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you could have made back then”it™s better some- the manufacture of radios and televisions, for ex-
times to turn these things upside down”and that ample. But I will draw a lesson from these busi-
was to short horses. Frankly, I™m disappointed that nesses: The key to investing is not assessing how
the Buffett family was not short horses through this much an industry is going to affect society, or how
entire period. And we really had no excuse: Living much it will grow, but rather determining the com-
in Nebraska, we would have found it super-easy to petitive advantage of any given company and,
borrow horses and avoid a “short squeeze.” above all, the durability of that advantage. The
products or services that have wide, sustainable
U.S. Horse Population
moats around them are the ones that deliver re-
1900: 21 million
wards to investors.
1998: 5 million
The other truly transforming business invention of Source: C. Loomis, “Mr. Buffett on the Stock Market,” Fortune
the first quarter of the century, besides the car, was (November 22, 1999), pp. 110“115.




302
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Principles of Corporate Capital Budgeting Present Values Come From Companies, 2003
Finance, Seventh Edition




CHAPTER 11 Where Positive Net Present Values Come From 303

technology immediately, Marvin reduced the value of its existing plant by $72 million.
Sometimes the losses on existing plants may completely offset the gains from a new
technology. That is why we sometimes see established, technologically advanced com-
panies deliberately slowing down the rate at which they introduce new products.
Notice that Marvin™s economic rents were equal to the difference between its costs
and those of the marginal producer. The costs of the marginal 2011-generation plant
consisted of the manufacturing costs plus the opportunity cost of not selling the
equipment. Therefore, if the salvage value of the 2011 equipment were higher, Mar-
vin™s competitors would incur higher costs and Marvin could earn higher rents.
We took the salvage value as given, but it in turn depends on the cost savings from
substituting outdated gargle blaster equipment for some other asset. In a well-
functioning economy, assets will be used so as to minimize the total cost of produc-
ing the chosen set of outputs. The economic rents earned by any asset are equal to
the total extra costs that would be incurred if that asset were withdrawn.
Here™s another point about salvage value which takes us back to our discussion
of Magna Charter in the last chapter: A high salvage value gives the firm an option
to abandon a project if things start to go wrong. However, if competitors know that
you can bail out easily, they are more likely to enter your market. If it is clear that




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you have no alternative but to stay and fight, they will be more cautious about
competing.
When Marvin announced its expansion plans, many owners of first-generation
equipment took comfort in the belief that Marvin could not compete with their
fully depreciated plant. Their comfort was misplaced. Regardless of past depreci-
ation policy, it paid to scrap first-generation equipment rather than keep it in pro-
duction. Do not expect that numbers in your balance sheet can protect you from
harsh economic reality.




SUMMARY
It helps to use present value when you are making investment decisions, but that is not
the whole story. Good investment decisions depend both on a sensible criterion and
on sensible forecasts. In this chapter we have looked at the problem of forecasting.
Projects may look attractive for two reasons: (1) There may be some errors in the
sponsor™s forecasts, and (2) the company can genuinely expect to earn excess profit
from the project. Good managers, therefore, try to ensure that the odds are stacked
in their favor by expanding in areas in which the company has a comparative ad-
vantage. We like to put this another way by saying that good managers try to iden-
tify projects that will generate economic rents. Good managers carefully avoid ex-
pansion when competitive advantages are absent and economic rents are unlikely.
They do not project favorable current product prices into the future without check-
ing whether entry or expansion by competitors will drive future prices down.
Our story of Marvin Enterprises illustrates the origin of rents and how they de-
termine a project™s cash flows and net present value.
Any present value calculation, including our calculation for Marvin Enterprises,
is subject to error. That™s life: There™s no other sensible way to value most capital
investment projects. But some assets, such as gold, real estate, crude oil, ships, and
airplanes, and financial assets, such as stocks and bonds, are traded in reasonably
competitive markets. When you have the market value of such an asset, use it, at
least as a starting point for your analysis.
Brealey’Meyers: III. Practical Problems in 11. Where Positive Net © The McGraw’Hill
Principles of Corporate Capital Budgeting Present Values Come From Companies, 2003
Finance, Seventh Edition




304 PART III Practical Problems in Capital Budgeting


FURTHER For an interesting analysis of the likely effect of a new technology on the present value of existing as-
READING sets, see:
S. P. Sobotka and C. Schnabel: “Linear Programming as a Device for Predicting Market
Value: Prices of Used Commercial Aircraft, 1959“65,” Journal of Business, 34:10“30 (Janu-
ary 1961).



QUIZ 1. You have inherited 250 acres of prime Iowa farmland. There is an active market in land
of this type, and similar properties are selling for $1,000 per acre. Net cash returns per acre
are $75 per year. These cash returns are expected to remain constant in real terms. How
much is the land worth? A local banker has advised you to use a 12 percent discount rate.
2. True or false?
a. A firm that earns the opportunity cost of capital is earning economic rents.
b. A firm that invests in positive-NPV ventures expects to earn economic rents.
c. Financial managers should try to identify areas where their firms can earn
economic rents, because it™s there that positive-NPV projects are likely to be found.
d. Economic rent is the equivalent annual cost of operating capital equipment.
3. Demand for concave utility meters is expanding rapidly, but the industry is highly com-
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petitive. A utility meter plant costs $50 million to set up, and it has an annual capacity
of 500,000 meters. The production cost is $5 per meter, and this cost is not expected to
change. The machines have an indefinite physical life and the cost of capital is 10 per-
cent. What is the competitive price of a utility meter?
a. $5 b. $10 c. $15
4. Look back to the polyzone example at the end of Section 11.2. Explain why it was nec-
essary to calculate the NPV of investment in polyzone capacity from the point of view
of a potential European competitor.
5. Your brother-in-law wants you to join him in purchasing a building on the outskirts of
town. You and he would then develop and run a Taco Palace restaurant. Both of you are
extremely optimistic about future real estate prices in this area, and your brother-in-law
has prepared a cash-flow forecast that implies a large positive NPV. This calculation as-
sumes sale of the property after 10 years.
What further calculations should you do before going ahead?
6. A new leaching process allows your company to recover some gold as a by-product of
its aluminum mining operations. How would you calculate the PV of the future cash
flows from gold sales?
7. On the London Metals Exchange the price for copper to be delivered in one year is
$1,600 a ton. Note: Payment is made when the copper is delivered. The risk-free inter-
est rate is 5 percent and the expected market return is 12 percent.
a. Suppose that you expect to produce and sell 100,000 tons of copper next year. What
is the PV of this output? Assume that the sale occurs at the end of the year.
b. If copper has a beta of 1.2, what is the expected price of copper at the end of the
year? What is the certainty-equivalent price?
8. New-model commercial airplanes are much more fuel-efficient than older models.
How is it possible for airlines flying older models to make money when its competitors
are flying newer planes? Explain briefly.
9. What are the lessons of Marvin Enterprises? Select from the following list. Note: Some
of the following statements may be partly true, or true in some circumstances but not
generally. Briefly explain your choices.
a. Companies should try to concentrate their investments in high-tech, high-growth
sectors of the economy.
b. Think when your competition is likely to catch up, and what that will mean for
product pricing and project cash flows.
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Principles of Corporate Capital Budgeting Present Values Come From Companies, 2003
Finance, Seventh Edition




CHAPTER 11 Where Positive Net Present Values Come From 305

c. Introduction of a new product may reduce the profits from an existing product but
this project interaction should be ignored in calculating the new project™s NPV.
d. In the long run, economic rents flow from some asset (usually intangible) or some
advantage that your competitors do not have.
e. Do not attempt to enter a new market when your competitors can produce with
fully depreciated plant.




PRACTICE
1. Suppose that you are considering investing in an asset for which there is a reasonably
QUESTIONS
good secondary market. Specifically, you™re Delta Airlines, and the asset is a Boeing
757”a widely used airplane. How does the presence of a secondary market simplify
your problem in principle? Do you think these simplifications could be realized in prac-
tice? Explain.
2. There is an active, competitive leasing (i.e., rental) market for most standard types of
commercial jets. Many of the planes flown by the major domestic and international air-
lines are not owned by them but leased for periods ranging from a few months to sev-
eral years.
Gamma Airlines, however, owns two long-range DC-11s just withdrawn from
Latin American service. Gamma is considering using these planes to develop the po-




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tentially lucrative new route from Akron to Yellowknife. A considerable investment in
terminal facilities, training, and advertising will be required. Once committed, Gamma
will have to operate the route for at least three years. One further complication: The
manager of Gamma™s international division is opposing commitment of the planes to
the Akron“Yellowknife route because of anticipated future growth in traffic through
Gamma™s new hub in Ulan Bator.
How would you evaluate the proposed Akron“Yellowknife project? Give a de-
tailed list of the necessary steps in your analysis. Explain how the airplane leasing mar-
ket would be taken into account. If the project is attractive, how would you respond to
the manager of the international division?
3. Why is an M.B.A. student who has just learned about DCF like a baby with a hammer?
What was the point of our answer?
4. Suppose the current price of gold is $280 per ounce. Hotshot Consultants advises you
that gold prices will increase at an average rate of 12 percent for the next two years. Af-
ter that the growth rate will fall to a long-run trend of 3 percent per year. What is the
price of 1 million ounces of gold produced in eight years? Assume that gold prices have
a beta of 0 and that the risk-free rate is 5.5 percent.
5. Thanks to acquisition of a key patent, your company now has exclusive production
rights for barkelgassers (BGs) in North America. Production facilities for 200,000 BGs
per year will require a $25 million immediate capital expenditure. Production costs are
estimated at $65 per BG. The BG marketing manager is confident that all 200,000 units
can be sold for $100 per unit (in real terms) until the patent runs out five years hence.
After that the marketing manager hasn™t a clue about what the selling price will be.
What is the NPV of the BG project? Assume the real cost of capital is 9 percent. To
keep things simple, also make the following assumptions:
• The technology for making BGs will not change. Capital and production costs will
stay the same in real terms.
• Competitors know the technology and can enter as soon as the patent expires, that
is, in year 6.
• If your company invests immediately, full production begins after 12 months, that is,
in year 1.
• There are no taxes.
• BG production facilities last 12 years. They have no salvage value at the end of their
useful life.
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Principles of Corporate Capital Budgeting Present Values Come From Companies, 2003
Finance, Seventh Edition




306 PART III Practical Problems in Capital Budgeting

6. How would your answer to question 5 change if:
• Technological improvements reduce the cost of new BG production facilities by 3
percent per year?
Thus a new plant built in year 1 would cost only 25 (1 .03) $24.25 million; a plant
built in year 2 would cost $23.52 million; and so on. Assume that production costs per
unit remain at $65.
7. Reevaluate the NPV of the proposed polyzone project under each of the following as-
sumptions. Follow the format of Table 11.3. What™s the right management decision in
each case?
a. Competitive entry does not begin until year 5, when the spread falls to $1.10 per
pound, and is complete in year 6, when the spread is $.95 per pound.
b. The U.S. chemical company can start up polyzone production at 40 million pounds
in year 1 rather than year 2.
c. The U.S. company makes a technological advance that reduces its annual
production costs to $25 million. Competitors™ production costs do not change.
8. Photographic laboratories recover and recycle the silver used in photographic film.
Stikine River Photo is considering purchase of improved equipment for their laboratory
EXCEL
at Telegraph Creek. Here is the information they have:
• The equipment costs $100,000.
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• It will cost $80,000 per year to run.
• It has an economic life of 10 years but can be depreciated over 5 years by the straight-
line method (see Section 6.2).
• It will recover an additional 5,000 ounces of silver per year.
• Silver is selling for $20 per ounce. Over the past 10 years, the price of silver has ap-
preciated by 4.5 percent per year in real terms. Silver is traded in an active, compet-
itive market.
• Stikine™s marginal tax rate is 35 percent. Assume U.S. tax law.
• Stikine™s company cost of capital is 8 percent in real terms.
What is the NPV of the new equipment? Make additional assumptions as necessary.
9. The Cambridge Opera Association has come up with a unique door prize for its
December (2004) fund-raising ball: Twenty door prizes will be distributed, each one
a ticket entitling the bearer to receive a cash award from the association on Decem-
ber 30, 2005. The cash award is to be determined by calculating the ratio of the level
of the Standard and Poor™s Composite Index of stock prices on December 30, 2005,
to its level on June 30, 2005, and multiplying by $100. Thus, if the index turns out
to be 1,000 on June 30, 2005, and 1,200 on December 30, 2005, the payoff will be
100 (1,200/1,000) $120.
After the ball, a black market springs up in which the tickets are traded. What
will the tickets sell for on January 1, 2005? On June 30, 2005? Assume the risk-free in-
terest rate is 10 percent per year. Also assume the Cambridge Opera Association will
be solvent at year-end 2005 and will, in fact, pay off on the tickets. Make other as-
sumptions as necessary.
Would ticket values be different if the tickets™ payoffs depended on the Dow Jones
Industrial index rather than the Standard and Poor™s composite?
10. You are asked to value a large building in northern New Jersey. The valuation is needed
for a bankruptcy settlement. Here are the facts:
EXCEL
• The settlement requires that the building™s value equal the PV value of the net cash pro-
ceeds the railroad would receive if it cleared the building and sold it for its highest
and best nonrailroad use, which is as a warehouse.
• The building has been appraised at $1 million. This figure is based on actual recent
selling prices of a sample of similar New Jersey buildings used as, or available for use
as, warehouses.
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Principles of Corporate Capital Budgeting Present Values Come From Companies, 2003
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CHAPTER 11 Where Positive Net Present Values Come From 307

• If rented today as a warehouse, the building could generate $80,000 per year. This
cash flow is calculated after out-of-pocket operating expenses and after real estate
taxes of $50,000 per year:

Gross rents $180,000
Operating expenses 50,000
Real estate taxes 50,000
Net $80,000

Gross rents, operating expenses, and real estate taxes are uncertain but are expected
to grow with inflation.
• However, it would take one year and $200,000 to clear out the railroad equipment
and prepare the building for use as a warehouse. This expenditure would be spread
evenly over the next year.
• The property will be put on the market when ready for use as a warehouse. Your real
estate adviser says that properties of this type take, on average, 1 year to sell after
they are put on the market. However, the railroad could rent the building as a ware-
house while waiting for it to sell.
• The opportunity cost of capital for investment in real estate is 8 percent in real terms.




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• Your real estate adviser notes that selling prices of comparable buildings in northern
New Jersey have declined, in real terms, at an average rate of 2 percent per year over
the last 10 years.
• A 5 percent sales commission would be paid by the railroad at the time of the sale.
• The railroad pays no income taxes. It would have to pay property taxes.




CHALLENGE
1. The manufacture of polysyllabic acid is a competitive industry. Most plants have an an-
QUESTIONS
nual output of 100,000 tons. Operating costs are $.90 a ton, and the sales price is $1 a
ton. A 100,000-ton plant costs $100,000 and has an indefinite life. Its current scrap value
of $60,000 is expected to decline to $57,900 over the next two years.
Phlogiston, Inc., proposes to invest $100,000 in a plant that employs a new low-cost
process to manufacture polysyllabic acid. The plant has the same capacity as existing
units, but operating costs are $.85 a ton. Phlogiston estimates that it has two years™ lead
over each of its rivals in use of the process but is unable to build any more plants itself
before year 2. Also it believes that demand over the next two years is likely to be slug-
gish and that its new plant will therefore cause temporary overcapacity.
You can assume that there are no taxes and that the cost of capital is 10 percent.
a. By the end of year 2, the prospective increase in acid demand will require the
construction of several new plants using the Phlogiston process. What is the likely
NPV of such plants?
b. What does that imply for the price of polysyllabic acid in year 3 and beyond?
c. Would you expect existing plant to be scrapped in year 2? How would your
answer differ if scrap value were $40,000 or $80,000?
d. The acid plants of United Alchemists, Inc., have been fully depreciated. Can it
operate them profitably after year 2?
e. Acidosis, Inc., purchased a new plant last year for $100,000 and is writing it down
by $10,000 a year. Should it scrap this plant in year 2?
f. What would be the NPV of Phlogiston™s venture?
2. The world airline system is composed of the routes X and Y, each of which requires 10
aircraft. These routes can be serviced by three types of aircraft”A, B, and C. There are
5 type A aircraft available, 10 type B, and 10 type C. These aircraft are identical except
for their operating costs, which are as follows:
Brealey’Meyers: III. Practical Problems in 11. Where Positive Net © The McGraw’Hill
Principles of Corporate Capital Budgeting Present Values Come From Companies, 2003
Finance, Seventh Edition




308 PART III Practical Problems in Capital Budgeting

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