimism is not altogether bad. Psychologists stress that optimism and confidence are likely to increase effort, commitment, and persistence. The problem is that hundreds of appropriation requests may reach senior management each year—all essentially sales documents presented by united fronts and designed to persuade. Alternative schemes have been filtered out at earlier stages. The forecasts have been doctored to ensure that NPV appears positive. One response of senior managers to this problem of biased information is to impose rigid expenditure limits on individual plants or divisions. These limits force the subunits to choose among projects. The firm ends up using capital rationing not because capital is unobtainable, but as a way of decentralizing decisions.
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Overoptimism and cost overruns
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It is probably impossible to eliminate bias completely, but senior managers should take care not to encourage it. For example, if divisional managers believe that success depends on having the largest division rather than the most profitable one, they will propose large expansion projects that they do not truly believe have positive NPVs. Or if new plant managers are pushed to generate increased earnings right away, they will be tempted to propose quick-payback projects even when NPV is sacrificed.
Sometimes senior managers try to offset overoptimism by increasing the hurdle rate for capital expenditure. Suppose the true cost of capital is 10%, but the CFO is frustrated by the large fraction of projects that don’t subsequently earn 10%. She therefore directs project sponsors to use a 15% discount rate. In other words, she adds a 5% fudge factor in an attempt to offset forecast bias. But it doesn’t work; it never works. Brealey, Myers, and Allen’s Second Law2 explains why. The law states: The proportion of proposed projects having positive NPVs at the corporate hurdle rate is independent of the hurdle rate.
The law is not a facetious conjecture. It was tested in a large oil company where staff kept careful statistics on capital investment projects. About 85% of projects had positive NPVs. (The remaining 15% were proposed for other reasons—for example, to meet environmental standards.) One year, after several quarters of disappointing earnings, top management decided that more financial discipline was called for and increased the corporate hurdle rate by several percentage points. But in the following year, the fraction of projects with positive NPVs stayed rock-steady at 85%. If you’re worried about bias in forecasted cash flows, the only remedy is careful analysis of the forecasts. Do not add fudge factors to the cost of capital.3
Postaudits
Most firms keep a check on the progress of large projects by conducting postaudits shortly after the projects have begun to operate. Postaudits identify problems that need fixing, check the accuracy of forecasts, and suggest questions that should have been asked before the project was undertaken. Postaudits pay off mainly by helping managers do a better job when it comes to the next round of investments. After a postaudit, the controller may say, “We should have anticipated the extra training required for production workers.” When the next proposal arrives, training will get the attention it deserves.
Postaudits may not be able to measure all of a project’s costs and benefits. It is often impossible to split the project away from the rest of the business. Suppose that you have just taken over a trucking firm that operates a delivery service for local stores. You decide to improve service by installing custom software to keep track of packages and to schedule trucks. You also construct a dispatching center and buy five new diesel trucks. A year later, you try a post-audit of the investment in software. You verify that it is working properly and check actual costs of purchase, installation, and operation against projections. But how do you identify the incremental cash inflows? No one has kept records of the extra diesel fuel that would have been used or the extra shipments that would have been lost absent the software. You may be able to verify that service is better, but how much of the improvement comes from the new trucks, how much from the dispatching center, and how much from the software? The only meaningful measures of success are for the delivery business as a whole.
11-2Look First to Market Values
Let us suppose that you have persuaded all your project sponsors to give honest forecasts. Although those forecasts are unbiased, they are still likely to contain errors, some positive and others negative. The average error will be zero, but that is little consolation because you want to accept only projects with truly superior profitability.
Think, for example, of what would happen if you were to jot down your estimates of the cash flows from operating various lines of business. You would probably find that about half appeared to have positive NPVs. This may not be because you personally possess any superior skill in operating jumbo jets or running a chain of laundromats but because you have inadvertently introduced large errors into your estimates of the cash flows. The more projects you contemplate, the more likely you are to uncover projects that appear to be extremely worthwhile.
What can you do to prevent forecast errors from swamping genuine information? As a senior manager, you can’t be expected to check every cash-flow forecast, but you can ask some questions to ensure that each project truly does have a positive NPV. We suggest that you begin by looking at market values.
The BMW and Your Sporting Idol
The following parable should help to illustrate what we mean. Your local BMW dealer is announcing a special offer. For $85,000, you get not only a brand-new BMW 6-Series convertible, but also the chance to enjoy a day’s coaching from your favorite sporting hero. You wonder how much you are paying for that day.
There are two possible approaches to the problem. You could evaluate each of the BMW’s features, starting with the Turbo V8 engine and ending with the exclusive Nappa leather interior, and conclude that the car is worth $80,000. This would seem to suggest that the day with your sporting hero is costing you $5,000. Alternatively, you might nip round to a couple other BMW dealers and discover that the going market price for the car is $85,000 so that the special offer is costing you nothing. As long as there is a competitive market for BMWs, the latter approach makes more sense.
Security analysts face a similar problem whenever they value a company’s stock. They must consider the information that is already known to the market about a company, and they must evaluate the information that is known only to them. The information that is known to the market is the BMW; the private information is the day with your sporting idol. Investors have already evaluated the information that is generally known. Security analysts do not need to evaluate this information again. They can start with the market price of the stock and concentrate on valuing their private information.
While lesser mortals would instinctively accept the BMW’s market value of $85,000, the financial manager is trained to enumerate and value all the costs and benefits from an investment and is therefore tempted to substitute his or her own opinion for the market’s. Unfortunately, this approach increases the chance of error. Many capital assets are traded in a competitive market, so it makes sense to start with the market price and then ask why you can earn more than your rivals from these assets.
EXAMPLE 11.1 
Investing in a New Department Store
We encountered a department store chain that estimated the present value of the expected cash flows from each proposed store, including the price at which it could eventually sell the store. Although the firm took considerable care with these estimates, it was disturbed to find that its conclusions were heavily influenced by the forecasted selling price of each store. Management disclaimed any particular real estate expertise, but it discovered that its investment decisions were unintentionally dominated by its assumptions about future real estate prices.
Once the financial managers realized this, they always checked the decision to open a new store by asking the following question: “Let us assume that the property is fairly priced. What is the evidence that it is best suited to one of our department stores rather than to some other use?” In other words, if an asset is worth more to others than it is to you, then beware of bidding for the asset against them.
Let us take the department store problem a little further. Suppose that the new store costs $100 million.4 You forecast 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, so the expected value of the real estate at the end of 10 years is 100 × (1.03)10 = $134 million. At a discount rate of 10%, your proposed department store has an NPV of $1 million:
Notice how sensitive this NPV is to the ending value of the real estate. For example, an ending value of $120 million implies an NPV of –$5 million.
It is helpful to imagine such a business as divided into two parts—a real estate subsidiary that buys the building and a retailing subsidiary that rents and operates it. Then figure out how much rent the real estate subsidiary would have to charge, and ask whether the retailing subsidiary could afford to pay the rent.
In some cases, a fair market rental can be estimated from real estate transactions. For example, we might observe that similar retail space recently rented for $10 million a year. In that case, we would conclude that our department store was an unattractive use for the site. Once the site had been acquired, it would be better to rent it out at $10 million than to use it for a store generating only $8 million.
Suppose, on the other hand, that the property could be rented for only $7 million per year. The department store could pay this amount to the real estate subsidiary and still earn a net operating cash flow of 8 – 7 = $1 million. It is therefore the best current use for the real estate.5
Will it also be the best future use? Maybe not, depending on whether retail profits keep pace with any rent increases. Suppose that real estate prices and rents are expected to increase by 3% per year. The real estate subsidiary must charge 7 × 1.03 = $7.21 million in year 2, 7.21 × 1.03 = $7.43 million in year 3, and so on.6 Figure 11.1 shows that the store’s income fails to cover the rental after year 5.
FIGURE 11.1 Beginning in year 6, the department store’s income fails to cover the rental charge.
If these forecasts are right, the store has only a five-year economic life; from that point on, the real estate is more valuable in some other use. If you stubbornly believe that the department store is the best long-term use for the site, you must be ignoring potential growth in income from the store.7
There is a general point here as illustrated in Example 11.1. Whenever you make a capital investment decision, think what bets you are placing. Our department store example involved at least two bets—one on real estate prices and another on the firm’s ability to run a successful department store. But that suggests some alternative strategies. For instance, it would be foolish to make a lousy department store investment just because you are optimistic about real estate prices. You would do better to buy real estate and rent it out to the highest bidders. The converse is also true. You shouldn’t be deterred from going ahead with a profitable department store because you are pessimistic about real estate prices. You would do better to sell the real estate and rent it back for the department store. We suggest that you separate the two bets by first asking, “Should we open a department store on this site, assuming that the real estate is fairly priced?” and then deciding whether you also want to go into the real estate business.
Let us look at another example of how market prices can help you make better decisions.
EXAMPLE 11.2 Opening a Gold Mine
Kingsley Solomon is considering a proposal to open a new gold mine. He estimates that the mine will cost $500 million to develop and that in each of the next 10 years, it will produce 1 million ounces of gold at a cost, after mining and refining, of $1,150 an ounce. Although the extraction costs can be predicted with reasonable accuracy, Mr. Solomon is much less confident about future gold prices. His best guess is that the price will rise by 5% per year from its current level of $1,500 an ounce. At a discount rate of 10%, this gives the mine an NPV of –$35 million:
Therefore, the gold mine project is rejected.
Unfortunately, Mr. Solomon did not look at what the market was telling him. What is the PV of an ounce of gold? Clearly, if the gold market is functioning properly, it is the current price, $1,500 an ounce. Gold does not produce any income, so $1,500 is the discounted value of the expected future gold price.8 Since the mine is expected to produce a total of 1 million ounces (.1 million ounces per year for 10 years), the present value of the revenue stream is 1 × 1,500 = $1,500 million.9 Suppose that 10% is an appropriate discount rate for the relatively certain extraction costs. Then
It looks as if Kingsley Solomon’s mine is not such a bad bet after all.10
Mr. Solomon’s gold, in Example 11.2, was just like anyone else’s gold. So there was no point in trying to value it separately. By taking the PV of the gold sales as given, Mr. Solomon was able to focus on the crucial issue: Were the extraction costs sufficiently low to make the venture worthwhile? That brings us to another of those fundamental truths: If others are producing a good or service profitably and (like Mr. Solomon) you can make it more cheaply than them, then you don’t need any NPV calculations to know that you are probably onto a good thing.
We confess that our example of Kingsley Solomon’s mine is somewhat special. Unlike gold, most commodities are not kept solely for investment purposes, and therefore you cannot automatically assume that today’s price is equal to the present value of the future price.11
However, here is another way that you may be able to tackle the problem. Suppose that you are considering investment in a new copper mine and that someone offers to buy the mine’s future output at a fixed price. If you accept the offer—and the buyer is completely creditworthy—the revenues from the mine are certain and can be discounted at the risk-free interest rate.12 That takes us back to Chapter 9, where we explained that there are two ways to calculate PV:
· Estimate the expected cash flows and discount at a rate that reflects the risk of those flows.
· Estimate what sure-fire cash flows would have the same values as the risky cash flows. Then discount these certainty-equivalent cash flows at the risk-free interest rate.
When you discount the fixed-price revenues at the risk-free rate, you are using the certainty-equivalent method to value the mine’s output. By doing so, you gain in two ways: You don’t need to estimate future mineral prices, and you don’t need to worry about the appropriate discount rate for risky cash flows.
But here’s the question: What is the fixed price at which you could agree today to sell your future output? In other words, what is the certainty-equivalent price? Fortunately, for many commodities, there is an active market in which firms fix today the price at which they will buy or sell copper and other commodities in the future. This market is known as the futures market, which we will cover in Chapter 26. Futures prices are certainty equivalents, and you can look them up in the daily newspaper. So you don’t need to make elaborate forecasts of copper prices to work out the PV of the mine’s output. The market has already done the work for you; you simply calculate future revenues using the price in the newspaper of copper futures and discount these revenues at the risk-free interest rate.
Of course, things are never as easy as textbooks suggest. Trades in organized futures exchanges are largely confined to deliveries over the next year or so; therefore, your newspaper won’t show the price at which you could sell output beyond this period. But financial economists have developed techniques for using the prices in the futures market to estimate the amount that buyers would agree to pay for more-distant deliveries.13
Our two examples of gold and copper producers are illustrations of a universal principle of finance: When you have the market value of an asset, use it, at least as a starting point in your analysis.
11-3Economic Rents and Competitive Advantage
Profits that more than cover the cost of capital are known as economic rents. Economics 101 teaches us that in the long run, competition eliminates economic rents. That is, in a long-run competitive equilibrium, no company can expand and earn more than the cost of capital on that investment.
Economic rents are earned when an industry has not settled down to equilibrium or when your firm has something valuable that your competitors don’t have. For example, suppose that demand takes off unexpectedly and that your firm can expand production capacity more quickly and cheaply than your competitors. This stroke of luck is pretty sure to generate economic rents, at least until other firms manage to catch up.
Some competitive advantages are longer lived. They include patents or proprietary technology; reputation, embodied in respected brand names, for example; economies of scale that customers can’t match; protected markets that competitors can’t enter; and strategic assets that competitors can’t easily duplicate.
Here’s an example of strategic assets. Think of the difference between railroads and trucking companies. It’s easy to enter the trucking business but nearly impossible to build a brand-new, long-haul railroad.14 The interstate lines operated by U.S. railroads are strategic assets. With these assets in place, railroads were able to increase revenues and profits rapidly when shipments surged and energy prices increased in the early years of this century. The high cost of diesel fuel was more burdensome for trucks, which are less fuel efficient than railroads. Thus, high energy prices actually handed the railroads a competitive advantage.
Corporate strategy aims to find and exploit sources of competitive advantage. The problem, as always, is how to do it. John Kay advises firms to pick out distinctive capabilities—existing strengths, not just ones that would be nice to have—and then identify the product markets where those capabilities can generate the most value added. The capabilities may come from durable relationships with customers or suppliers, from the skills and experience of employees, from brand names and reputation, and from the ability to innovate.15
Michael Porter identifies five aspects of industry structure (or “five forces”) that determine which industries are able to provide sustained economic rents.16 These are the rivalry among existing competitors, the likelihood of new competition, the threat of substitutes, and the bargaining power both of suppliers and customers. With increasing global competition, firms cannot rely so easily on industry structure to provide high returns. Therefore, managers also need to ensure that the firm is positioned within its industry so as to secure a competitive advantage. Porter goes on to suggest three ways this can be done—by cost leadership, by product differentiation, and by focus on a particular market niche.17
These advantages will protect a firm only if they are durable and can be sustained against competition from other businesses. Warren Buffett stresses that successful businesses require the equivalent of a castle moat to deter marauders:
I want a business with a moat around it with a very valuable castle in the middle. And then I want the duke who’s in charge of that castle to be honest and hard-working and able. . . .
Our managers of the businesses we run, I’ve got one message to them, which is to widen the moat. And we want to throw crocodiles and sharks and everything else, gators, I guess, into the moat to keep away competitors. And that comes about through service, it comes about through quality of product, it comes about through cost, it comes about sometimes through patents, it comes about through real estate location.18
You can see how business strategy and finance reinforce each other. Managers who have a clear understanding of their firm’s competitive strengths (and the moats that protect their products and services) are better placed to separate those projects that truly have a positive NPV from those that do not. Therefore, when you are presented with a project that appears to have a positive NPV, do not just accept the calculations at face value. They may reflect simple estimation errors in forecasting cash flows. Probe behind the cash-flow estimates, and try to identify a source of economic rents. A positive NPV for a new project is believable only if you believe that your company has some special advantage.
Thinking about competitive advantage can also help ferret out negative-NPV calculations that are negative by mistake. For example, if you are the lowest-cost producer of a profitable product in a growing market, you should invest to expand along with the market. If your calculations show a negative NPV for such an expansion, you have probably made a mistake.
We will work through shortly an extended example that shows how a firm’s analysis of its competitive position confirmed that a major investment had a positive NPV. But first we look at an example in which the analysis helped a firm to identify a negative-NPV transaction and avoid a costly mistake.
EXAMPLE 11.3 How One Company Avoided a $100 Million Mistake
A U.S. chemical producer was about to modify an existing plant to produce a specialty product, polyzone, which was in short supply on world markets.19 At prevailing raw material and finished-product prices, the expansion would have been strongly profitable. Table 11.1 shows a simplified version of management’s analysis. Note the assumed constant spread between selling price and the cost of raw materials. Given this spread, the resulting NPV was about $64 million at the company’s 8% real cost of capital—not bad for a $100 million outlay.
TABLE 11.1 NPV calculation for proposed investment in polyzone production by a U.S. chemical company (figures in $ millions except as noted)
Note: For simplicity, we assume no inflation and no taxes. Plant and equipment have no salvage value after 10 years.
a Production capacity is 80 million pounds per year.
b Production costs are $.375 per pound after start up ($.75 per pound in year 2, when production is only 40 million pounds).
c Transportation costs are $.10 per pound to European ports.
Then doubt began to creep in. Notice the outlay for transportation costs. Some of the project’s raw materials were commodity chemicals, largely imported from Europe, and much of the polyzone production would be exported back to Europe. Moreover, the U.S. company had no long-run technological edge over potential European competitors. It had a head start perhaps, but was that really enough to generate a positive NPV?
Notice the importance of the price spread between raw materials and finished product. The analysis in Table 11.1 forecasted the spread at a constant $1.20 per pound of polyzone for 10 years. That had to be wrong: European producers, who did not face the U.S. company’s transportation costs, would see an even larger NPV and expand capacity. Increased competition would almost surely squeeze the spread. The U.S. company decided to calculate the competitive spread—the spread at which a European competitor would see polyzone capacity as zero NPV. Table 11.2 shows management’s analysis. The resulting spread of about $.95 per pound was the best long-run forecast for the polyzone market, other things constant of course.
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Try It! Polyzone project
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TABLE 11.2 What is the competitive spread to a European producer? About $.95 per pound of polyzone. Note that European producers face no transportation costs. Compare Table 11.1 (figures in $ millions except as noted).
How much of a head start did the U.S. producer have? How long before competitors forced the spread down to $.95? Management’s best guess was five years. It prepared Table 11.3, which is identical to Table 11.1 except for the forecasted spread, which would shrink to $.95 by the start of year 5. Now the NPV was negative.
TABLE 11.3 Recalculation of NPV for polyzone investment by U.S. company (figures in $ millions except as noted). If expansion by European producers forces competitive spreads by year 5, the U.S. producer’s NPV falls to −$9.8 million. Compare Table 11.1.
The project might have been saved if production could have been started in year 1 rather than 2 or if local markets could have been expanded, thus reducing transportation costs. But these changes were not feasible, so management canceled the project, albeit with a sigh of relief that its analysis had not stopped at Table 11.1.
This is a perfect example of the importance of thinking through sources of economic rents. Positive NPVs are suspect without some long-run competitive advantage. When a company contemplates investing in a new product or expanding production of an existing product, it should specifically identify its advantages or disadvantages over its most dangerous competitors. It should calculate NPV from those competitors’ points of view. If competitors’ NPVs come out strongly positive, the company had better expect decreasing prices (or spreads) and evaluate the proposed investment accordingly.
11-4Marvin Enterprises Decides to Exploit a New Technology—an Example
To illustrate some of the problems involved in predicting economic rents, let us leap forward several years and look at the decision by Marvin Enterprises to exploit a new technology.20
One of the most unexpected developments of these years was the remarkable growth of a completely new industry. By 2041, annual sales of gargle blasters totaled $1.68 billion, or 240 million units. Although it controlled only 10% of the market, Marvin Enterprises was among the most exciting growth companies of the decade. Marvin had come late into the business, but it had pioneered the use of implanted microcircuits to control the genetic engineering processes used to manufacture gargle blasters. This development had enabled producers to cut the price of gargle blasters from $9 to $7 and had thereby contributed to the dramatic growth in the size of the market. The estimated demand curve in Figure 11.2 shows just how responsive demand is to such price reductions.
FIGURE 11.2 The demand “curve” for gargle blasters shows that for each $1 cut in price there is an increase in demand of 80 million units.
Table 11.4 summarizes the cost structure of the old and new technologies. While companies with the new technology were earning 20% on their initial investment, those with first-generation equipment had been hit by the successive price cuts. Since all Marvin’s investment was in the 2037 technology, it had been particularly well placed during this period.
TABLE 11.4 Size and cost structure of the gargle blaster industry before Marvin announced its expansion plans
Note: Selling price is $7 per unit. One unit means one gargle blaster.
Rumors of new developments at Marvin had been circulating for some time, and the total market value of Marvin’s stock had risen to $460 million by January 2042. At that point, Marvin called a press conference to announce another technological breakthrough. Management claimed that its new third-generation process involving mutant neurons enabled the firm to reduce capital costs to $10 and manufacturing costs to $3 per unit. Marvin proposed to capitalize on this invention by embarking on a huge $1 billion expansion program that would add 100 million units to capacity. The company expected to be in full operation within 12 months.
Before deciding to go ahead with this development, Marvin had undertaken extensive calculations on the effect of the new investment. The basic assumptions were as follows:
1. The cost of capital was 20%.
2. The production facilities had an indefinite physical life.
3. The demand curve and the costs of each technology would not change.
4. There was no chance of a fourth-generation technology in the foreseeable future.
5. The corporate income tax, which had been abolished in 2032, was not likely to be reintroduced.
Marvin’s competitors greeted the news with varying degrees of concern. There was general agreement that it would be five years before any of them would have access to the new technology. On the other hand, many consoled themselves with the reflection that Marvin’s new plant could not compete with an existing plant that had been fully depreciated.
Suppose that you were Marvin’s financial manager. Would you have agreed 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?
You have a choice. You can go on immediately to read our solution to these questions. But you will learn much more if you stop and work out your own answer first. Try it.
Forecasting Prices of Gargle Blasters
Up to this point in any capital budgeting problem, we have always given you the set of cash-flow forecasts. In the present case, you have to derive those forecasts.
The first problem is to decide what is going to happen to the price of gargle blasters. Marvin’s new venture will increase industry capacity to 340 million units. From the demand curve in Figure 11.2, you can see that the industry can sell this number of gargle blasters only if the price declines to $5.75:
If the price falls to $5.75, what will happen to companies with the 2029 technology? They also have to make an investment decision: Should they stay in business, or should they sell their equipment for its salvage value of $2.50 per unit? With a 20% opportunity cost of capital, the NPV of staying in business is
Smart companies with 2029 equipment will, therefore, see that it is better to sell off capacity. No matter what their equipment originally cost or how far it is depreciated, it is more profitable to sell the equipment for $2.50 per unit than to operate it and lose $1.25 per unit.
As capacity is sold off, the supply of gargle blasters will decline and the price will rise. An equilibrium is reached when the price gets to $6. At this point 2029 equipment has a zero NPV:
How much capacity will have to be sold off before the price reaches $6? You can check that by going back to the demand curve:
Therefore Marvin’s expansion will cause the price to settle down at $6 a unit and will induce first-generation producers to withdraw 20 million units of capacity.
But after five years, Marvin’s competitors will also be in a position to build third-generation plants. As long as these plants have positive NPVs, companies will increase their capacity and force prices down once again. A new equilibrium will be reached when the price reaches $5. At this point, the NPV of new third-generation plants is zero, and there is no incentive for companies to expand further:
Looking back once more at our demand curve, you can see that with a price of $5 the industry can sell a total of 400 million gargle blasters:
Demand = 80 × (10 − price) = 80 × (10 − 5) = 400 million units
The effect of the third-generation technology is, therefore, to cause industry sales to expand from 240 million units in 2041 to 400 million five years later. But that rapid growth is no protection against failure. By the end of five years, any company that has only first-generation equipment will no longer be able to cover its manufacturing costs and will be forced out of business.
The Value of Marvin’s New Expansion
We have shown that the introduction of third-generation technology is likely to cause gargle blaster prices to decline to $6 for the next five years and to $5 thereafter. We can now set down the expected cash flows from Marvin’s new plant:
|
Year 0 |
Years 1–5 |
Year 6, 7, 8, . . . |
|
|
Cash flow per unit ($) |
−10 |
6 − 3 = 3 |
5 − 3 = 2 |
|
Cash flow (100 million units, $ millions) |
−1,000 |
600 − 300 = 300 |
500 − 300 = 200 |
Discounting these cash flows at 20% gives us
It looks as if Marvin’s decision to go ahead was correct. But there is something we have forgotten. When we evaluate an investment, we must consider all incremental cash flows. One effect of Marvin’s decision to expand is to reduce the value of its existing 2037 plant. If Marvin decided not to go ahead with the new technology, the $7 price of gargle blasters would hold until Marvin’s competitors started to cut prices in five years’ time. Marvin’s decision, therefore, leads to an immediate $1 cut in price. This reduces the present value of its 2037 equipment by
Considered in isolation, Marvin’s decision has an NPV of $299 million. But it also reduces the value of existing plant by $72 million. The net present value of Marvin’s venture is, therefore, 299 – 72 = $227 million.
Alternative Expansion Plans
Marvin’s expansion has a positive NPV, but perhaps Marvin would do better to build a larger or smaller plant. You can check that by going through the same calculations as above. First you need to estimate how the additional capacity will affect gargle blaster prices. Then you can calculate the net present value of the new plant and the change in the present value of the existing plant. The total NPV of Marvin’s expansion plan is
Total NPV = NPV of new plant + change in PV of existing plant
We have undertaken these calculations and plotted the results in Figure 11.3. You can see how total NPV would be affected by a smaller or larger expansion.
When the new technology becomes generally available in 2047, firms will construct a total of 280 million units of new capacity.21 But Figure 11.3 shows that it would be foolish for Marvin to go that far. If Marvin added 280 million units of new capacity in 2042, the discounted value of the cash flows from the new plant would be zero and the company would have reduced the value of its old plant by $144 million. To maximize NPV, Marvin should construct 200 million units of new capacity and set the price just below $6 to drive out the 2029 manufacturers. Output is, therefore, less and price is higher than either would be under free competition.22
FIGURE 11.3 Effect on net present value of alternative expansion plans. Marvin’s 100-million-unit expansion has a total NPV of $227 million (total NPV = NPV new plant + change in PV existing plant = 299 − 72 = 227). Total NPV is maximized if Marvin builds 200 million units of new capacity. If Marvin builds 280 million units of new capacity, total NPV is –$144 million.
The Value of Marvin Stock
Let us think about the effect of Marvin’s announcement on the value of its common stock. Marvin has 24 million units of second-generation capacity. In the absence of any third-generation technology, gargle blaster prices would hold at $7 and Marvin’s existing plant would be worth
Marvin’s new technology reduces the price of gargle blasters initially to $6 and after five years to $5. Therefore the value of existing plant declines to
But the new plant makes a net addition to shareholders’ wealth of $299 million. So after Marvin’s announcement its stock will be worth
252 + 299 = $551 million23
Now here is an illustration of something we talked about in Chapter 4: Before the announcement, Marvin’s stock was valued in the market at $460 million. The difference between this figure and the value of the existing plant represented the present value of Marvin’s growth opportunities (PVGO). The market valued Marvin’s ability to stay ahead of the game at $40 million even before the announcement. After the announcement PVGO rose to $299 million.24
The Lessons of Marvin Enterprises
Marvin Enterprises may be just a piece of science fiction, but the problems that it confronts are very real. Whenever Intel considers developing a new microprocessor or Pfizer considers developing a new drug, these firms must face up to exactly the same issues as Marvin. We have tried to illustrate the kind of questions that you should be asking when presented with a set of cash-flow forecasts. Of course, no economic model is going to predict the future with accuracy. Perhaps Marvin can hold the price above $6. Perhaps competitors will not appreciate the rich pickings to be had in the year 2047. In that case, Marvin’s expansion would be even more profitable. But would you want to bet $1 billion on such possibilities? We don’t think so.
Investments often turn out to earn far more than the cost of capital because of a favorable surprise. This surprise may in turn create a temporary opportunity for further investments earning more than the cost of capital. But anticipated and more prolonged rents will naturally lead to the entry of rival producers. That is why you should be suspicious of any investment proposal that predicts a stream of economic rents into the indefinite future. Try to estimate when competition will drive the NPV down to zero, and think what that implies for the price of your product.
Many companies try to identify the major growth areas in the economy and then concentrate their investment in these areas. But the sad fate of first-generation gargle blaster manufacturers illustrates how rapidly existing plants can be made obsolete by changes in technology. It is fun being in a growth industry when you are at the forefront of the new technology, but a growth industry has no mercy on technological laggards.
Therefore, do not simply follow the herd of investors stampeding into high-growth sectors of the economy. Think of the fate of the dot-com companies in the “new economy” of the late 1990s. Optimists argued that the information revolution was opening up opportunities for companies to grow at unprecedented rates. The pessimists pointed out that competition in e-commerce was likely to be intense and that competition would ensure that the benefits of the information revolution would go largely to consumers. The Finance in Practice box emphasizes that rapid growth is no guarantee of superior profits.
We do not wish to imply that good investment opportunities don’t exist. For example, good opportunities frequently arise because the firm has invested money in the past, which gives it the option to expand cheaply in the future. Perhaps the firm can increase its output just by adding an extra production line, whereas its rivals would need to construct an entirely new factory.
Marvin also reminds us to include a project’s impact on the rest of the firm when estimating incremental cash flows. By introducing the new technology immediately, Marvin reduced the value of its existing plant by $72 million.
Sometimes the losses on existing plants may completely offset the gains from a new technology. That is why we may see established, technologically advanced companies deliberately slowing down the rate at which they introduce new products. But this can be a dangerous game to play if it opens up opportunities for competitors. For example, for many years Bausch & Lomb was the dominant producer of contact lenses and earned large profits from glass contact lenses that needed to be sterilized every night. Because its existing business generated high returns, the company was slow to introduce disposable lenses. This delay opened up an opportunity for competitors and enabled Johnson & Johnson to introduce disposable lenses.
Marvin’s economic rents were equal to the difference between its costs and those of the marginal producer. The costs of the marginal 2029-generation plant consisted of the manufacturing costs plus the opportunity cost of not selling the equipment. Therefore, if the salvage value of the 2029 equipment were higher, Marvin’s competitors would incur higher costs and Marvin could earn higher rents. We took the salvage value as given, but it in turn depends on the cost savings from substituting outdated gargle blaster equipment for some other asset. In a well-functioning economy, assets will be used so as to minimize the total cost of producing the chosen set of outputs. The economic rents earned by any asset are equal to the total extra costs that would be incurred if that asset were withdrawn.
FINANCE IN PRACTICE
Cautionary Tales
What would be your list of growth industries that have transformed people’s lives over the past century? One obvious candidate is the automobile industry. Sales of vehicles in the United States have grown from almost nothing 100 years ago to more than 16.5 million a year today. Many companies foresaw this rapid growth and concluded that it offered a likely source of juicy profits. Wikipedia lists 1,800 U.S. car manufacturers that were established at some point in the United States, with exotic names such as Ben Hur, O-We-Go, and Motor Bob. Almost all these companies blossomed briefly and then withered. Only a handful of U.S. car companies remain today, two of which filed for bankruptcy in 2009 and had to be rescued by the U.S. government.25
An equally profitless growth industry has been the aviation sector. Since 1948, the number of passenger miles flown by U.S. airlines has multiplied nearly 300 times. Yet since that date, airlines have, in aggregate, suffered an operating loss, and more than 150 airlines have entered into Chapter 11 bankruptcy, in some cases two or three times.26 While a number of smaller airlines continue to operate, the sector today is dominated by just four companies: American, Delta, United, and Southwest. (Profitability at these companies has recently improved, however, and by early 2017, Warren Buffett’s Berkshire Hathaway had acquired large stakes in each company’s shares.)
A third and more recent example of a growth industry is the manufacture of computers. With the exception of IBM, the giants of the industry today barely existed in the 1970s. At that time, investors in the industry referred to Snow White and the seven dwarfs. IBM was Snow White and the seven hefty and well-respected dwarfs were the other major mainframe manufacturers—Burroughs, UNIVAC, NCR, Control Data, Honeywell, General Electric, and RCA. In addition to these major producers, there were a number of glamorous dwarflets, such as Amdahl, Wang Laboratories, Data General, and DEC. As the role of the mainframe changed, only Snow White survived as a major force, while the dwarfs and most of their smaller brethren either no longer exist or have exited computer manufacturing.
Do these cautionary stories mean that companies should seek out stagnant or declining industries? Of course not; other things equal, it is better to operate in a growth industry than a declining one. The problem is that the prospect of rapid industry growth attracts competition. And, if the industry is also characterized by rapidly changing technology or consumer taste, then competitive advantage is likely to be less persistent. Think, for example, of Nokia and BlackBerry, whose phones once dominated the smartphone market until they were quickly overtaken by Apple’s iPhone and Android phones. The message, in Warren Buffett’s words, is that “the key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”27
When Marvin announced its expansion plans, many owners of first-generation equipment took comfort in the belief that Marvin could not compete with their fully depreciated plant. Their comfort was misplaced. Regardless of past depreciation policy, it paid to scrap first-generation equipment rather than keep it in production. Do not expect that numbers in your balance sheet can protect you from harsh economic reality.
SUMMARY
All good financial managers want their firms to generate investment ideas with positive NPVs and to weed out the wrong-headed schemes. To do this, they need to establish a well-designed set of procedures for developing and approving investment proposals. For most firms, the investment process starts with approval of the capital budget, which is a list of planned investments over the coming year. The proposed investment projects are evaluated one by one later, based on appropriation requests that provide more detailed information and analysis. They are approved one by one, provided that the requests are convincing.
The appropriation requests that arrive on senior managers’ desks will almost always show positive NPVs. But NPVs can be positive for two reasons: (1) The company really can expect to earn superior profits, or (2) there are optimistic biases or errors in cash-flow forecasts. Good managers are wary of these “false positives” and try to keep the odds stacked in their favor by investing in areas where the company has clear competitive advantages. They give careful attention to corporate strategy, which attempts to identify distinct capabilities and deploy them in markets where economic rents can be generated. They avoid expansion where competitive advantages are absent and economic rents are unlikely. They do not project favorable current product prices far into the future without checking whether entry or expansion by competitors will drive future prices down.
Our story of Marvin Enterprises illustrates the origin of rents and how they determine a project’s cash flows and net present value.
Any present value calculation, including our calculation for Marvin Enterprises, is subject to error. That’s life: There’s no other sensible way to value most capital investment projects. But some assets, such as gold, real estate, crude oil, ships, and airplanes, as well as financial assets, such as stocks and bonds, are traded in reasonably competitive markets. When you have the market value of such an asset, use it, at least as a starting point for your analysis.
FURTHER READING
For a very readable discussion of the problem of overconfidence and other behavioral traits in financial decision making, see:
J. S. Hammond, R. L. Keeney, and H. Raiffa, “The Hidden Traps in Decision Making,” Harvard Business Review 84 (January 2006), pp. 118–126.
The following papers discuss capital investment and strategy:
P. Barwise, P. Marsh, and R. Wensley, “Must Finance and Strategy Clash?” Harvard Business Review, September–October 1989, pp. 85–90.
M. Porter, “What Is Strategy?” Harvard Business Review, November–December 1996, pp. 61–78.
S. C. Myers, “Finance Theory and Financial Strategy,” Midland Corporate Finance Journal 5 (Spring 1987), pp. 6–13. Reprinted from Interfaces (January–February 1984).
R. Rumelt, Good Strategy/ Bad Strategy: The Difference and Why It Matters (London, U.K.: Profile Books, 2017)
The following book describes how to identify economic rents and positive NPVs:
S. Woolley, Sources of Value (Cambridge, U.K.: Cambridge University Press, 2009).
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Capital budgeting process* True or false?
a. The approval of a firm’s capital budget allows managers to go ahead with any project included in the budget.
b. Capital budgets and project authorizations are mostly developed “bottom up.” Strategic planning is a “top-down” process.
c. Project sponsors are likely to be overoptimistic.
2. Capital budgeting process Explain how each of the following actions or problems can distort or disrupt the capital budgeting process.
a. Overoptimism by project sponsors.
b. Inconsistent forecasts of industry and macroeconomic variables.
c. Capital budgeting organized solely as a bottom-up process.
3. Capital budgeting process Draw up an outline or flowchart tracing the capital budgeting process from the initial idea for a new investment project to the completion of the project and the start of operations. Assume the idea for a new obfuscator machine comes from a plant manager in the Deconstruction Division of the Modern Language Corporation.
Here are some questions your outline or flowchart should consider: Who will prepare the original proposal? What information will the proposal contain? Who will evaluate it? What approvals will be needed, and who will give them? What happens if the machine costs 40% more to purchase and install than originally forecasted? What will happen when the machine is finally up and running?
4. Biased forecasts Explain why setting a higher discount rate is not a cure for upward-biased cash-flow forecasts.
5. Biased forecasts Look back to the cash flows for projects F and G in Section 5-3. The cost of capital was assumed to be 10%. Assume that the forecasted cash flows for projects of this type are overstated by 8% on average. That is, the forecast for each cash flow from each project should be reduced by 8%. But a lazy financial manager, unwilling to take the time to argue with the projects’ sponsors, instructs them to use a discount rate of 18%.
a. What are the projects’ true NPVs?
b. What are the NPVs at the 18% discount rate?
c. Are there any circumstances in which the 18% discount rate would give the correct NPVs? (Hint: Could upward bias be more severe for more-distant cash flows?)
6. Market prices Your brother-in-law wants you to join him in purchasing a building on the outskirts of town. You and he would then develop and run a Taco Palace restaurant. Both of you are extremely optimistic about future real estate prices in this area, and your brother-in-law has prepared a cash-flow forecast that implies a large positive NPV. This calculation assumes sale of the property after 10 years. What further calculations should you do before going ahead?
7. Market prices Suppose that you are considering investing in an asset for which there is a reasonably good secondary market. Specifically, your company is Delta Airlines, and the asset is a Boeing 757—a widely used airplane. How does the presence of a secondary market simplify your problem in principle? Do you think these simplifications could be realized in practice? Explain.
8. Market prices There is an active, competitive leasing (i.e., rental) market for most standard types of commercial jets. Many of the planes flown by the major domestic and international airlines are not owned by them but leased for periods ranging from a few months to several years. Gamma Airlines, however, owns two long-range DC-11s just withdrawn from Latin American service. Gamma is considering using these planes to develop the potentially lucrative new route from Akron to Yellowknife. A considerable investment in terminal facilities, training, and advertising will be required. Once committed, Gamma will have to operate the route for at least three years. One further complication: The manager of Gamma’s international division is opposing commitment of the planes to the Akron–Yellowknife route because of anticipated future growth in traffic through Gamma’s new hub in Ulaanbaatar. How would you evaluate the proposed Akron–Yellowknife project? Give a detailed list of the necessary steps in your analysis. Explain how the airplane leasing market would be taken into account. If the project is attractive, how would you respond to the manager of the international division?
9. Market prices Suppose the current price of gold is $1,200 an ounce. Hotshot Consultants advises you that gold prices will increase at an average rate of 12% for the next two years. After that the growth rate will fall to a long-run trend of 3% per year. What is the present value of 1 million ounces of gold produced in eight years? Assume that gold prices have a beta of 0 and that the risk-free rate is 5.5%.
10. Market prices* On the London Metals Exchange, the price for copper to be delivered in one year is $5,500 a ton. (Note: Payment is made when the copper is delivered.) The risk-free interest rate is 2% and the expected market return is 8%.
a. Suppose that you expect to produce and sell 10,000 tons of copper next year. What is the PV of this output? Assume that the sale occurs at the end of the year.
b. If copper has a beta of 1.2, what is the expected price of copper at the end of the year? What is the certainty-equivalent end-year price?
11. Market prices Photographic laboratories recover and recycle the silver used in photographic film. Stikine River Photo is considering purchase of improved equipment for their laboratory at Telegraph Creek. Here is the information they have:
· The equipment costs $100,000 and will cost $80,000 per year to run.
· It has an economic life of 10 years but can be depreciated over 5 years by the straightline method (see Section 6-3).
· It will recover an additional 5,000 ounces of silver per year.
· Silver is selling for $40 per ounce. Over the past 10 years, the price of silver has appreciated by 4.5% per year in real terms. Silver is traded in an active, competitive market.
· Stikine’s marginal tax rate is 25%.
· Stikine’s company cost of capital is 8% in real terms. The nominal interest rate is 6%.
· What is the NPV of the new equipment?
Make additional assumptions as necessary.
12. Market prices The Cambridge Opera Association has come up with a unique door prize for its December 2019 fund-raising ball: Twenty door prizes will be distributed, each one a ticket entitling the bearer to receive a cash award from the association on December 31, 2020. The cash award is to be determined by calculating the ratio of the level of the Standard and Poor’s Composite Index of stock prices on December 31, 2020, to its level on June 30, 2020, and multiplying by $100. Thus, if the index turns out to be 1,000 on June 30, 2020, and 1,200 on December 31, 2020, the payoff will be 100 × (1,200/1,000) = $120.
After the ball, a black market springs up in which the tickets are traded. What will the tickets sell for on January 1, 2020? On June 30, 2020? Assume the risk-free interest rate is 10% per year. Also assume the Cambridge Opera Association will be solvent at year-end 2020 and will, in fact, pay off on the tickets. Make other assumptions as necessary.
Would ticket values be different if the tickets’ payoffs depended on the Dow Jones Industrial Index rather than the Standard and Poor’s Composite?
13. Market prices You are asked to value a large building in northern New Jersey. The valuation is needed for a bankruptcy settlement. Here are the facts:
· The settlement requires that the building’s value equal the PV of the net cash proceeds the railroad would receive if it cleared out the building and sold it for its highest and best non-railroad use, which is as a warehouse.
· The building has been appraised at $1 million. This figure is based on actual recent selling prices of a sample of similar New Jersey buildings used as, or available for use as, warehouses.
· If rented today as a warehouse, the building could generate $80,000 per year. This cash flow is calculated after out-of-pocket operating expenses and after real estate taxes of $50,000 per year:
|
Gross rents |
$180,000 |
|
Operating expenses |
50,000 |
|
Real estate taxes |
50,000 |
|
Net |
$80,000 |
14. Gross rents, operating expenses, and real estate taxes are uncertain but are expected to grow with inflation.
· However, it would take one year and $200,000 to clear out the railroad equipment and prepare the building for use as a warehouse. The $200,000 would have to be invested immediately.
· The property will be put on the market when ready for use as a warehouse. Your real estate adviser says that properties of this type take, on average, one year to sell after they are put on the market. However, the railroad could rent the building as a warehouse while waiting for it to sell.
· The opportunity cost of capital for investment in real estate is 8% in real terms.
· Your real estate adviser notes that selling prices of comparable buildings in northern New Jersey have declined, in real terms, at an average rate of 2% per year over the last 10 years.
· A 5% sales commission would be paid by the railroad at the time of the sale.
· The railroad pays no income taxes. It would have to pay property taxes.
15. Market prices Sulphur Ridge Mining is considering the development of a new calonium mine at Moose Bend in northern Alberta. The mine would require an upfront investment of $110 million and would produce 100,000 tons of high-grade calonium a year, which is small compared with the current annual worldwide production of 9 million tons. Proved reserves of calonium at the Moose Bend mine are 1.2 million tons. The extraction cost is estimated at $120 a ton and is expected to remain constant in real terms. The market price of calonium is currently $240 a ton, and the consultancy firm, Powder River Associates, is estimating that the real price of calonium will increase by 3% a year in real terms for the foreseeable future. There are several other producers of calonium. Several Canadian mines are believed to be barely breaking even. Others with costs in the $150 to $200 a ton range are making good profits. There are no taxes and the real cost of capital is estimated as 8%. Calonium mining is an environmentally friendly activity, and there are zero costs to shutting down a mine. Should Sulphur Ridge go ahead with the project? Make whatever additional assumptions you think are needed.
16. Economic rents* True or false?
a. A firm that earns the opportunity cost of capital is earning economic rents.
b. A firm that invests in positive-NPV ventures expects to earn economic rents.
c. Financial managers should try to identify areas where their firms can earn economic rents, because it is there that positive-NPV projects are likely to be found.
d. Economic rent is the equivalent annual cost of operating capital equipment.
17. Economic rents We characterized the interstate rail lines owned by major U.S. railroads as “strategic assets” that could generate increased profits. In what conditions would you expect these assets to generate economic rents? Keep in mind that railroads compete with trucking companies as well as other railroads. Trucking companies have some advantages, including flexibility.
18. Economic rents 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? Assume the real cost of capital is 9%. To keep things simple, also make the following assumptions:
· 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, they can construct new plants in year 5 and start selling BGs 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.
19. Economic rents How would your answer to Problem 17 change if technological improvements reduce the cost of new BG production facilities by 3% per year? Thus a new plant built in year 1 would cost only 25 (1 – .03) = $24.25 million, a plant built in year 2 would cost $23.52 million, and so on. Assume that production costs per unit remain at $65.
20. Economic rents Reevaluate the NPV of the proposed polyzone project (Example 11.3) under each of the following assumptions. What’s the right management decision in each case?
a. Spread in year 4 holds at $1.20 per pound.
b. The U.S. chemical company can start up polyzone production at 40 million pounds in year 1 rather than year 2.
c. The U.S. company makes a technological advance that reduces its annual production costs to $25 million. Competitors’ production costs do not change.
21. Equilibrium prices Demand for concave utility meters is expanding rapidly, but the industry is highly competitive. A utility meter plant costs $50 million to set up, and it has an annual capacity of 500,000 meters. The production cost is $5 per meter, and this cost is not expected to change. The machines have an indefinite physical life and the cost of capital is 10%. What is the competitive price of a utility meter?
a. $5
b. $10
c. $15
22. Opportunity costs New-model commercial airplanes are much more fuel-efficient than older models. How is it possible for airlines flying older models to make money when its competitors are flying newer planes? Explain briefly.
CHALLENGE PROBLEMS
22. Economic rents The manufacture of polysyllabic acid is a competitive industry. Most plants have an annual output of 100,000 tons. Operating costs are $.90 a ton, and the sales price is $1 a ton. A 100,000-ton plant costs $100,000 and has an indefinite life. Its current scrap value of $60,000 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 $.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. Also it believes that demand over the next two years is likely to be sluggish and that its new plant will therefore cause temporary overcapacity.
You can assume that there are no taxes and that the cost of capital is 10%.
a. 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?
b. What does that imply for the price of polysyllabic acid in year 3 and beyond?
c. 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?
d. The acid plants of United Alchemists Inc. have been fully depreciated. Can it operate them profitably after year 2?
e. Acidosis Inc. purchased a new plant last year for $100,000 and is writing it down by $10,000 a year. Should it scrap this plant in year 2?
f. What would be the NPV of Phlogiston’s venture?
23. Equilibrium prices The world airline system is composed of the routes X and Y, each of which requires 10 aircraft. These routes can be serviced by three types of aircraft—A, B, and C. There are 5 type A aircraft available, 10 type B, and 10 type C. These aircraft are identical except for their operating costs, which are as follows:
|
Annual Operating Cost ($ millions) |
||
|
Aircraft Type |
Route X |
Route Y |
|
A |
1.5 |
1.5 |
|
B |
2.5 |
2.0 |
|
C |
4.5 |
3.5 |
24. The aircraft have a useful life of five years and a salvage value of $1 million.
25. The aircraft owners do not operate the aircraft themselves but rent them to the operators. Owners act competitively to maximize their rental income, and operators attempt to minimize their operating costs. Airfares are also competitively determined. Assume the cost of capital is 10%.
a. Which aircraft would be used on which route, and how much would each aircraft be worth?
b. What would happen to usage and prices of each aircraft if the number of type A aircraft increased to 10?
c. What would happen if the number of type A aircraft increased to 15?
d. What would happen if the number of type A aircraft increased to 20?
State any additional assumptions you need to make.
26. Economic rents Taxes are a cost, and, therefore, changes in tax rates can affect consumer prices, project lives, and the value of existing firms. The following problem illustrates this. It also illustrates that tax changes that appear to be “good for business” do not always increase the value of existing firms. Indeed, unless new investment incentives increase consumer demand, they can work only by rendering existing equipment obsolete.
The manufacture of bucolic acid is a competitive business. Demand is steadily expanding, and new plants are constantly being opened. Expected cash flows from an investment in a new plant are as follows:
Assumptions:
1. Tax depreciation is straight-line over three years.
2. Pretax salvage value is 25 in year 3 and 50 if the asset is scrapped in year 2.
3. Tax on salvage value is 40% of the difference between salvage value and depreciated investment.
4. The cost of capital is 20%.
e. What is the value of a one-year-old plant? Of a two-year-old plant?
f. Suppose that the government now changes tax depreciation to allow a 100% writeoff in year 1. How does this affect the value of existing one- and two-year-old plants? Existing plants must continue using the original tax depreciation schedule.
g. Would it now make sense to scrap existing plants when they are two rather than three years old?
h. How would your answers change if the corporate income tax were abolished entirely?
MINI-CASE 
Ecsy-Cola28
Libby Flannery, the regional manager of Ecsy-Cola, the international soft drinks empire, was reviewing her investment plans for Central Asia. She had contemplated launching Ecsy-Cola in the ex-Soviet republic of Inglistan in 2022. This would involve a capital outlay of $20 million in 2021 to build a bottling plant and set up a distribution system there. Fixed costs (for manufacturing, distribution, and marketing) would then be $3 million per year from 2021 onward. This would be sufficient to make and sell 200 million liters per year—enough for every man, woman, and child in Inglistan to drink four bottles per week! But there would be few savings from building a smaller plant, and import tariffs and transport costs in the region would keep all production within national borders.
The variable costs of production and distribution would be 12 cents per liter. Company policy requires a rate of return of 25% in nominal dollar terms, after local taxes but before deducting any costs of financing. The sales revenue is forecasted to be 35 cents per liter.
Bottling plants last almost forever, and all unit costs and revenues were expected to remain constant in nominal terms. Tax would be payable at a rate of 30%, and under the Inglistan corporate tax code, capital expenditures can be written off on a straight-line basis over four years.
All these inputs were reasonably clear. But Ms. Flannery racked her brain trying to forecast sales. Ecsy-Cola found that the “1–2–4” rule works in most new markets. Sales typically double in the second year, double again in the third year, and after that remain roughly constant. Libby’s best guess was that, if she went ahead immediately, initial sales in Inglistan would be 12.5 million liters in 2023, ramping up to 50 million in 2025 and onward.
Ms. Flannery also worried whether it would be better to wait a year. The soft drink market was developing rapidly in neighboring countries, and in a year’s time she should have a much better idea whether Ecsy-Cola would be likely to catch on in Inglistan. If it didn’t catch on and sales stalled below 20 million liters, a large investment probably would not be justified.
Ms. Flannery had assumed that Ecsy-Cola’s keen rival, Sparky-Cola, would not also enter the market. But last week she received a shock when in the lobby of the Kapitaliste Hotel she bumped into her opposite number at Sparky-Cola. Sparky-Cola would face costs similar to Ecsy-Cola. How would Sparky-Cola respond if Ecsy-Cola entered the market? Would it decide to enter also? If so, how would that affect the profitability of Ecsy-Cola’s project?
Ms. Flannery thought again about postponing investment for a year. Suppose Sparky-Cola were interested in the Inglistan market. Would that favor delay or immediate action?
Maybe Ecsy-Cola should announce its plans before Sparky-Cola has a chance to develop its own proposals. It seemed that the Inglistan project was becoming more complicated by the day.
QUESTIONS
1. Calculate the NPV of the proposed investment, using the inputs suggested in this case. How sensitive is this NPV to future sales volume?
2. What are the pros and cons of waiting for a year before deciding whether to invest? (Hint: What happens if demand turns out high and Sparky-Cola also invests? What if Ecsy-Cola invests right away and gains a one-year head start on Sparky-Cola?)
1For example, in a classic test of overconfidence, a large group of students was asked to provide estimates—for example, the number of physicians listed in the Boston yellow pages or the number of automobile imports into the United States. In each case, they were also asked to provide limits within which they were 98% confident that the actual value fell. If these estimated limits were unbiased, the true answer to the questions would fall outside the limits only 2% of the time. But the tests consistently showed that the limits were breached far more often than this (51% of the time in the case of the question about the yellow pages). In other words, the students were much more confident of their estimates than was justified. See M. Alpert and H. Raiffa, “A Progress Report on the Training of Probability Assessors,” in D. Kahneman, P. Slovic, L. A. Tversky (eds.), Judgment under Uncertainty: Heuristics and Biases (Cambridge, U.K.: Cambridge University Press, 1982), pp. 294–305.
2There is no First Law. We think “Second Law” sounds better. There is a Third Law, but that is for another chapter.
3Adding a fudge factor to the cost of capital also favors quick-payback projects and penalizes longer-lived projects, which tend to have lower rates of return but higher NPVs. Adding a 5% fudge factor to the discount rate is roughly equivalent to reducing the forecast and present value of the first year’s cash flow by 5%. The impact on the present value of a cash flow 10 years in the future is much greater because the fudge factor is compounded in the discount rate. The fudge factor is not too much of a burden for a 2- or 3-year project but is an enormous burden for a 10- or 20-year project.
4For simplicity, we assume the $100 million goes entirely to real estate. In real life, there would also be substantial investments in fixtures, information systems, training, and start-up costs.
5The fair market rent equals the profit generated by the real estate’s second-best use.
6This rental stream yields a 10% rate of return to the real estate subsidiary. Each year it gets a 7% “dividend” and 3% capital gain. Growth at 3% would bring the value of the property to $134 million by year 10.
The present value (at r = .10) of the growing stream of rents is
This PV is the initial market value of the property.
7Another possibility is that real estate rents and values are expected to grow at less than 3% a year. But in that case, the real estate subsidiary would have to charge more than $7 million rent in year 1 to justify its $100 million real estate investment (see footnote 4). That would make the department store even less attractive.
8Investing in an ounce of gold is like investing in a stock that pays no dividends: The investor’s return comes entirely as capital gains. Look back at Section 4-2, where we showed that P0, the price of the stock today, depends on DIV1 and P1, the expected dividend and price for next year, and the opportunity cost of capital r:
But for gold DIV1 = 0, so
In words, today’s price is the present value of next year’s price. Therefore, we don’t have to know either P1 or r to find the present value. Also since DIV2 = 0,
and we can express P0 as
In general,
This holds for any asset that pays no dividends, is traded in a competitive market, and costs nothing to store. Storage costs for gold or common stocks are very small compared to asset value.
We also assume that guaranteed future delivery of gold is just as good as having gold in hand today. This is not quite right. As we will see in Chapter 26, gold in hand can generate a small “convenience yield.”
9We assume that the extraction rate does not vary. If it can vary, Mr. Solomon has a valuable operating option to increase output when gold prices are high or to cut back when prices fall. Option pricing techniques are needed to value the mine when operating options are important. See Chapter 22.
10As in the case of our department store example, Mr. Solomon is placing two bets: one on his ability to mine gold at a low cost and the other on the price of gold. Suppose that he really does believe that gold is overvalued. That should not deter him from running a low-cost gold mine as long as he can place separate bets on gold prices. For example, he might be able to enter into a long-term contract to sell the mine’s output or he could sell gold futures. (We explain futures in Chapter 26.)
11Abnormal returns are also often calculated using the Fama-French three-factor model that we discussed in Chapter 8. The stock return is adjusted for the market return, the difference between the returns on small- and large-company stocks, and the difference between the returns on high and low book-to-market firms.
12We assume that the volume of output is certain (or does not have any market risk).
13After reading Chapter 26, check out E. S. Schwartz, “The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging,” Journal of Finance 52 (July 1997), pp. 923–973; and A. J. Neuberger, “Hedging Long-Term Exposures with Multiple Short-Term Futures Contracts,” Review of Financial Studies 12 (1999), pp. 429–459.
14The Dakota, Minnesota & Eastern Railroad developed plans to build a new line to transport coal from Wyoming to the Midwest. Although the plans were approved by the regulatory authorities, the project was abandoned in 2012 after the railroad was acquired by the Canadian Pacific Railway.
15John Kay, Why Firms Succeed (New York: Oxford University Press, 1995).
16See M. E. Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: The Free Press, 1980).
17See M. E. Porter, Competitive Advantage: Creating and Sustaining Superior Advantage (New York: The Free Press, 1985).
18Berkshire Hathaway 2000 Annual Report and 2007 talk to students at the University of Florida.
19This is a true story, but names and details have been changed to protect the innocent.
20We thank Stewart Hodges for permission to adapt this example from a case prepared by him, and we thank the BBC for permission to use the term gargle blasters.
21Total industry capacity in 2047 will be 400 million units. Of this, 120 million units are second-generation capacity, and the remaining 280 million units are third-generation capacity.
22Notice that we are assuming that all customers have to pay the same price for their gargle blasters. If Marvin could charge each customer the maximum price that that customer would be willing to pay, output would be the same as under free competition. Such direct price discrimination is illegal and, in any case, difficult to enforce. But firms do search for indirect ways to differentiate between customers. For example, stores often offer free delivery, which is equivalent to a price discount for customers who live at an inconvenient distance.
23To finance the expansion, Marvin is going to have to sell $1,000 million of new stock. Therefore the total value of Marvin’s stock will rise to $1,551 million. But investors who put up the new money will receive shares worth $1,000 million. The value of Marvin’s old shares after the announcement is therefore $551 million.
24The market value of Marvin stock will be greater than $551 million if investors expect the company to expand again within the five-year period. In other words, PVGO after the expansion may still be positive. Investors may expect Marvin to stay one step ahead of its competitors or to successfully apply its special technology in other areas.
25Profitless growth in the auto and aviation industries is the subject of a very insightful and entertaining article by Warren Buffett. See C. Loomis, “Mr. Buffett on the Stock Market,” Fortune (November 22, 1999), pp. 110–115.
26Transworld Airlines (TWA) went into bankruptcy three times, prompting jokes about “Chapter 22” and “Chapter 33.” TWA is one of nearly 450 U.S. airlines that are no longer operating. See https://en.wikipedia.org/wiki/List_of_defunct_airlines_of_the_United_States.
27See C. Loomis, “Mr. Buffett on the Stock Market,” op. cit.
28We thank Anthony Neuberger for suggesting this topic.