Transcript Froeb_05 - Vanderbilt Business School

Chapter 5
Investment Decisions: Look Ahead
and Reason Back
Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb, [email protected]
Brian T. McCann, [email protected]
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
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.
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 postinvestment 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 hold-up and choose
organizational or contractual forms to give each
party both the incentive to make relationshipspecific investments and to trade after these
investments are made.
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.
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.
•
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?
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.
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
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.
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
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
break-even analysis
• Nissan had a 3% share of the market, implying
Deciding between two technologies
• In 1983, John Deere was in the midst of building a HenryFord-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 breakeven analysis to justify higher prices or greater
output.
The decision to shut-down
• Shut-down decisions are made using break-even 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
Cost Taxonomy
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?
Sunk costs and post-investment
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.
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.
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?
1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3. Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7. Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19. The problem of adverse selection
20. The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?
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