Managerial economics 3rd by froeb ch05

11

Chapter 5
Investment
Decisions: Look
Ahead and
Reason Back
1

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Chapter 5 – Summary of main
points
•

Investments imply willingness to trade dollars in the present
for dollars in the future. Wealth-creating transactions occur
when individuals with low discount rates (rate at which they
value future vs current dollars) lend to those with high
discount rates.

•

Companies, like individuals, have different discount rates,
determined by their cost of capital. They invest only in
projects that earn a return higher than the cost of capital.

•

The NPV rule states that if the present value of the net cash

flow of a project is larger than zero, the project earns
economic profit (i.e., the investment earns more than the
cost of capital).

•

Although NPV is the correct way to analyze investments, not
all companies use it. Instead, they use break-even analysis
because it is easier and more intuitive.

•

Break-even quantity is equal to fixed cost divided by the
contribution margin. If you expect to sell more than the
break-even quantity, then your investment is profitable.

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Chapter 5 – Summary (cont.)
•

Avoidable costs can be recovered by shutting
down. If the benefits of shutting down (you
recover your avoidable costs) are larger than
the costs (you forgo revenue), then shut
down. The break-even price is average
avoidable cost.
• If you incur sunk costs, you are vulnerable to
post-investment hold-up. Anticipate hold-up

and choose contracts or organizational forms
that minimize the costs of hold-up.
• Once relationship-specific investments are
made, parties are locked into a trading
relationship with each other, and can be held
up by their trading partners. Anticipate holdup and choose organizational or contractual
forms to give each party both the incentive to
make relationship-specific investments and to
trade after these investments are made.
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Introductory anecdote
•

In summer 2007, Bert Matthews was contemplating purchasing
a 48-unit apartment building.

• The building was 95% occupied and generated $550,000 in annual
profit.
• Investors expected a 15% return on their capital
• The bank offered to loan Mr. Matthews 80% of the purchase price
at a rate of 5.5%

•

Mr. Matthews computed the cost of capital as a weighted
average of equity and debt.
• .2*(15%) + .8*(5.5%) = 7.4%
• Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million

and still break even.

•

Mr. Matthews decided not to buy the building. A good decision –
one year later, the cost of capital was 10.125% and Mr.
Matthews could offer only $5.4 million for the building.

•

This story illustrates both the effect of the bursting credit
bubble on real estate valuations and, more importantly, the
relevant costs and benefits of investment decisions.

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Background: Investment
profitability
• All investments represent a trade-off between
possible future gain and current sacrifice.
• Willingness to invest in projects with a low
rate of return, indicates a willingness to trade
current dollars for future dollars at a
relatively low rate.
• This is also known as having a low discount rate (r).

• Individuals with low discount rates would
willingly lend to those with higher discount
rates.

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Determining investment
profitability
• The current/future trade-off can be calculated by,

• Compounding
•

Xt+1=(1+r) Xt

•

Xt+s=(1+r)s Xt

• Discounting (the opposite of compounding)
•

Xt+1/(1+r)= Xt

•

Xt+s/(1+r)s= Xt

• Discussion: If my discount rate is 10%, would I
lend to or borrow from someone with a
discount rate of 15%?

• What does this say about behavior?
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Present value and investment
decisions
• Companies also have discount rates, which are
determined by cost of capital.

• A company’s cost of capital is a blend of debt
and equity, its “weighted average cost of
capital” or WACC
• Time is a critical element in investment decisions

• cash flows to be received in the future need to be
discounted to present value using the cost of capital

• The NPV Rule: if the present value of the net
cash flows is larger than zero, the project if
profitable.
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The NPV rule in action

• For this example the company’s cost of capital is 14%
• To determine profitability, discount future inflows and
outflows to compare with the initial investment – here
$100
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NPV and economic profit
• Projects with a positive NPV create economic
profit.
• Only positive NPV projects earn a return higher
than the company’s cost of capital.
• Projects with negative NPV may create accounting
profits, but not economic profit.
• In making investment decisions, choose only
projects with a positive NPV.

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Background: break-even
quantities
• The break-even quantity is the amount you
need to sell to just cover your costs

• At this sales level, profit is zero.
• The break-even quantity is Q=FC/(P-MC),
where FC are fixed costs, P is price, and MC is
marginal cost

• (P-MC) is the “contribution margin” – what’s
left after marginal cost to “contribute” to
covering fixed costs

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Decision making example: Nissan
truck
• Nissan’s popular truck model, the Titan, had only two
years remaining on its production cycle. Redesigning
the “Titan” would cost $400M.

• Cost of capital was 12%, implying annual fixed cost of

$48M
• Contribution margin on each truck is $1,500
• Break-even quantity is 32,000 trucks
• The decision to redesign or not came down to a breakeven analysis

• Nissan had a 3% share of the market, implying only
12,000 Titan sales per year – not enough to break
even.
• Instead they decided to license the Dodge Ram Truck,
which would reduce the fixed cost of redesign, and a
lower break-even point.

• After the Government took over Chrysler, Nissan
reconsidered

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Deciding between two
technologies

• In 1983, John Deere was in the midst of building a
Henry-Ford-style production line factory for large
4WD tractors
• Unexpectedly, wheat prices fell dramatically reducing
demand for large tractors

• Deere decided to abandon the new factory and
instead purchased Versatile, a company that
assembled tractors in a garage using off-the-shelf
components
• A discrete investment decision – the factory had big FC and
small MC, Versatile had small FC but bigger MC

• Remember this advice: Do not invoke
break-even analysis to justify higher
prices or greater output.
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The decision to shut-down
• Shut-down decisions are made using breakeven prices rather than quantities.

• The break-even price is the average avoidable
cost per unit
• Profit = Rev-Cost= (P-AC)(Q)

• If you shut down, you lose your revenue, but
you get back your avoidable cost.
• If average avoidable cost is less than price, shut down.

• Determining avoidable costs can be difficult.

• To identify avoidable costs firms use Cost
Taxonomy

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Cost Taxonomy

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Using the cost taxonomy
• Example problem:

• Fixed cost (FC)=$100/year
• Marginal costs (MC)=$5/unit
• Quantity (Q)=100/year
• What is the break-even price for this
scenario?
• How low can prices go before shut down is
profitable?

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Sunk costs and postinvestment hold up
• National Geographic can reduce shipping costs by
printing with regional printers.

• To print a high quality magazine, the printer must
•
•
•
•

buy a $12 million printing press.
Each magazine has a MC of $1 and the printer
would print 12 million copies over two years.
The break-even cost/average cost is $7 = ($12M /
2M copies) + $1/copy
BUT once the press is purchased, the cost is sunk
and the break-even price changes.
Because of this the magazine can hold up the
printer by renogiating the terms of the deal –
because the price of the press is unavoidable, and
sunk, the break-even price falls to $1, the marginal
cost.

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Sunk costs and post-investment
hold up (cont.)
• Always remember the business maxim “look
ahead and reason back.” This can help you avoid
potential hold up.
• Before making a sunk cost investment, ask what
you will do if you are held up.

• What would you do to address hold up?

• One possible solution to post-investment hold-up
is vertical integration.

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Vertical integration
• Example: Bauxite mine and alumina refinery

• Refineries are tailored to specific qualities of
ore
• The transaction options are:
•
•
•

•

Spot-market transactions
Long-term contracts
Vertical integration
• Vertical integration refers to the common
ownership of two firms in separate stages of
the vertical supply chain that connects raw
materials to finished goods
Discussion: How is vertical integration a
solution to hold up?

• Contractual view of marriage

• What is the hold-up problem?
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