Principles of cororate finance 6th brealey myers chapter 11

Principles of Corporate Finance
Brealey and Myers

Sixth Edition

Where Net Present Values
Come
From


Slides by
Matthew Will
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Chapter 11

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11- 2

Topics Covered
 Look First To Market Values
 Forecasting Economic Rents
 Marvin Enterprises

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11- 3

Market Values
 Smart investment decisions make
MORE money than smart
financing decisions

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11- 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 . . .

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11- 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.

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11- 6

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

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11- 7

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.

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11- 8

Market Values
 Don’t 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?

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11- 9

Department Store Rents

NPV = -100 + 8
1.10

+ ... +

8 + 134

= $ 1 million

1.1010

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

Rental yield = 10 - 3 = 7%

NPV

8-7
1.10

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+

8 - 7.21
1.102

+...+

8 - 8.87
1.109

+

8 - 9.13

= $1 million

1.1010

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11- 10

Using Market Values
EXAMPLE: KING SOLOMON’S 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%

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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 do not need to forecast future gold prices:
NPV = -investment + PV revenues - PV costs
= 200 + 400 -  ((.1 x 200)/1.10t) = $77 million

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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.

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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?

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11- 14

Marvin Enterprises
Capacity

Unit cost

Technology Industry Marvin Capital Prodn. Salvage
value
1. 2011
120
17.5
5
2.5
2. 2019

120

24

17.5

5

2.5

* Proposed

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11- 15

Marvin Enterprises
Prices

Technology Production Interest Interest Invest Scrap
cost
on
on
above below
capital salvage
1. 2011

5.5

3.5

.5

9

6

2. 2019

3.5

3,5

.5

7

4

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11- 16

Marvin Enterprises
Demand for Garbage Blasters

Demand
800
Demand = 80 (10 - Price)

400
320
240

Price = 10 x quantity/80

5

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6 7

10

Price

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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
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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 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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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
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