Slides by

1
Principles of Corporate Finance Brealey and Myers
Sixth Edition

• Where Net Present Values
  Come From

• Slides by
• Matthew Will

Chapter 11

• The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
2
Topics Covered

• Look First To Market Values
• Forecasting Economic Rents
• Marvin Enterprises

3
Market Values

• Smart investment decisions make MORE money than
  smart financing decisions

4
Market Values

• Smart investments are worth more than they cost
  they have positive NPVs
• Firms calculate project NPVs by discounting
  forecast cash flows, but . . .

5
Market Values

• Projects may appear to have positive NPVs because
  of forecasting errors.e.g. some acquisitions
  result from errors in a DCF analysis.

6
Market Values

• Positive NPVs stem from a comparative advantage.
• Strategic decision-making identifies this
  comparative advantage it does not identify
  growth areas.

7
Market Values

• Dont 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.

8
Market Values

• Dont assume that other firms will watch
  passively.Ask --How long a lead do I have over
  my rivals? What will happen to prices when that
  lead disappears?In the meantime how will rivals
  react to my move? Will they cut prices or
  imitate my product?

9
Department Store Rents
8 8 134 1.10
1.1010
NPV -100 . . .
1 million assumes price
of property appreciates by 3 a year Rental
yield 10 - 3 7 NPV
. . .
1 million
8 - 7 8 - 7.21 8 - 8.87
8 - 9.13 1.10 1.102
1.109 1.1010
10
Using Market Values
EXAMPLE KING SOLOMONS MINE Investment
200 million Life 10 years
Production .1 million oz. a year
Production cost 200 per oz. Current gold
price 400 per oz. Discount rate 10
11
Using Market Values
EXAMPLE KING SOLOMONS 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 do not need to forecast
future gold prices NPV -investment PV
revenues - PV costs 200 400 -
S ((.1 x 200)/1.10t) 77 million
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.

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?

14
Marvin Enterprises
15
Marvin Enterprises
16
Marvin Enterprises
Demand for Garbage Blasters
Demand 80 (10 - Price) Price 10 x
quantity/80
17
Marvin Enterprises
Value of Garbage Blaster Investment
NPV new plant 100 x -10 S ((6 -
3)/1.2t ) 10/1.25
299 million Change PV existing plant 24
x S (1/1.2t ) 72 million Net benefit
299 - 72 227 million
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 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

19
Marvin Enterprises
Alternative Expansion Plans
NPV m.
600
NPV new plant
400
200
Total NPV of investment
Addition to capacity millions
100 200
280
-200
Change in PV existing plant