Principles of Corporate Finance Brealey and Myers Sixth Edition Where Net Present Values Come From Slides by Matthew Will Irwin/McGraw Hill Chapter 11 ©The McGraw-Hill Companies, Inc., 200 11- Topics Covered Look First To Market Values Forecasting Economic Rents Marvin Enterprises Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Market Values Smart investment decisions make MORE money than smart financing decisions Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Market Values Smart investments are worth more than they cost: they have positive NPVs Firms calculate project NPVs by discounting forecast cash flows, but Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Market Values Projects may appear to have positive NPVs because of forecasting errors e.g some acquisitions result from errors in a DCF analysis Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Market Values Positive NPVs stem from a comparative advantage Strategic decision-making identifies this comparative advantage; it does not identify growth areas Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Market Values Don’t make investment decisions on the basis of errors in your DCF analysis Start with the market price of the asset and ask whether it is worth more to you than to others Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Market Values Don’t assume that other firms will watch passively Ask -How long a lead I have over my rivals? What will happen to prices when that lead disappears? In the meantime how will rivals react to my move? Will they cut prices or imitate my product? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- Department Store Rents NPV = -100 + 1.10 + + + 134 = $ million 1.1010 [assumes price of property appreciates by 3% a year] Rental yield = 10 - = 7% NPV 8-7 1.10 Irwin/McGraw Hill + - 7.21 1.102 + + - 8.87 1.109 + - 9.13 = $1 million 1.1010 ©The McGraw-Hill Companies, Inc., 200 11- 10 Using Market Values EXAMPLE: KING SOLOMON’S MINE Investment = $200 million Life = 10 years Production = million oz a year Production cost = $200 per oz Current gold price = $400 per oz Discount rate = 10% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 11 Using Market Values EXAMPLE: KING SOLOMON’S MINE - continued If the gold price is forecasted to rise by 5% p.a.: NPV = -200 + (.1(420 - 200))/1.10 + (.1(441 - 200))/1.102 + = - $10 m But if gold is fairly priced, you not need to forecast future gold prices: NPV = -investment + PV revenues - PV costs = 200 + 400 - ((.1 x 200)/1.10t) = $77 million Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 12 Do Projects Have Positive NPVs? Rents = profits that more than cover the cost of capital NPV = PV (rents) Rents come only when you have a better product, lower costs or some other competitive edge Sooner or later competition is likely to eliminate rents Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 13 Competitive Advantage Proposal to manufacture specialty chemicals Raw materials were commodity chemicals imported from Europe Finished product was exported to Europe High early profits, but what happens when competitors enter? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 14 Marvin Enterprises Capacity Unit cost Technology Industry Marvin Capital Prodn Salvage value 2011 120 17.5 2.5 2019 120 24 17.5 2.5 * Proposed Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 15 Marvin Enterprises Prices Technology Production Interest Interest Invest Scrap cost on on above below capital salvage 2011 5.5 3.5 2019 3.5 3,5 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 16 Marvin Enterprises Demand for Garbage Blasters Demand 800 Demand = 80 (10 - Price) 400 320 240 Price = 10 x quantity/80 Irwin/McGraw Hill 10 Price ©The McGraw-Hill Companies, Inc., 200 11- 17 Marvin Enterprises Value of Garbage Blaster Investment NPV new plant = 100 x [-10 + ((6 - 3)/1.2t ) + 10/1.25 = $299 million Change PV existing plant = 24 x (1/1.2t ) = $72 million Net benefit = 299 - 72 = $227 million Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 18 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 years, Loss = - 24 x (2 / 20) x (1 / 1.20)5 - 96 •VALUE OF NEW INVESTMENT: Rent gained on new investment = 100 x for years = 299 Rent lost on old investment = - 24 x for years = - 72 227 227 TOTAL VALUE: 551 CURRENT MARKET PRICE: 460 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 19 Marvin Enterprises Alternative Expansion Plans NPV $m 600 NPV new plant 400 Total NPV of investment 200 100 200 -200 Addition to 280 capacity millions Change in PV existing plant Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 ... McGraw-Hill Companies, Inc., 200 11- Market Values Don’t make investment decisions on the basis of errors in your DCF analysis Start with the market price of the asset and ask whether it is... Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 12 Do Projects Have Positive NPVs? Rents = profits that more than cover the cost of capital NPV = PV (rents) Rents come only when... million Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 11- 18 Marvin Enterprises •VALUE OF CURRENT BUSINESS: VALUE At price of $7 PV = 24 x 3.5/.20 420 •WINDFALL LOSS: Since price falls