Chapter 11 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Tenth Edition

Investment, Strategy, and Economic Rents

Slides by

Matthew Will

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Topics Covered

Look First To Market ValuesEconomic Rents and Competitive

AdvantageExample - Marvin Enterprises

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Department Store Rents

[assumes price of property appreciates by 3% a year]

Rental yield = 10 - 3 = 7%

000,000,1$10.1

8...

10.1

8100

10NPV

000,000,1$10.1

13.98

10.1

87.88...

10.1

21.78

10.1

781092

NPV

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Department Store Rents

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Do Projects Have Positive NPVs?

Rents = profits that more than cover the cost of capital

NPV = PV (rents)

Rents come only when you have a better product, lower costs or some other competitive edge

Sooner or later competition is likely to eliminate rents

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Competitive Advantage

Proposal to manufacture specialty chemicals

Raw materials were commodity chemicals imported from Europe

Finished product was exported to Europe

High early profits, but . . .

. . . what happens when competitors enter?

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Polyzone Production NPV

Year 0 Year 1 Year 2 Year 3-10

Investment 100Production, Millions of pounds per year 0 0 40 80Spread, dollars per pound 1.2 1.2 1.2 1.2Net revenues 0 0 48 96Production costs 0 0 30 30Transport 0 0 4 8Other costs 0 20 20 20Cash flow -100 -20 -6 38

NPV (at r=8%) = $63.6 million

U.S. Company (figures in millions)

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Polyzone Production NPV

Year 0 Year 1 Year 2 Year 3-10

Investment 100Production, Millions of pounds per year 0 0 40 80Spread, dollars per pound 0.95 0.95 0.95 0.95Net revenues 0 0 38 76Production costs 0 0 30 30Transport 0 0 0 0Other costs 0 20 20 20Cash flow -100 -20 -12 26

NPV (at r=8%) = 0

European Company (figures in millions)

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Polyzone Production NPV

0 1 2 3 4 5 - 10Investment 100Production, Millions of pounds per year 0 0 40 80 80 80Spread, dollars per pound 1.2 1.2 1.2 1.2 1.1 0.95Net revenues 0 0 48 96 88 76Production costs 0 0 30 30 30 30Transport 0 0 4 8 8 8Other costs 0 20 20 20 20 20

Cash flow -100 -20 -6 38 30 18NPV (at r= 8%)= -9.8

Year

U.S. Company w/ European Competition (figures in millions)

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Marvin Enterprises

Capacity, Millions of Units

Technology Industry MarvinCapital Cost per

Unit ($)Manufacturing

Cost per Unit ($)Salvage Value per

Unit ($)

First generation (2017) 120 _ 17.5 5.5 2.5

Second generation (2025) 120 24 17.5 3.5 2.5

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Marvin Enterprises

Demand = 80 (10 - Price)

Price = 10 x quantity/80

Demand for Garbage Blasters

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Marvin Enterprises

Value of Garbage Blaster Investment

million

million

million

t

t

227$72299benefit Net

72$2.1

124plant existingPV Change

299$

25.1

10

2.1

3610100Plant New NPV

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Marvin Enterprises

•VALUE OF CURRENT BUSINESS: VALUE

At price of $7 PV = 24 x 3.5/.20 420

•WINDFALL LOSS:

Since price falls to $5 after 5 years,

Loss = - 24 x (2 / .20) x (1 / 1.20)5 - 96

•VALUE OF NEW INVESTMENT:

Rent gained on new investment = 100 x 1 for 5 years = 299

Rent lost on old investment = - 24 x 1 for 5 years = - 72

227 227

TOTAL VALUE: 551

CURRENT MARKET PRICE: 460

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Marvin Enterprises

100 200 280

NPV new plant

Change in PV existing plant

Total NPV of investment

400

600

200

-200

NPV $m.

Addition to capacity millions

Alternative Expansion Plans