chapter 2: capitalbudgeting principles and techniquesleeds-faculty.colorado.edu/donchez/fnce...

Chapter 2: Capital-Budgeting Principles and Techniques


QUESTIONS1. a. What is the relationship between accounting income and economic profit?

Answer: Accounting income is calculated by taking revenues and subtracting all cash and non-cash expenses (such as depreciation). Accounting income also often recognizes losses for tax purposes as well, even though the economic loss may have taken place at another time. Economic profit is the sum of the present values of all the cash flows net of expenses generated by the firm’s actions. Economic profit measures true increments to value, but is hard to measure. Accounting profit is correlated with economic profit, but not perfectly so. Accounting profit can be measured much more easily.

b. What is the relationship between accounting rate of return and economic rate of return?

Answer: The accounting rate of return is the ratio of after-tax profit to average book investment. Economic rate of return is the ratio of after-tax economic profit to the market value of the investment. Economic profit equals cash accruals to the asset combined with changes in its market value.

2. In 1991, AT&T laid a transatlantic fiber optic cable costing $400 million that can handle 80,000 calls simultaneously. What is the payback on this investment if AT&T uses just half its capacity while netting one cent per minute on calls?

Answer: $210 Million per year assuming the half capacity is for 24 hours a day, 365 days per year. The annual payback is then 53%.

3. The satisfied owner of a new $15,000 car can be expected to buy another ten cars from the same company over the next 30 years (an average of one every three years) at an average price of $15,000 (ignore the effects of inflation). If the net profit margin on these cars is 20 percent, how much should an auto manufacturer be willing to spend to keep its customers satisfied? Assume a 9 percent discount rate.

Answer: At a 20 percent profit margin, the auto company will earn an annuity of about $3,000 every three years for the next 30 years. Discounted at 9 percent, this annuity is worth $9,402, assuming that the first new car is purchased three years from today. Hence, an investment to keep customers satisfied will have a positive NPV as long as the amount spent is less than $9,402. Thus, a car company should be willing to spend up to $9,402 in present value terms to keep its customers satisfied. A trick is available to calculate the present value of this annuity. Recognize that an annuity received every three years for 30 years and discounted at 9 percent is equivalent to a 10-year annuity discounted at 29.5029 percent since each cash flow term is discounted at (1.09)3 = 1.295029.


4. Demonstrate that the following project has internal rates of return of 0 percent, 100 percent, and 200 percent.

Year 1 2 3 4 Cash flow –$1,200 +7,200 –13,200 +7,200

Answer: To demonstrate that an IRR calculation is valid, compute the net present value at the IRR. A valid IRR yields NPV = 0.

Year Cash Flow PV@0% PV@100% PV@200%

1 -1,200 -1,200 -600 -400.00

2 +7,200 +7,200 +1,800 +800.00

3 -13,200 -13,200 -1,650 -488.89

4 +7,200 +7,200 +450 +88.89

Total 0 0 0 0

5. During 1990, Dow Chemical generated the following returns on investment in its different business units:

Business Unit Return on Investment (%)

Plastics 16.6 Chemicals/Performance Products

16.7

Consumer Specialties 12.7 Hydrocarbons/Energy 5.2 Other 1.6 Dow Chemical overall 11.8

Given these returns, which of the business units should Dow invest additional capital in? What additional information would you need in order to make that decision?

Answer: These figures tell you what Dow earned in 1990. In order to decide on future investments, you need the following information:

1. Whether these returns are representative of those expected to be earned in the future in these different divisions. What matters for investment decisionmaking are projected future returns, not past returns. To the extent that these returns vary widely from year to year—which they do in the chemical business—historical return data for

mailto:PV@200%25

mailto:PV@0%25


one year are meaningless. One reason these data may be misleading is that they are based on historical cost figures for investment. You really want to calculate returns on the replacement cost of assets. Inflation will cause asset values to be understated, which will lead the return on investment to be overstated.

2. The cost of capital for these divisions. Each division is likely to have its own risk and, hence, its own cost of capital. A high return could just indicate a high degree of risk and, therefore, a high required return. What matters is the projected return relative to the cost of capital. A high projected return that is less than the risk-adjusted cost of capital will yield a negative NPV investment. Conversely, a low projected return that exceeds the cost of capital will yield a positive NPV investment.

3. The marginal return on investment in each division. Even if the figures for, say, the plastics and chemical/performance products divisions exceed their cost of capital and are representative of those expected to be earned in the future, that does not automatically justify additional investment in those divisions. These figures tell us the average ROI; for investment purposes you need the marginal ROI. That is, what matters for investment purposes is not the return on past investments but the return on future investments. As we have seen, many companies (e.g., Monsanto, Philip Morris) have divisions that yield high returns on past investments but very low returns on incremental investments.

4. The extent to which these divisions sell to one another. Dow Chemical is a vertically-integrated company. Its hydrocarbons/energy unit sells to its downstream plastics unit, which in turn sells to its consumer specialties unit. Thus, the profitability of these units depends critically on the prices at which these internal transactions take place. For example, the hydrocarbons/energy unit may be showing a low ROI simply because it sells petroleum to the plastics unit at a below-market price. That is, the hydrocarbons unit may be very profitable but its profits are showing up in the plastics unit in the form of a low price on raw materials. This is a form of cross-subsidization. Disentangling the true profitability of the different units of a vertically-integrated company like Dow turns out to be a very difficult task, but it is a necessary one for capital budgeting purposes. What matters is how profitable investments are from the standpoint of the overall company, not from the standpoint of the units undertaking those investments.

5. The returns associated with specific assets and activities within each division. What matters from an investment standpoint is not just how well each division can be expected to do in the future but how well specific projects within each division can be expected to do. For example, certain products within the profitable plastics division may be earning a 40% return while others are only earning a 2% return. Similarly, certain R&D investments may be expected to yield a high return relative to their riskiness, whereas others have little chance of a significant payoff. At the same time, the low-return hydrocarbons/energy division may have some very high-return projects, which are masked by a lot of value-destroying activities elsewhere. Without detailed data on the


returns associated with each division’s various activities, customers, and products, one can’t say where investment dollars would be best spent.

CHAPTER 2: PROBLEMS1. A firm is considering investing in a project with the following cash flows:

Year 1 2 3 4 5 6 7 8 Net cashflow ($)

2,000

3,000

4,000

3,500

3,000

2,000

1,000

1,000

The project requires an initial investment of $12,500, and the firm has a required rate of return of 10 percent. Compute the payback, discounted payback, and net present value, and determine whether the project should be accepted.

Answer: Payback period = 4 years exactly.Discounted payback period (r = 10%) = 5.84 years.Net Present Value (r = 10%) = $1164.70. The project should be accepted.

Intermediate Calculations:

Cash PV CumulativeCash Flows -12,500.00

1 2,000.00 1,818.18 1,818.18 2 3,000.00 2,479.34 4,297.52 3 4,000.00 3,005.26 7,302.78 4 3,500.00 2,390.55 9,693.33 5 3,000.00 1,862.76 11,556.096 2,000.00 1,128.95 12,685.047 1,000.00 513.16 13,198.20 8 1,000.00 466.51 13,664.70

2. The Pennco Oil Co. must decide whether it is financially feasible to open an oil well off the coast of China. The drilling and rigging cost for the well is $5,000,000. The well is expected to yield 585,000 barrels of oil a year at a net profit to Pennco of $5 a barrel for four years. The well will then be effectively depleted but must be capped and secured at a cost of $4,000,000. Pennco requires an annual rate of return of 14 percent on its investment projects. Should Pennco open the well? (Assume all of a year’s production occurs at the end of the year.)

Answer: Net annual profit = 585,000($5.00) = $2.925M.PV(Production) = $2.925M _ PVIFAr=14%,n=4 = 2.925M _ 2.9137 = $8.523M.PV(Capping) = $4.000M _ PVIFr=14%,n=4 = 4 _ 0.5921 = $2.368M.


PV(Drilling) = $5.000M.NPV = PV(Production) Ä PV(Capping) Ä PV(Drilling) = $8.523M Ä 2.368M Ä 5.000M =

$1.154M.The well should be drilled, since the present value of the benefits exceeds the present value of the costs. The term NPV (Net Present Value) refers precisely to the difference in present value between the benefits and the costs of a project.

3. Jack Nicklaus, the golfing pro and real estate developer, is thinking of acquiring an 800-acre property outside Atlanta that he intends to turn into an exclusive community for 600 families. The cost of this property and the necessary improvements is $30 million. After setting aside a mandatory 25 percent of the property as green space, he figures he can sell the remaining lots for an average of $90,000 an acre. By putting in a golf course on the 200 acres of green space, Nicklaus believes he can instead sell the lots for an average of $140,000 an acre. The golf course, including clubhouse, has a projected price tag of $6 million. In either event, the project is expected to take eight years to sell out at a rate of 75 lots per year. Jack Nicklaus faces a marginal tax rate of 40 percent and can write off his land and development costs by prorating these costs against each lot sold.

a. If his required return is 14 percent, should Jack Nicklaus go ahead with the initial project (i.e., a community with no golf course)?

Answer: The initial project, a community with no golf course, requires an initial outlay of $30M, and reaps 6.75M per year for 8 years in the absence of taxes and depreciation. The present value of the decision at r = 14% and t = 40% can be determined from the following formula:

b. Should he put in the golf course?

Answer: With the golf course, the cost is $36M, and pretax revenues are 10.5M per year. The same calculations as above can be made with the new data:

NPV = ─36,000,000 + (1 ─ 0.40)(10,500,000)(4.6389) + (0.40)(4,500,000)(4.6389) = $1,574,797.54.

Nicklaus should build the golf course (exactly as we expected).


a.b. * An alternate display is illustrative:

Housing Only

With Golf Course

Annual Sales $6,750,000 $10,500,000

Ann. Amortization 3,750,000 4,500,000Ann. Pretax Profit 3,000,000 6,000,000Tax ( @ 40% ) 1,200,000 2,400,000Ann. Aftertax Profit

1,800,000 3,600,000

Cash Flow 5,550,000 8,100,000PVIFA(r=14%,n=8)

4.638864 4.638864

Present Value 25,745,695 37,574,798Cost 30,000,000 36,000,000Net Present Value ─$4,254,30

5$1,574,798

4. The Coin Coalition is trying to get the U.S. government to replace the dollar bill with a gold-colored dollar coin. One argument is cost savings. A dollar bill costs 2.6 cents to produce and lasts only about 17 months. A dollar coin, on the other hand, while costing 6 cents to produce, lasts for 30 years. About 1.8 billion dollar bills must be replaced each year. The start-up costs of switching to a dollar coin are likely to be quite high, however. These costs have not been estimated.

a. What are the projected average annual cost savings associated with switching from the dollar bill to a dollar coin?

Answer: Since each dollar bill in circulation lasts an average of 1.42 years (17/12), and 1.8 billion are replaced each year, this must mean that there are about 2.556 billion dollar bills in circulation. The cost of replacing 1.8 billion dollar bills each year at a cost per bill of 2.6 cents is $46.8 million. Since the dollar coin lasts 30 years, only about 85.2 million (2.556 billion/30) coins must be replaced each year at an annual cost of $5.1 million. Thus, the annual cost savings comes to approximately $41.7 million.

b. Taking into account only the cost savings estimated in part a, how high can the start-up costs for this replacement project be and still yield a positive NPV for the U.S. government? Use an 8 percent discount rate.

Answer: The present value of the cost savings perpetuity estimated in part a, discounted at 8 percent, is $41,700,000/.08, or $521.25 million. Hence, the start-up costs for replacing the dollar bill with a dollar coin can be as high as $521.25 million in present value terms and this project will still yield a positive net present value.


5. Recent Census Bureau data show that the average income of a college-educated person was $34,391 versus $24,701 for those without college. At the same time, the annual tuition at public universities was $1,566 versus $7,693 for private colleges. In the following questions, assume there is no difference in income between public and private university graduates.

a. Based on these figures, what is the payback period for a college education, taking into account the four years of lost earnings while being in college? Do these calculations for both public and private colleges.

Answer: Based on the figures presented, the lost income during four years of college is 4 * $24,701 = $98,804 (if they don’t go to college they earn non-college incomes). The cost of the four years of college at a public (private) university is $6,264 ($30,772). Combining these figures yields a total (undiscounted) cost for a public university of $105,068. For a private college, this cost comes to $129,576. The income advantage to a college education is $9,690 ($34,391 - $24,701). From graduation, it takes 105,068/9,690 = 10.84 years to recover the cost of a public university education. The equivalent figure for a private college is 129,576/9,690 = 13.37 years.

b. Assuming college graduation at age 22 and retirement at age 65, what is the internal rate of return on a college degree from a public university? a private university?

Answer: For a public university, the cash flows are four years of annual net cash outflows equal to $26,267 ($1,566 + $24,701) and then 43 years of net cash inflows equal to $9,690 annually. Whether all these cash flows occur at the beginning or end of the year, the IRR equals 7.89 percent (the timing of the cash flows doesn’t matter because you are just multiplying the NPV—which must equal zero—by a constant).

For a private university, the cash flows are four years of annual net cash outflows equal to $32,394 ($7,693 + $24,701) and then 43 years of net cash inflows equal to $9,690 annually. The IRR based on these numbers is 6.32 percent.

c. Assuming a 7 percent discount rate, and the same working life as in part b, what is the net present value of a college degree from a public university? a private university?

Answer: Assuming all cash flows occur at the end of the year (here the timing does matter), the NPV for a public university education is $10,878. For a private college, the NPV is -$9,876.

6. The Fun Foods Corporation must decide on what new product lines to introduce next year. After-tax cash flows are listed below along with initial investments. The firm’s cost of capital is 12 percent and its target accounting rate of return is 20 percent. Assume straight-line depreciation and an asset life of five years. The corporate tax rate is 35 percent. All projects are independent.


Project Investment Year 1 2 3 4 5ABC

$5,0007,5004,000

$8001,250

600

$1,0003,0001,200

$3502,5001,200

$1,2505,0002,400

$3,0005,0003,000

a. Calculate the accounting rate of return on the project. Which projects are acceptable according to this criterion? (Note: Assume net income is equal to after-tax cash flow less depreciation.)

Answer:

Project A Project B Project CTotal AT Cash Flow

6400 16750 8400

Total Depreciation 5000 7500 4000Net Income 1400 9250 4400Avg Net Income 280 1850 880

Acctg Rate of return (Average Net Income /Average Book Inv)ABI = Total depreciation/2.11.2% 49.3% 44%

Projects B and C are acceptable based on a 20% accounting rate of return.

b. Calculate the payback period. All projects with a payback of fewer than four years are acceptable. Which are acceptable according to this criterion?

Answer: Assuming depreciation effects are included in the cash flows:Payback A (years) = 4.53, Payback B = 3.15, Payback C = 3.42.Projects B and C are acceptable.

Assuming depreciation has not been included:Payback A (years) = 4.06, Payback B = 2.73, Payback C = 3.06.Projects B and C are acceptable.

c. Calculate the projects’ NPVs. Which are acceptable according to this criterion?

Answer: NPV = PV(After Tax Cash Flows) ─ Initial InvestmentAssuming depreciation has already been incorporated:NPV A = ─$742.72, NPV B = $3801.83, NPV C = $1574.01.Projects B and C are acceptable.

If depreciation has not been incorporated, and all writeoffs can be used:NPV = PV(After Tax Cash Flows) ─ Init Inv + PV(Depr Tax Shield)NPV A = $518.95, NPV B = $5694.34, NPV C = $2583.34.


All projects are acceptable.


d. Calculate the projects’ IRRs. Which are acceptable according to this criterion?

Answer: IRR is the discount rate that makes NPV = 0.Depreciation included:IRR A = 7.0%, IRR B = 27.0%, IRR C = 23.37%Projects B and C are acceptable. (IRR > 12%)

Depreciation not included:IRR A = 15.43%, IRR B = 34.23%, IRR C = 30.50%All projects are acceptable. (IRR > 12%)

e. Which projects should be chosen?

Answer: The firm should follow the guidelines of the NPV rule.

7. Aptec, Inc., is negotiating with the U.S. Department of Housing and Urban Development (HUD) to open a manufacturing plant in South Central L.A., the scene of much of the rioting in April 1992. The proposed plant will cost $3.5 million and is projected to generate annual after-tax profits of $550,000 million over its estimated four-year life. Depreciation is straight-line over the four-year period and Aptec’s tax rate is 35 percent. However, given the risks involved, Aptec is looking for a tax-exempt government subsidy. According to Aptec, the subsidy must be able to achieve any of the following four objectives:(1) Provide a 2-year payback.(2) Provide an accounting rate of return of 35 percent.(3) Raise the plant’s IRR to 22 percent.(4) Provide an NPV of $1 million when cash flows are discounted at 18 percent.

a. For each alternative suggested by Aptec, develop a subsidy plan that minimizes the costs to HUD of achieving Aptec’s objective. You can schedule the subsidy payments at any time over the four-year period.

Answer. Here are the alternatives with their costs:Payback. The annual cash flows are the sum of after-tax profits plus depreciation of $306,250 (0.35*$3,500,000/4), or $856,250. The sum of the first two years’ cash flows is $1,712,500. To bring the payback to two years will require a subsidy of $1,787,500 ($3,500,000 - $1,712,500). Since the computation of payback is insensitive to when the subsidy is paid, as long as it happens within the two-year period, the present value of its cost can be minimized by providing it at the end of year 2.

ARR. The accounting rate of return is 31.43% (550,000/1,750,000). In order to bring this up to 35%, it is necessary to bring average annual income up to $612,500 (0.35*1,750,000), an average annual increase of 62,500. The subsidy will equal $250,000 (62,500*4). Since the computation of ARR is insensitive to when the subsidy is received, its present value can be minimized by providing it at the end of the four years.


IRR. With a subsidy of $1,365,000 at time 0, thereby lowering its net investment to $2,135,000, Aptec will get its IRR up to 22%. Any delay will result in a correspondingly higher required subsidy (it will accrue at the rate of 22% annually. For example, if the subsidy were to be provided at the end of the first year, it would have to equal $1,665,300 ($1,365,000 ? 1.22) to get Aptec’s IRR up to 22%. Hence, HUD will minimize its costs of getting Aptec’s IRR up to 22% by providing the subsidy immediately instead of waiting.

NPV. The NPV of the project, discounted at 18%, is (1,196,635). Hence, a subsidy equal to $1,196,635 that is paid up front will just provide a zero NPV when discounted at 18%. The subsidy will rise at the rate of 18% annually if it is paid in a future year.

b. Which of the four subsidy plans would you recommend to HUD if it uses a 15 percent discount rate?

Answer. The winning subsidy plan is that associated with the ARR criterion. By paying $250,000 at the end of the four-year period, the present value of HUD’s cost when discounted at 15% will be $142,938.

8. The Fast Food chain is trying to introduce its new Hot and Spicy line of hamburgers. One plan (S) will include a big media campaign but less in-house production capability. The other plan (L) will concentrate on a more gradual roll-out of the project but will involve more investment in personnel training and so forth. The cost of capital is 15 percent. The cash flows ($000) are listed below. The initial investment for each is $400,000.

Plan Year 1 2 3 4 5SL

$250100

$250125

$150200

$100250

$ 50125

a. Construct the NPV profiles for plans S and L. Which has the higher IRR?

Answer: Plan S has NPV(000’s) = $187.09 and IRR = 39.28%, Plan L has NPV(000’s) = $118.06 and IRR = 25.63%. Plan S has the higher IRR.

b. Which plan should Fast Food choose using the NPV method?

Answer: Plan S also has the higher NPV.

c. Which plan (S or L) should Fast Food choose? Why?

Answer: Under either criterion, Fast Food should choose Plan S.


d. At what cost of capital will the NPV and the IRR rankings conflict?

Answer: For this discount rate (15%), the NPV and IRR do not conflict. To find the discount rate where a conflict might occur, calculate the discount rate that makes the present value of the difference in cash flows zero. In this case, the cash flow differences are:

Year 1 2 3 4 5Diff $150 $125 ─$50 ─$150 ─$75

Inspection reveals that the present value is zero when the discount rate is zero. NPV and IRR give identical recommendations for all positive discount rates in this example.9. The Roost Corp. is considering a multiple-use dockside complex in a major lakeside city.

Roost uses accounting rate of return as its sole capital-budgeting criterion. The sales and expenses (excluding depreciation) are as follows ($000):

Year 1 2 3 4 5SalesExpenses

$800700

$5,0003,500

$15,000 10,500

$25,000 17,500

$25,000 18,500

Investment in the project is $40 million today and the accelerated depreciation schedule applicable to this project is

Year 1 2 3 4 515% 22% 21% 21% 21%

a. Should Roost accept the project using straight-line depreciation? Assume a target rate of return of 15 percent. Its tax rate is 40 percent.

Answer: We assume that Roost Corp. has sufficient income to take full advantage of the tax shields afforded by depreciation.

Year 1 2 3 4 5After Tax Income 180 900 2700 4500 3900SL Depr 8000 8000 8000 8000 8000ACC Depr 6000 8800 8400 8400 8400SL Net Cash Flow 3380 4100 5900 7700 7100ACC Net Cash Fl 2580 4420 6060 7860 7260

Under straight-line average book value is the same, namely $20,000. Average after tax income is $2556, and average annual depreciation is $8000. The accounting rate of return is (2556 ─ 8000)/20,000 = ─27.22%. The project would be rejected on this basis.


b. Would your answer to (a) change if Roost used accelerated depreciation?

Answer: Accelerated depreciation results in the same numbers.

c. With a cost of capital of 10 percent, would the project have a positive NPV under straight-line depreciation? Under accelerated depreciation?

Answer: With a cost of capital of 10%, the present value of the net cash flows under straight-line depreciation is $20.56M. Under accelerated depreciation, the figure comes to $20.43M. Note that “accelerated depreciation” does not improve the present value in this problem. Neither method of depreciation justifies the $40M expense; the net present value is negative regardless of the depreciation method chosen.

10. Sweet Delights Co. is considering a marketing policy for its brand of chocolates. Two mutually exclusive advertising strategy changes are under consideration. The cash flows associated with each are as follows. The cost of capital for Sweet Delights is 10 percent.

Strategy Year 0 1 2 3 4 5

B-80-40

+40+20

+40+20

+40+20

-+20

-+20

a. Which of the two strategies would you prefer if neither decision can be repeated (i.e., all future strategies/ decisions are expected to have zero NPVs)?

Answer: If neither decision can be repeated, then one should choose the strategy with the highest NPV. For plans A and B, the NPV’s are 19.47 and 35.82, respectively. Therefore, plan B would be preferred.

b. Which of the two strategies would you prefer if each strategy can be repeated as often as possible?

Answer: If each strategy can be repeated as often as possible, one should calculate the equivalent annual benefit derived from each of the proposals. Equivalent Annual Benefit * PVIFA = NPV.

Plan A BSummary of NPV

19.47

35.82

Results: Years

3 5

PVIFA 2.48 3.79EAB 7.83 9.45

Plan B would be preferred in this instance as well.


CHAPTER 2: SPECIAL PROBLEM1. Owen Corporation plans to purchase a new machine that costs $120,000, has six years of

economic life, and generates a net annual cash flow of $40,000 at the end of years 1-6 (all cash flows have taken into account depreciation and taxes). The firm also has the option to sell the machine at the end of years 1-6. The following are the net cash flows Owen will receive from the sale of the machine at the end of each year.

End of Year Net Cash Flow From Sale123456

$100,000 85,000 75,000 60,000 30,000

0

The manager wants to determine an optimal replacement policy for the machine. Once a policy has been adopted, it will be implemented perpetually because it is assumed that the cost of the machine, the cash inflows, and the net cash flow from selling the old machines will be the same over time. Determine the optimal policy, assuming a 12 percent discount rate.

Answer: The optimal replacement policy for the machine requires that the machine be sold on the date that maximizes the equivalent annual benefit derived from running the machine. For example, if the machine is placed in service for 3 years only, the cash flows are:

Year 1 2 3Cash Flow $40,000 $40,000 $40,000+75,00

0 = $115,000

With an initial investment of $120,000, the NPV at r=12% is given by $29,456.77. On an annual basis, this represents a $12,264.30 benefit. This fact follows from the equation:

NPV = Equivalent Annual Benefit * PVIFA


The table below summarizes the results for all possible service lives:

Termination Year NPV EAB

1 5,000.00 5,600.002 15,363.52 9,090.573 29,456.77 12,264.3

04 39,625.06 13,045.93*

5 41,213.85

11,433.12

6 44,456.29

10,812.91

The maximal equivalent annual benefit is realized when the machine is replaced every four years.

CHAPTER 3: QUESTIONS1. A new investment project is to demolish an existing gas station and construct a small

shopping mall. Which of the items should be treated as incremental cash flows relevant to the investment decision? a. The current value of the land. b. The current value of the gasoline-retailing business. c. The cost of wrecking the gas station, digging up the tanks, and cleaning the land. d. The cost of new antipollution devices installed by order of the local government six

months ago. e. Lost earnings on other real estate projects owing to staff time that will be spent if the

mall is built. f. An allocated portion of the depreciation from the company’s headquarters building. g. The fee that has already been paid to an architect for designing the mall. h. Future noncash expenses such as depreciation that will result if the mall is built. i.

Allocation of corporate overhead to the project.

Answer: The incremental cash flows relevant to the decision include items a, b, c, e, and h. The current value of the land (a) is used by both the gas station and the mall. However, the land may be sold; therefore, its value is incremental (as an opportunity cost). Items (d) and (g) are sunk costs. Items (f) and (i) represent suspicious allocations of corporate overhead to the mini-mall project.

In effect, the owner must examine the following three alternatives and select the one with the maximum value:

i) Keep the gasoline business and either continue to operate it or sell it to someone else. ii) Tear the gasoline station down and selling the land. iii) Tear the gasoline station down and put up the shopping mall.


2. A soft drink bottler is trying to determine the present value of its business in an area where it forecasts no growth in unit sales. Sales this year will be $10 million and expenses will be $9

Chapter 3: Estimating Project Cash Flows

million. The present rate of return required is 20 percent, and inflation is expected to be 10 percent indefinitely.

The company president believes that the present value of the business is $5 million, that is, $1 million per year discounted at 20 percent. His assistant argues that the present value is $1 million divided by 10 percent, the expected real interest rate. This yields an NPV of $10 million. What is the correct solution to the valuation problem?

Answer: We interpret the phrase “no growth” to refer to lack of unit sales growth. The price of soft drinks and the corresponding expenses are assumed to grow at the average rate of inflation. The assistant is correct; real cash flows should be discounted at real interest rates. We expect to have $1M in earnings in the next year. In real terms, this represents $1M/(1.10) = 0.909M, since the one year inflation rate is 10%. If these earnings continue to grow at the rate of inflation, then they will be constant in real terms, so we discount the level perpetuity of 0.909M at the real interest rate of 9.09% (Note that (1 + nominal rate) = (1 + real rate)(1 + expected inflation). The NPV is $10M (=0.909M/0.0909).

3. In late 1985, Donald Trump, the New York real estate developer, unveiled a plan to build the tallest building in the world on Manhattan’s West Side as the centerpiece of a commercial and residential complex to be known as Television City. He bought the land in 1981 for only $81 million. By 1985, its estimated value was $2 billion. “I can do things that no one else can do because I got the land so cheap,” said Trump. The Donald is (was?) very rich, but is he correct?

Answer: Perhaps Donald Trump presents a different face to the public. If he uses $81M as the cost of the property, any investment will look profitable, even the simple strategy of selling the undeveloped property for $2B. Other development strategies have to compete against this simple strategy; they will not look as profitable in this light. In other words, the present value of the marginal benefits of any development project he undertakes should exceed the present value of the marginal costs of the development. The calculation of marginal benefits will not include the tremendous increase in the value of the land.

Consider the following example. Suppose the present value of the benefits of a proposed real-estate project is $100M. How should Trump determine its NPV?

A. $100M ─ $81M = $19 MillionB. $100M ─ $ 2B = ─$1.9 Billion

Method A is consistent with Trump’s statement. Method B, however, is correct.

4. In May 1992, IBM announced plans to resell the ultra-powerful PCs of Parallan Computer. However, according to one analyst, “In pushing into increasingly powerful and expensive PCs, IBM runs the risk of cannibalizing its own sales of minicomputers.” How should this possibility be factored into IBM’s investment decision?


Answer: Answer. The real question that IBM should raise is not whether it will lose sales of its existing minicomputers but what will happen to sales if it doesn’t sell Parallan’s PCs. In other words, the relevant consequence of sales of Parallan’s PCs for capital budgeting purposes is the incremental effect of any cannibalization that occurs—which equals the lost profit on lost sales that would not otherwise have been lost had the new product not been introduced. Those sales that would have been lost anyway should not be counted a casualty of cannibalization.In general, a project’s incremental cash flows can be found only by subtracting worldwide corporate cash flows without the investment—the base case—from post-investment corporate cash flows. To come up with a realistic base case, and thus a reasonable estimate of incremental cash flows, the key question that managers must ask is, “What will happen if we don’t make this investment?” The critical error made by many companies is to ignore competitor behavior and assume that the base case is the status quo. But in a competitive world economy, the least likely future scenario is the status quo. A company that opts not to come out with a new product because it is afraid that the product will cannibalize its existing product line is most likely leaving a profitable niche for some other company to exploit. Sales will be lost anyway, but now they will be lost to a competitor. Similarly, a company that chooses not to invest in a new process technology because it calculates that the higher quality is not worth the added cost may discover that it is losing sales to competitors who have made the investment. In a competitive market, the rule is simple: If you must be the victim of a cannibal, make sure the cannibal is a member of your family.

Failure to heed this rule led IBM to slight investment in and sales of small computers despite the challenge from personal computers, minicomputers, and workstations; small computers looked less profitable to sell than IBM’s mainframes. Instead of trying to figure out a way to compete in a world in which the advent of the microprocessor, and the powerful personal computers and workstations it helped create, turned computer hardware into a low-margin commodity product, IBM tried to protect its profitable mainframe business by slowing down or axing products that were even vaguely competitive with its mainframes. For example, in the mid-1970s, IBM researchers pioneered reduced instruction-set computing, or RISC, a revolutionary technology for designing faster computers. But the advance wasn’t rushed into products, largely because it was seen as a menace to IBM’s mainframe business. Competitors like Sun Microsystems, Dell, Compaq, and Hewlett-Packard, with no mainframe business of their own to protect, took advantage of IBM’s inertia by running rings around it in the personal computer and workstation markets (Sun harnessed RISC technology to now lead in RISC-based workstations), stealing sales from its mainframe business anyway. By trying so hard not to cannibalize its mainframes, IBM lost sales and profits to its competitors.

In contrast to IBM, Intel is a model cannibal. Once threatened by copycats cloning its popular 80386 chip, the semiconductor giant responded aggressively. Intel slashed prices, undercutting the cloners, then rolled out a better generation of chips that will eventually make its old lines obsolete. According to one analyst, “Intel said to competitors: ‘You’d better run as fast as we are, because we’re destroying the pavement behind us as we move along.’ They plundered and burned the 386 market. Trashed it. Destroyed it.” If IBM fails to sell Parallan’s PCs because of a fear of cannibalization, it will likely just be repeating its past errors.


5. Flexible manufacturing systems enable companies to respond quickly to emerging market trends and to easily accommodate product redesigns as technology changes. What is there in these advantages that sometimes leads companies applying the traditional discounted cash flow analysis to under-invest in such systems? That is, why do companies sometimes underestimate the value of flexible manufacturing systems in the sense of assigning negative NPVs to positive NPV projects?

Answer: Flexible manufacturing systems are often costly, difficult to administer, and hard to defend in the short term. However, they make it easier for a company to adapt to a changing technological and business environment and a more competitive marketplace. That is, they give companies options that would otherwise might not exist. With such systems in place, the firm will find it easier to enter and capture niche markets as they emerge. The relevant base case may not be the status quo, but rather, an anticipated decline in sales following competitors’ adaptations to the new technology. This ease of adaptation has a value to the firm; it may make all future investments more profitable. Firms may underestimate NPV when they fail to take the option-like characteristics of the new technology into account, and mistakenly assume that the status quo will be maintained in the absence of adaptation.

6. Many companies are now installing marketing and sales productivity (MSP) systems that automate routine tasks and gather, update, and interpret data that were either scattered or uncollected before. These data include information about every sales lead generated, every sales task performed, and every customer prospect closed or terminated. Describe some of the direct costs and benefits that might be associated with an MSP system. What are some intangible benefits of an MSP system as well as some hidden costs of implementing such a system?

Answer: An MSP system delivers tangible productivity gains, like reducing paper work, improving the quality of telephone campaigns by pre-qualifying sales leads, and increasing sales force productivity by reducing the time salepeople spend on non-selling tasks (such as scheduling sales calls, compiling sales reports, generating proposals and bids, and entering orders). Intangible benefits are more difficult to quantify, but may be more important in the long run. An MSP system tracks every one of a company’s marketing and sales activities, from advertising that generates sales leads to direct mail and telephone qualification of the leads to closing the first sale—all the way through the life of each account. By analyzing the data the MSP system gathers—data that were previously unavailable—marketing and sales management are now able to relate marketing actions with marketplace results. As such, an MSP system can improve the timeliness and quality of marketing decision making and lead to more responsive customer service and deeper understanding of customers. MSP systems also reduce marketing inertia because they streamline the implementation of marketing programs. Moreover, by linking orders, services delivered, and prices paid with the actual costs of lead generation, preselling, closing, distribution, and post sale support, MSP systems furnish the tools for analyzing and adjusting the marketing mix (personal selling, direct mail, telemarketing, advertising, pricing, other promotional efforts) and product mix.


The direct costs of such a system include the cost of the computer and telecommunications hardware, the software, and the cost of tying all those pieces together. Expensive as these direct costs are, the hidden costs can double or even triple the overall cost. These hidden costs include system customization, expert consulting, and end-user training. Moreover, because malfunctioning of an automated marketing system can threaten a business’s revenue stream, most companies will probably have to run both systems—automated and manual—until the network has proved out .

7. Accrued pension benefits represent an obligation of a company for the past service of its employees. No current or future action can affect this obligation. The amortization of accrued pension benefits must be recognized, however, as a current expense in the company’s financial statements. Many companies turn around and allocate these costs to divisions. One company allocated these costs in proportion to pension benefits accrued by its workers. A plant with an older work force received almost all of its division’s accrued pension costs, adding $4 per hour to the plant’s labor cost relative to the cost of several newer plants with much younger workers.

a. How is this allocation of accrued pension benefits likely to affect future investment decisions? The competitiveness of products manufactured by the plant?

Answer: Some positive NPV future investment decisions may be foregone if the divisions assign accrued pension benefits to the projects considered. Pension obligations committed in the past represent sunk costs. Also, the division in a competitive environment will be expected to show strong profits net of accrued pension benefits. In a competitive market, the firm may not be able to cut price enough to retain market share if it is required to price high enough to cover its accrued pension liabilities.

b. Suppose that because of its high labor costs, the company decided to shut down the older plant and shift work to the newer ones. How will this decision affect the company’s competitiveness?

Answer: The company must still meet its accrued pension obligation. It is possible that the shut-down will improve the company’s competitiveness, but the merits of this decision should be evaluated in the absence of lower apparent accrued pension costs. It is more likely that the company would become less competitive; older workers may be more skilled and/or more productive than their younger counterparts.

c. How should the company treat accrued pension benefits for investment, product sourcing, and pricing purposes?

Answer: The company should treat existing pension benefits as (sunk) overhead. For pricing purposes, it should examine only the marginal addition to pension liability that a project will cause, and allocate only this cost to the project.


8. Starshine Products is considering the launch of a new line of dolls that would use an assembly line that currently has some spare capacity. Some Starshine executives argued that because the assembly line was already paid for, its cost was sunk and should not be included in the project evaluation. Others argued that the assembly line was a scarce resource and should be priced accordingly. What cost should Starshine assign to use of the excess assembly line capacity?

Answer: The cost associated with the additional use of the line due to the new project should be allocated to the new project. This includes, but is not limited to, the additional costs of power, labor, maintenance and repair, changes in expected replacement costs incurred earlier by additional use, and any opportunity costs of the line usage. For example, are there other potential future uses of the spare capacity, e.g. sales growth of the current product line? The answer depends upon the alternative uses of the assembly line.

9. In order to produce its new line of canned foods, Hammond Foods must purchase a specialized piece of equipment that has the capacity to fill a million cans annually. Suppose Hammond plans to initially produce 150,000 cans annually. Some executives argued that the new product line should be charged for only 15 percent of the cost of the new equipment. Others argued that it should bear the full cost of the special-purpose machinery. Who is right? Explain.

Answer: It would be appropriate to charge the full cost of equipment against the project’s benefits provided there is no other user. Clearly, the machine (the remaining 85%) would not be purchased in the absence of this production decision; it represents a truly incremental cash flow. Also, to the extent that the extra capacity gives the company an option to cheaply expand production, the option value should also be included in the purchase/production decision.

10. Happy Tub makes traditional cast-iron bathtubs. However, the company was thinking of adopting a novel proprietary casting process to make lighter bathtubs that could compete better against plastic ones which were eating into sales, while also reducing raw materials costs. The $25 million investment seemed wise from a marketing perspective, but its NPV came to -$3 million. What other factors should you consider in light of the following assumptions that entered into this figure?

a.The base case implicitly assumed that sales would stay the same without the new investment.

b.Happy Tub has two plants, both running below capacity. Since just one plant would be upgraded, however, only products made at that plant would benefit from the new efficiencies. Thus, the finance director used a high discount rate to reflect the highly uncertain volumes and costs savings from using the new process.

c. Happy Tub used a standard ten-year life to evaluate the new project. Since ten years was


also the standard life over which plant and machinery were depreciated, the finance director inserted a zero terminal value for the upgraded plant.

d.Happy Tub ignored the other opportunities that the introduction of the proprietary casting process might create since these opportunities were purely speculative.

e. Although the proprietary casting process promised quality improvements, the investment analysis assumed that any sales of the new bathtub would just replace sales of Happy Tub’s cast iron tubs. The analysis considered the cost savings from reduced raw materials usage to be the only source of project gains.

Answer: CHAPTER 3: PROBLEMS

1. TelCo must decide whether to replace a computer system with a new model. TelCo forecasts net before-tax cost savings from the new computer over five years as given below (in $000). It has a 12 percent cost of capital, a 35 percent tax rate, and uses straight-line depreciation.

Year 1 2 3 4 5($) 350 350 300 300 300

a. The new computer costs $1 million but TelCo is eligible for a 15 percent investment tax credit (ITC) in the first year. The ITC reduces Telco’s taxes by an amount equal to 15 percent of the equipment’s purchase price. In addition, the old computer can be sold for $450,000. If the old computer originally cost $1.25 million and is three years old (depreciable, not economic, life is five years), what is the net investment required in the new system? Assume that there was no ITC on the old computer and that both computers are being depreciated to a zero salvage value.

Answer: All figures are in thousands. The net investment in the machine can be found by the following equation:

Net Inv = Cost - Salv(Old) + Tax from sale of Old = 1000 - 450 - 0.35(50) = $532.50.

The book value of the old machine was $500, but it can be sold for $450, at a $50 loss. The writeoff is worth 0.35(50) = $17.50 to the company. This reduces the effective investment in the new machine.

b. Estimate the incremental operating cash flows associated with the new system.

Answer: The incremental cash flows can be found by calculating:


Incr Cash Flow = After Tax Savings + t * (Net Depreciation)

c. If the new computer’s salvage value at the end of five years is projected to be $100,000, should TelCo purchase it?

Answer: If the computer has a salvage value after 5 years, and is sold at that time, the book value will be zero, and the company will have to pay a tax of 0.35 * 100 = $35 at that time. This changes the marginal cash flow to 265 + 100 - 35 = $330 in year 5.

The present value of the marginal cash flows (at 12%) is $899.19. The net present value is 899.19 - 532.50 = $366.70. The new computer should be purchased.

2. New diesel locomotives will cost a railroad $600,000 each and can be depreciated straight-line over their five-year life. Using a diesel instead of a coal-fired steam locomotive will save $12,000 annually in operating expenses. Railroads have a required rate of return of 10 percent and a tax rate of 40 percent.

a. What is the maximum price a railroad would be willing to pay for a coal-fired steam locomotive? (Hint: Set up the cash flows for a coal-fired locomotive at a price of P, including depreciation, and then compare them to the incremental cash flows associated with a diesel costing $600,000.)

Answer: PVIFAr=10%,n=5 = 3.790787.Consider the decision to switch from coal-fired steam locomotives to diesel locomotives. We will find the indifference point by assuming that the net present value of the switching decision is zero.

All figures are reported in thousands. The incremental cost is (600 ─ P). Annual incremental cash flows = (1─t)(Savings) + t(Incr Depr). = 0.6(12) + 0.4(120 ─ 0.2P) = 55.2 ─ 0.08P. The present value of the incremental cash flows is PVIFA´(55.2 ─ 0.08P) or 209.251442 ─ 0.303263P. Setting this expression equal to 600 ─ P, we solve for P = $560.826. This makes NPV = 0.

b. Will your answer to (a) change if the railroad has enormous tax-loss carryforwards that put it in a zero taxpaying position for the foreseeable future?

Answer: Enormous tax loss carryforwards make the effective tax rate equal to zero. Therefore, the annual incremental cash flow is $12, and its present value is 12 ´ 3.790787 = 45.4894. Setting this equal to the marginal cost of (600 ─ P), we get P = $554,511. The value of the cost savings obtained by the purchase of diesel locomotives is higher, since the savings are not taxed. This makes the diesel relatively more valuable in this instance.

3. Varico produces HO-scale trains, including a diesel locomotive that sells 100,000 units annually. Each unit requires an electric motor. Presently these are purchased once a week


from a local manufacturer for $10 apiece. However, a foreign firm has offered to sell Varico a container of 100,000 motors of like quality for only $9.50 apiece. Given an interest rate of 15 percent, what should Varico do?

Answer: By buying 100,000 motors today, the firm will have average inventory on hand of 50,000 during the year. The opportunity cost of maintaining this inventory equals

Average Number of Units on

Hand

x Price Per Unit x Interest Rate

= 50,000 x $9.50 x 0.15 = $1,250

By buying weekly, the firm incurs no interest expense. Thus, the real cost of buying 100,000 motors today is $950,000 + $71,250 = $1,021,250. This exceeds the $1M that it costs to buy motors at $10 apiece on a weekly basis.

4. To capitalize on consumers’ concerns about healthful food, Specific Foods, Inc., is considering a new cereal, Veggie Crisp, which contains small bits of cooked vegetables with bran flakes. As part of its cash flow analysis, the finance department has made the following forecasts of demand and cost: a. Sales revenue for the first year will be $200,000 and increase to $1,000,000 the next

year. Revenue will then grow by 15 percent a year for the next four years, remain the same in the seventh year, and then decline by 15 percent a year for the next three years, when the product will be terminated.

b. Cost of goods sold will be 60 percent of sales. c. Advertising and general expenses will be $10,000 a year. d. Equipment will be purchased today for $1,250,000 and will be depreciated over the ten-

year project using the straight-line method. Installation cost today is $25,000, and this is depreciated over five years, also on a straight-line basis. The equipment has no salvage value. Other initial costs (which are expensed, not depreciated) total $875,000. There is no investment tax credit.

(i). Calculate net income and operating cash flow using a 35 percent tax rate.

Answer: The income and cash flow statement ($000’s) appears below (rounded mercilessly: Total PV is accurate to decimal places shown)

Year 1 2 3 4 5 6 7 8 9 10Sales 200 1000 1150 1323 1521 1749 1749 1487 1264 1074CGS 120 600 690 794 913 1049 1049 892 758 644

Adv/Gen 10 10 10 10 10 10 10 10 10 10Depr (Equip) 125 125 125 125 125 125 125 125 125 125

Depr(Inst) 5 5 5 5 5 0 0 0 0 0


OCF 91 299 338 383 434 492 492 424 366 317PV(r=10%) 83 247 254 261 270 278 252 198 155 122

Tax rate = 35% Total PV = $2120.065

b. Find the net present value of the project using a 10 percent cost of capital. Answer: Cost today = 1250 + 25 + 875(1 ─ 0.35) = $1843.750.NPV($000’s) = 2120.065 ─ 1843.750 = $276.315.The project should be accepted.

c. In an effort to adjust for inflation, the finance department has produced an alternative estimate of cash flows. The product price will remain the same, but advertising and general expenses will grow by 5 percent a year from its initial level of $10,000. In addition, the cost of goods sold will grow by 20 percent a year from its initial level of $600,000 until year 6, remain the same in year 7, and then decline by 15 percent a year through year 10. What is the project’s net present value under these assumptions?

Answer: Under the new cash flow estimates, the project should be rejected:

Year 1 2 3 4 5 6 7 8 9 10Sales 200 1000 1150 1323 1521 1749 1749 1487 1264 1074CGS 120 600 720 864 1037 1244 1244 1058 899 764Depr(Equip)

10 11 11 12 12 13 13 14 15 16

Depr(Inst)OCFPV(r=10%)

┌─────────┬─────────────────────────────────────────────┐ │Year │ 1 2 3 4 5 6 7 8 9 10 ││Sales │200 1000 1150 1323 1521 1749 1749 1487 1264 1074 ││CGS │120 600 720 864 10371244 1244 1058 899 764 ││Adv/Gen │ 10 11 11 12 12 13 13 14 15 16 ││Depr(Equip) │ 125 125 125 125 125 125 125 125

125 125 ││Depr(Inst) │ 5 5 5 5 5 0 0 0 0 0 ││OCF │ 91 299 318 336 352 364 363 314

271 235 ││PV(r=10%) │ 83 247 239 229 219 205 186 146 115

91 │└─────────┴───────────────────────────────────┘Tax rate = 35% Total PV = $1760.160 NPV($000’s) = 1760.160 ─ 1843.750 = ─$83.590.

5. In building a new facility for producing trucks, International Truck (IT) must estimate the total investment required. In the current year, IT estimates it will acquire land for the plant at $1,000,000 and modify existing plant equipment for $123,000. Next year, construction will begin and require $866,000, and further plant modifications will require $344,000. In addition, new equipment worth $140,000 will be purchased (with a 10 percent investment tax credit). The new equipment will require $250,000 of installation expense. Finally, in the next year, construction will be completed at a cost of $750,000; installation charges will total $229,000; and building modifications will require $350,000. Lastly, more new equipment will be purchased for $230,000 (with a 10 percent ITC). With a cost of capital of 10 percent, what is the present value of the initial investment required for the plant?

Answer: Year 0 1 2Land 1,000,000Modification 123,000Construction 866,000 750,000Modification 344,000 350,000New Equipment 126,000* 207,000*Installation 250,000 229,000Totals 1,123,000 1,586,000 1,536,000PV (10%) 1,123,000 1,441,818 1,269,421Total PV $3,834,239*Net of investment tax credit

6. Yankee Atomic Electric Co. announced in 1992 that it would decommission its Yankee Rowe nuclear plant at an estimated cost of $247 million. The cost includes:i. $32 million to maintain the plant until 2000, when dismantling will begin. These expenses will accrue at the rate of $4 million a year.ii. $56.5 million for the cost of building a facility to store its spent fuel until it is shipped in 2000 to a permanent repository. This storage facility will be depreciated straight-line over its eight-year estimated life.iii. $158.5 million for the cost of dismantling the plant in 2000 and disposing of its nuclear wastes.At the same time, Yankee Atomic estimated that decommissioning the plant in 1992, eight years earlier than its planned retirement in 2000, will save it $116 million ($14.5 million a year) before tax by enabling the utility to purchase cheaper electricity than Yankee Rowe could provide. In addition, Yankee Atomic said it had accumulated $72 million in a decommissioning fund required by the Nuclear Regulatory Commission.

a. What is the present value of Yankee’s $247 million decommissioning cost. Assume a cost of capital equal to 12 percent and a 34 percent tax rate.

Answer: . In order to answer this question we must make some assumptions regarding the timing of the various cash flows. Assume that the maintenance and storage facility costs begin immediately in 1992. The costs associated with the storage facility include an initial outlay of $56.5 million and subsequent depreciation tax shields worth $2,471,875 annually (0.35 ? $56,500,000/8) beginning in 1993 and continuing through 2000. All cash flows are assumed to

occur at the beginning of the year, that is, the 1992 cash flows are expected to occur immediately and so on. As shown in the bottom row of this table, the present value of these net costs discounted at 12% is $160 million.

Year Maintenance Storage Facility Dismantling/Disposal Costs Total Cash Flows

1992 56,500,000 56,500,000 1993 4,000,000 (2,471,875) 1,528,125 1994 4,000,000 (2,471,875) 1,528,125 1995 4,000,000 (2,471,875) 1,528,125 1996 4,000,000 (2,471,875) 1,528,125 1997 4,000,000 (2,471,875) 1,528,125 1998 4,000,000 (2,471,875) 1,528,125 1999 4,000,000 (2,471,875) 1,528,125 2000 4,000,000 (2,471,875) 158,500,000 160,028,125 Present value @ 12% $128,106,666b. Taking into account the savings on the purchase of cheaper electricity, and the $72 million already set aside, how much additional money does Yankee Atomic have to set aside in 1992 to have enough money to pay for the decommissioning expense?Answer: The following table takes into account the savings on the purchase of cheaper electricity. Not that the annual after-tax fuel savings of $9,245,000 ($14.5 million net of tax at 35%, or $14,500,000 ? 0.65) show up with a negative sign because it is a cost reduction. The net present value of these costs as shown on the bottom line is $81.3 million. Yankee Atomic has to set aside an additional $9.3 million in 1992 to make up the shortfall ($81.3 million - $72 million).Year Maintenance Storage Facility Dismantling/Disposal Costs After-tax Fuel SavingsTotal Cash Flows1992 56,500,000 56,500,000 1993 4,000,000 (2,471,875) (9,425,000) (7,896,875)1994 4,000,000 (2,471,875) (9,425,000) (7,896,875)1995 4,000,000 (2,471,875) (9,425,000) (7,896,875)1996 4,000,000 (2,471,875) (9,425,000) (7,896,875)1997 4,000,000 (2,471,875) (9,425,000) (7,896,875)1998 4,000,000 (2,471,875) (9,425,000) (7,896,875)1999 4,000,000 (2,471,875) (9,425,000) (7,896,875)2000 4,000,000 (2,471,875) 158,500,000 (9,425,000) 150,603,125 Present value @ 12% $81,286,661c. What other factors might you consider in calculating the cost of decommissioniong?

Answer: Given the ever-stiffening environmental laws, it would make sense to take into account the likelihood that cleanup standards–and hence costs–will rise over time. At the same time, it would make sense to try to lock politicians into the decommissioning program so that it would be grandfathered in the event of tougher laws.

7. Oldham Industries is considering replacing a 5-year old machine with an original life of 10 years, a cost of $100,000, and a zero salvage value, with a new and more efficient machine. The new machine will cost $200,000 installed and will have a 10-year life. The new machine will increase sales by $25,000 and decrease scrap cost by $10,000 per year. The old machine can be sold currently at $50,000, and Oldham’s marginal tax rate is 50 percent. Assume straight-line depreciation and a 10 percent investment tax credit for both the old and the new machines. A

prorated portion of any investment tax credit must be returned to the IRS for equipment sold before the end of its depreciable life; that is, if half the equipment’s life remains, then half the ITC is reclaimed by the IRS. Assume depreciation is taken on 100 percent of the cost of equipment.a. What is the initial cash outflow generated by the machine replacement?

Answer: b. What are the annual operating cash flows generated by this project?

Answer:

c. What is the net present value of this replacement project, given a 12 percent cost of capital?

Answer: 8. Molecugen has developed a new kind of cardiac diagnostic unit. Owing to the highly competitive nature of the market, the sales department forecasts demand of 5,000 units in the first year and a decrease in demand of 10 percent a year after that. After five years, the project will be discontinued with no salvage value. The marketing department forecasts a sales price of $15 a unit. Production estimates operating cost of $5 a unit, and the finance department estimates general and administrative expenses of $15,000 a year. The initial investment in land is $10,000, and other nondepreciable setup costs are $10,000. a. Is the new project acceptable at a cost of capital of 10 percent? (Note: Use straight-line depreciation over the life of the project and a tax rate of 35 percent.) Answer: Demand Growth ─10% Price Growth 0% ┌─────────┬────────────────────────────────────┐ │Year │ 1 2 3 4 5 │ │Demand │ 5000 4500 4050 3645 3281 │ │Sales Price │ 15.00 15.00 15.00 15.00 15.00 │ │Revenue │ 75,000 67,500 60,750 54,675 49,208 │ │Costs │ 25,000 22,500 20,250 18,225 16,403 │ │Expenses │ 15,000 15,000 15,000 15,000 15,000 │ │NOI │ 22,750 19,500 16,575 13,943 11,573 │ └─────────┴────────────────────────────────────┘ Total PV = 65,960 NPV = 45,960 (Acceptable)b. If the marketing department had forecast a decline of 15 percent a year in demand, would the project be acceptable? Answer: Demand Growth ─15% ┌─────────┬────────────────────────────────────┐ │Year │ 1 2 3 4 5 │ │Demand │ 5000 4250 3613 3071 2610 │ │Revenue │ 75,000 63,750 54,188 46,059 39,150 │ │Costs │ 25,000 21,250 18,063 15,353 13,050 │ │NOI │ 22,750 17,875 13,731 10,209 7,215 │ └─────────┴────────────────────────────────────┘ Total PV = 57,224 NPV = 37,224 (Acceptable)c. If the marketing department had forecast a decline in sales price of 10 percent a year, along with the 15 percent annual decline in demand predicted in (b), would the project be acceptable?

Answer: . Demand Growth ─15% Price Growth ─10% ┌─────────┬──────────────────────────────┐ │Year │ 1 2 3 4 5 │ │Demand │ 5000 4250 3613 3071 2610 │ │Sales Price │ 15.00 13.50 12.15 10.94 9.84 │ │Revenue │ 75,000 57,375 43,892 33,577 25,687│ │Costs │ 25,000 21,250 18,063 15,353 13,050│ │Expenses │ 15,000 15,000 15,000 15,000 15,000│ │NOI │ 22,750 13,731 7,039 2,096 ─1,536│ └─────────┴───────────────────────────── ┘ Total PV = 37,796 NPV = 17,796 (Acceptable)d. If prices decline by 10 percent a year, the marketing department estimates that demand will be a constant 5,000 units a year. Is the project acceptable?

Answer: Demand Growth 0% Price Growth ─10% ┌─────────┬───────────────────────────────────┐ │Year │ 1 2 3 4 5 │ │Demand │ 5000 5000 5000 5000 5000 │ │Sales Price │ 15.00 13.50 12.15 10.94 9.84 │ │Revenue │ 75,000 67,500 60,750 54,675 49,208 │ │Costs │ 25,000 25,000 25,000 25,000 25,000 │ │Expenses │ 15,000 15,000 15,000 15,000 15,000 │ │NOI │ 22,750 17,875 13,488 9,539 5,985 │ └─────────┴──────────────────────────────────── ┘ Total PV = 55,819 NPV = 35,819 (Acceptable)9. Salterell Textiles is considering replacing the looming equipment in its North Carolina mill. The original purchase price was $79,300 two years ago. The machine has a useful life of ten years and is being depreciated using the straight-line method. The old equipment can be sold today for $10,800. The new equipment costs $80,500 and has an eight-year life. Its salvage value is expected to be $8,000. The new equipment is expected to increase output and sales revenue by $9,000 a year (after tax) and reduce costs by $7,500 (after tax). a. With a tax rate of 25 percent and a 14 percent cost of capital, what should Salterell’s decision be? Answer: NPV = PV(Revenue & Savings) + NPV(New Machine) + NPV(Old)NPV(Revenue & Savings) = (9000 + 7500) ´ PVIFr=14%,n=8= 16,500 ´ 4.6389 = $76,541.25. (after tax)NPV(New Machine) = ─Cost + PV(Depr) + PV(After tax salvage)= ─80,500 + 0.25 ´ 10,062.50 ´ 4.6389 + 8000(0.75)(0.3506 = PVIF)= ─$66,726.67.NPV(Old Machine) = [After Tax Sales Proceeds] ─ PV(Depr)= [10,800 ─ 0.25(10,800 ─ 63,440*)] ─ 7930 ´ 0.25 ´ 4.6389= $14,763.45.Overall NPV = $76,541.25 ─ 62,830.27 + 14,763.45 = $24,578.b. Would a 10 percent ITC change the analysis? Answer: A 10% Investment Tax Credit would reduce current taxes by 0.10(80,500) = $8050.

The effective NPV of the New Machine is increased to ─58,676.67, and the overall NPV is increased to $32,628.

c. If an inflation rate of 7 percent a year must be incorporated into the decision, is the project acceptable?

Answer: An inflation rate of 7% will increase nominal revenues, costs and salvage values, but will not affect depreciation or after-tax value of the sale of an existing asset (assuming the 7% inflation rate was already included in the nominal discount rate). As such, the inclusion of inflation will only make the net present value picture rosier.

10. Ross Designs is thinking of replacing its seven-year-old knitting machine with a new one that can also emboss designs on cloth. This will allow Ross to sell its textiles, which currently wholesale for $1.20 a yard, for $0.07 a yard more. The embossing should also raise sales 15 percent, to 2.07 million yards annually. The new machine costs $320,000, has annual operating costs of $27,000, and is expected to last for eight years. Labor, materials, and other expenses are estimated to rise by $0.02, to $1.10 per yard. Working capital requirements should remain at 30 percent of sales. All working capital investments will be recaptured in eight years. The current machine was purchased for $190,000 and is being depreciated on a straight-line basis assuming a 10-year life. Its economic life as of today, however, is estimated to be eight years, the same as that of the new machine. It can be sold for $70,000 today, or for an estimated salvage value of $5,000 in eight years. The new machine will be depreciated straight line over a five-year period, and has an estimated salvage value of $20,000 in eight years. The appropriate discount rate is estimated at 12 percent.a. What is the change in operating cash flows for each year? What is their present value?Answer: Here are the incremental cash flows associated with the new machine. The present value of these cash flows, discounted at 12%, is $416,409. Although it is not mentioned in the problem, the tax rate is assumed to be 35%. Note that the incremental depreciation varies from year to year, depending on the old and new depreciation schedules.

Year 1 2 3 4 5 6 7 82,628,900 2,628,900 2,628,900 2,628,900 2,628,900

2,628,900 2,628,900 2,628,900 Old sales revenue 2,160,000 2,160,000 2,160,000 2,160,000

2,160,000 2,160,000 2,160,000 2,160,000 Incremental sales revenue 468,900 468,900 468,900 468,900 468,900 468,900 468,900 468,900 Annual machine operating costs 27,000 27,000 27,000 27,000 27,000 27,000 27,000 27,000 Other costs (new) 2,277,000 2,277,000 2,277,000 2,277,000 2,277,000 2,277,000 2,277,000 2,277,000 Other costs (old) 1,944,000 1,944,000 1,944,000 1,944,000 1,944,000 1,944,000 1,944,000 1,944,000 Incremental other costs 333,000 333,000 333,000 333,000 333,000 333,000 333,000 333,000 Depreciation (new) 64,000 64,000 64,000 64,000 64,000 Depreciation (old) 19,000 19,000 19,000

Incremental depreciation 45,000 45,000 45,000 64,000 64,000 Incremental before-tax profit 63,900 63,900 63,900 44,900 44,900 108,900 108,900 108,900 Incremental tax @ 35% 22,365 22,365 22,365 15,715 15,715 38,115 38,115 38,115 Incremental after-tax profit 41,535 41,535 41,535 29,185 29,185 70,785 70,785 70,785 Incremental depreciation 45,000 45,000 45,000 64,000 64,000 Incremental operating cash flow 86,535 86,535 86,535 93,185 93,185 70,785 70,785 70,785 Present value @12% 77,263 68,985 61,594 59,221 52,876 35,862 32,020 28,589 Cumulative present value $77,263 $146,249 $207,842 $267,063 $319,939 $355,801 $387,820 $416,409b. What are the net cash flows associated with the purchase of the new knitting machine and sale of the old one?

Answer: If Ross purchases the new machine, it will have an initial outlay of$320,000 and cash receipts of $70,000 from the sale of the old machine. After seven years of straight-line depreciation, the old machine will have a book value of $57,000. Hence, Ross will have to pay tax of $4,550 on the recapture of $13,000 in excess depreciation ($13,000 x 0.35). Thus, Ross’s net cash outlay will be $254,550 ($320,000 - 70,000 + 4,550). At the end of eight years, Ross will sell its new machine for an estimated $20,000. However, since the book value will be 0, Ross will have to pay tax of $7,000 ($20,000 x 0.35) on the recaptured depreciation. This leaves Ross with a net cash inflow of $13,000 in eight years. There is one more impact of the purchase of the new machine: Ross loses the estimated $5,000 salvage value of the old machine at the end of year 8. At the same time, Ross avoids paying tax of $1,750 on the recaptured depreciation, leaving it with a net loss of $3,250. Hence, the net effect of the purchase of the new machine and sale of the old one on year 8 cash flows is a net increase in cash flow for that year of $9,750 ($13,000 - $3,250). The purchase of the new machine also affects intermediate-term cash flows through its effects on depreciation. However, these effects have already been incorporated into the operating cash flow analysis. The present value of Ross’s investment in the new machine is $250,612 ($254,550 - $9,750/1.128)c. What is the NPV of the investment in working capital?Answer: The incremental working capital requirement is 30% of incremental sales, or $140,670 ($468,900 x 0.30). Ross will recapture this investment at the end of year 8. Hence, the net present value of its incremental working capital investment is $83,856 ($140,670 - $140,670/1.128).

d. What is the NPV of the acquisition of the new knitting machine? Should Ross buy it?

Answer: Combining the answers to parts (a)-(c) yields an NPV for the new knitting machine of $81,941 ($416,409 - $250,612 - $83,856).

e. Suppose that all prices and costs are in nominal terms and will increase at the rate of inflation, which is projected at 4 percent. How does the analysis in parts (a) through (d) change? The 12 percent discount rate is expressed in nominal terms as well.

Answer: Assuming growth in costs and sales of 4% annually yields a new present value of operating profits equal to $460,514, as shown below, an increase of $44,105 compared its value before.

Year 1 2 3 4 5 6 7 8New sales revenue 2,628,900 2,734,056 2,843,418 2,957,155 3,075,441 3,198,459 3,326,397 3,459,453 Old sales revenue 2,160,000 2,246,400 2,336,256 2,429,706 2,526,894

2,627,970 2,733,089 2,842,413 Incremental sales revenue 468,900 487,656 507,162 527,449 548,547 570,489 593,308 617,040 Annual machine operating costs 27,000 28,080 29,203 30,371 31,586 32,850 34,164 35,530 Other costs (new) 2,277,000 2,368,080 2,462,803 2,561,315 2,663,768 2,770,319 2,881,131 2,996,377 Other costs (old) 1,944,000 2,021,760 2,102,630 2,186,736 2,274,205 2,365,173 2,459,780 2,558,171 Incremental other costs 333,000 346,320 360,173 374,580 389,563 405,145 421,351 438,205

Depreciation (new) 64,000 64,000 64,000 64,000 64,000

Depreciation (old) 19,000 19,000 19,000 Incremental depreciation 45,000 45,000 45,000 64,000 64,000 Incremental before-tax profit 63,900 68,256 72,786 58,498 63,398 132,494 137,793 143,305 Incremental tax @ 35% 22,365 23,890 25,475 20,474 22,189 46,373 48,228 50,157 Incremental after-tax profit 41,535 44,366 47,311 38,023 41,208 86,121 89,566 93,148 Incremental depreciation 45,000 45,000 45,000 64,000 64,000Incremental operating cash flow86,535 89,366 92,311 102,023 105,208 86,121 89,566 93,148 Present value @12% 77,263 71,242 65,705 64,838 59,698 43,631 40,515 37,621 Cumulative present value $77,263 $148,506 $214,211 $279,049

$338,747 $382,378 $422,893 $460,514At the same time, working capital requirements rise year by year at the rate of 4% annually. The present value of these increases net of their return at the end of year 8 is $94,374, as shown below. This figure is $10,518 more than its value of $83,856 under the no-inflation scenario.Year 0 1 2 3 4 5 6 7 8Incremental working capital req 140,670 5,627 5,852 6,086 6,329 6,583 6,846

7,120 (185,112)Present value @12% $140,670 $5,024 $4,665 $4,332 $4,022 $3,735 $3,468 $3,221

-$74,764Cumulative present value $140,670 $145,694 $150,359 $154,691 $158,713 $162,448

$165,917 $169,137 $94,374

The net effect of these changes is to increase the project NPV by $33,587 ($44,105 - $10,518).

Chapter 4: Real Options and Project Analysis

CHAPTER 4: QUESTIONS1. Imagine that the price of copper rises to the point that the copper value of a penny is worth more than $.01. As a result, pennies disappear from circulation. Your firm uses copper in its production process, and you can melt pennies down and retrieve their copper content at zero cost. At present, you have a six-month supply of copper reserves and you have also managed to collect 1 million pennies. Should you melt the pennies down and add the copper to your stockpile? Why or why not?Answer: The ownership of a penny is an option. If the penny is melted, the owner gets the valuable copper to sell at current market prices. However, if the owner keeps the penny, he retains the option to use it as legal tender. If the price of copper makes the penny’s copper content worth less than $.01, it is more valuable as legal tender. If the penny was melted and prices dropped, the owner may not mint a new penny. The penny is generally more valuable as an option. Hence, it should not be melted. (It is also illegal to deface or alter legal tender.)2. Will a gold mine ever be shut permanently? Why or why not? Answer: A gold mine is an option to mine the gold if the market prices make it profitable to do so. Closing a mine permanently kills the value of the option to re-open the mine if market conditions change favorably. The only time that a mine would be closed forever is when the cost of maintaining the mine (including opportunity costs) is higher than the marginal option value. If the value of the option truly drops to zero, it will be optimal to close the mine.


3. Some economists have stated that too many companies aren’t calculating the cost of not investing in new technology, world-class manufacturing facilities, or market position overseas. What are some of these costs? How do these costs relate to the notion of growth options discussed in the chapter?Answer: Executives in this situation need to consider the option values associated with new technological investment. New technologies, while often costly, difficult to administer and hard to defend in the short term, make it easier for a company to adapt to a changing technological environment and a more competitive marketplace. With technology in place, the firm will find it easier to enter and capture niche markets as they emerge. The relevant base case may not be the status quo, but rather, an anticipated decline in sales following competitors’ adaptations to the new technology.

This ease of adaptation has a value to the firm; it may make all future investments more profitable. Firms may underestimate NPV when they fail to take the option-like characteristics of the new technology into account, and mistakenly assume that the status quo will be maintained in the absence of adaptation.

4. In December 1989, General Electric spent $150 million to buy a controlling interest in Tungsram, the Hungarian state-owned light bulb maker. Even in its best year, Tungsram earned less than a 4% return on equity (based on the price GE paid). What might account for GE’s decision to spend so much money to acquire such a dilapidated, inefficient manufacturer?

Answer: Eastern Europe has the potential to be both a large market for Western goods and a low-cost manufacturing platform for export to Western Europe. But there are major uncertainties as to whether Eastern Europe will ever realize its market potential. As to manufacturing there, questions exist as to whether a workforce with 45 years experience in “they pretend to pay us and we pretend to work” can produce at the level and quality necessary to be competitive with their Western counterparts. By investing in Hungary, GE is buying an option to participate in the growth of the Eastern European market. It also is learning what it takes to install modern Western management methods in a former communist country and to use Hungary as a low-cost backdoor to Western Europe. The latter is especially critical to GE as part of its strategy to expand its weak global presence.

GE’s presence is particularly dim in the European lighting market, where it is just sixth in sales, even though historically it has dominated the U.S. market. Then came a highly successful raid on GE’s U.S. fortress by Philips, which is the world’s largest light bulb producer. GE decided to fight back by storming Philip’s European base. But GE was unable to acquire a controlling interest in any Western European firm and building a new plant would have cost at least $300 million and several years. Buying Tungsram seemed a more promising alternative, since the Hungarian firm already exported 70% of its output to the West. Thus, it offered a tempting mix of Western European market share and low Eastern European wages. In effect, by investing in Tungsram, GE is buying options on: (a) the Western European market; (b) introducing new technologies and higher-priced products to Tungsram; and (c) a low-cost export platform. In response to GE’s purchase, Philips recently took over Poland’s leading lamp producer and another Western European competitor, Siemens’ Osram unit, has acquired an East German producer.


CHAPTER 4: PROBLEMS1. A biotech firm must decide whether to purchase the patent to a new food additive, a low-cal starch substitute. It is estimated that the funds required to bring the additive to the market can be as high as $50 million or as low as $25 million. The payoff is uncertain as well: The present value of profits could be as high as $500 million or as low as $30 million. The risk-free rate is 10 percent, and the standard deviation of rate of return on biotech products is 35 percent. The patent’s life is estimated at one year. a. In a worst-case scenario, how much is the patent worth?Answer: We need to make a few assumptions to solve this problem. We assume that in one year, the present value of profits will take values of $500M and $30M with equal probability. We further assume that the risk-free discount rate is the appropriate capitalization rate for the firm.

In a worst-case scenario, the costs will be $50M. The firm will only adopt the project if NPV > 0, or PV(Benefits) = $500M. The expected net present value is 0.5(500 Ä 50) + 0.5(0) = $225M. The present value is $225M/(1.10) = $204.55M, which represents the maximum value of the patent.

b. In a best-case scenario, how much is the patent worth?

Answer: In a best-case scenario, the costs will be $25M, and the project will be adopted no matter what. The expected NPV is 0.5(500 Ä 25) + 0.5(30 Ä 25) = $240M. The present value is $218.18.

2. The managers of a firm are asked to consider two possible new product lines for the firm. Project 1 is quite risky and may result in a market value for the firm of $50 million in two years, or nothing. Project 2 is much more certain in outcome and may result in a firm market value as high as $25 million or as low as $15 million.

The face value of the company’s debt, payable in two years, is $20 million.

a. What are the possible payoffs to the bondholders under projects 1 and 2?

Answer: (Payoffs in 2 years, in millions of dollars)

PROJECT 1:Total Payoff Debt Distribution50 20 0 0PROJECT 2:

Total Payoff Debt Distribution25 2015 15b. What are the possible payoffs to the shareholders under projects 1 and 2? Answer: (Payoffs in 2 years, in millions of dollars)

PROJECT 1:Total Payoff Equity Distribution 50 30


0 0PROJECT 2: Total Payoff Equity Distribution 25 515 0c. Which will the shareholders favor? The bondholders?Answer: Shareholders will favor project 1, which provides an equal or higher payoff in each state. Bondholders favor project 2 for the same reason.3. Eastern Shallow, Ltd., is a gold mining company operating a single mine. The present price of gold is $300 an ounce and it costs the company $250 an ounce to produce the gold. Last year, 50,000 ounces were produced and engineers estimate that at this rate of production the mine will be exhausted in seven years. The required rate of return on gold mines is 10 percent. a. What is the value of the mine? Answer: The present value of the mine is the present value of 7 years of payments of $50/oz ? 50,000 oz = $2.5M, discounted at r = 10%. This present value is $12.171M.

b. Suppose inflation is expected to increase the cost of producing gold by 10 percent a year but the price of gold does not change because of large sales of stock-piled gold by foreign governments. Furthermore, imagine that the inflation raises the required rate of return to 21 percent. Now, what is the value of the mine?

Answer: If the costs rise by 10% per year while the price remains the same, we will not operate the mine after one year. In the first year, profits are (300 Ä 275) ? 50,000 = $1.25M, discounted one year at r = 21%. In the second year, profits are zero; we will not mine gold at $302.50 per ounce to sell at $300 per ounce. The value of the mine is $1.25M/1.21 = $1.033M.

c. Suppose the company may shut, reopen, or abandon the mine in response to fluctuations in the price of gold. Can the NPV method be used to value the mine under these conditions?

Answer: The NPV method can be used to determine the value of the mine if the company can choose an optimal extraction policy. The analysis requires a potentially complex decision tree formulation, and the determination of the optimal strategy as a function of the path of the price for gold. The correct solution of the problem requires option-pricing methodologies.

4. G.D. Sorrell is developing an anticancer drug. The project is in its preliminary stage. G.D.S. must decide whether to initiate a large-scale drug test costing $1.5 million a year for two years. If the test results are positive, a $17.5 million plant to produce the drug for commercial trials will be built at the end of the testing period. If commercial sales of the drug meet the company’s forecast for the next two years, a second, larger plant costing $50 million will be built to produce the drug in quantity. The cash flows resulting from this larger plant are expected to be $76 million for eight years after it is built. The following are the relevant cash flows associated with the three possible scenarios.

Year 0 1 2 3 4 5-12Scenario 1Scenario 2Scenario 3

($1,5000)*

(1,500) (1,500)

($1,500)(1,500)(1,500)

Unsuccessful(17,500)(17,500)

$3,0005,000

$2,0007,500(50,000)

Unsuccessful9,500

a. With a cost of capital of 10 percent, value the research project using DCF analysis. Is the project acceptable? (Assume the two plants are built.)

Answer: Assuming scenario 3 occurs, NPV = S Ci/(1.10)i = $5229.78M.b. Assuming that the three possible scenarios have equal probability, is the project acceptable? (Hint: Value this project as a growth option.)

Answer: In any event, $1.5M must be spent in years 0 and 1. Under scenario 1, the project is scrapped. If the test result is successful, we may purchase an option on future cash flows for $17.5M. At this point, either scenario has 50% chance of occurring. The PV of the cash flows as of year 2 for scenarios 2 and 3 respectively are $4.380M and $14.637M. In either scenario, we do not recover the $17.5M cost of obtaining the option. Therefore, the project is unacceptable in any circumstance.5. An oil company has paid $100,000 for the right to pump oil on a plot of land during the next three years. A well has already been sunk and all other necessary facilities are in place. The land has known reserves of 60,000 barrels. The company wishes to know the market value of this operation. The interest rate is 8 percent and the marginal cost of pumping is $8 per barrel. Both of these costs are expected to remain unchanged over the three-year period. The current price of oil is $10 per barrel. Company economists have estimated the following: (i) Oil will increase in price by 10 percent with a probability of 40 percent, or decrease in price by 12 percent with a probability of 60 percent during each of the next three years. (ii) The cost of storing oil in above-ground tanks is $.50 per year. (iii) The company can pump a maximum of 20,000 barrels per year at the site. (iv) The site may be shut down for a year and then reopened at a cost of $2,000. Determine the market value of the operation ignoring taxes. Assume that all cash flows occur at the end of each year. (Hint: Chart all possible sequences of oil prices, and calculate the optimal production decisions and payoffs associated with each sequence.)

Answer: The possible oil price paths are diagramed below. ┌────── 13.31

┌────── 12.10 ───────┤ │ └────── 10.65 ┌─ 11.00 ────┤ ┌────── 10.65 │ └────── 9.68 ───────┤ 10.00 ─┤ └─────── 8.52 │ ┌────── 10.65 │ ┌────── 9.68 ───────┤ └─ 8.80 ────┤ └─────── 8.52 │ ┌─────── 8.52

└────── 7.74 ───────┤

└─────── 6.81

It is never optimal to store oil above ground; the expected price appreciation is (0.4)(0.10) + (0.6)(─0.12) = ─3%. Furthermore, the cost is $0.50 per barrel per year. When oil prices are high (guaranteed to be over $8.00), it is always optimal to drill. However, at the point where prices reach $7.74, it is optimal to close. If we drill, the expected profits next year are

0.4(8.52 ─ 8.00) + 0.6(6.81 ─ 8.00) = ─0.45 per barrel. Note that there would be no point in keeping the oil; the extraction costs would be sunk. By closing, we incur a $2000 (0.10 per barrel) cost next year, and lose $0.26 per barrel in selling last year’s production.

The results are summarized as follows: Prob Cash Flow/Barrel PV Prob ́ PV

0.064 3.00,4.10,5.31 10.51 0.6725 0.096 3.00,4.10,2.65 8.40 0.8061 0.096 3.00,1.68,2.65 6.32 0.6069 0.144 3.00,1.68,0.52 4.63 0.6668 0.096 0.80,1.68,2.65 4.28 0.4113 0.144 0.80,1.68,0.52 2.59 0.3735 0.144 0.80,─.26,─.10 0.44 0.0631

0.216 0.80,─.26,─.10 0.44 ─0.0947

1.000 3.6950The value of the project is the probability-weighted sum of the present values of the paths. Project value = 20,000 ´ 3.6950 = $73,900.32. We ignored the value of the oil in the ground in case of a big price drop. If that value is less than $26,099.68, it seems the oil company paid too much for the property.

Chapter 5: Risk Analysis in Capital Budgeting

QUESTIONS1. Comment on the following statements:

a. “Because our new expansion project has the same systematic risk as the firm as a whole, we need do no further risk analysis on the project.”

Answer: Investors holding the firm’s stock in their portfolios will consider the systematic risk calculation most important. However, analysis and simulation may reveal risks hidden by the systematic risk calculation. For example, if a project might drive a firm into bankruptcy, shareholders would have to bear deadweight bankruptcy losses and the costs of financial distress in general.

b. “Our company should accept the new potash mine project at Moosejaw. The cost of additional loans to fund the project is 12 percent, and our simulations lead us to expect a 14 percent return from the project.” Answer: While the company expects a 14% return on assets, this calculation fails to determine the required discount rate for cash flows. Furthermore, the cost of debt is not necessarily equal to the project cost of capital. One needs to know what it would cost to finance the project on a stand-alone basis. The 12% cost of debt financing is based on the riskiness of the company’s assets that back the debt, not the riskiness of the project itself.


c. “It is difficult to decide whether to spend $10 million to reopen our mine because the price of gold is so uncertain. However, if we assume the price of gold grows at an average of 5 percent a year with a standard deviation of 20 percent a year, simulation indicates the mine has an average NPV of $500,000. Therefore, we should reopen.” Answer: Expected net present value was calculated in the absence of a risk adjustment. For a risk-neutral profit maximizing firm, the decision is appropriate. Since the shareholders of most firms are not risk-neutral, a discount rate different than the risk-free rate must be used.

2. Assess the impact of the following events on a firm’s operating leverage: a. an increase in output price due to increased demand. b. a decrease in fixed cost. c. negotiation of a new contract with suppliers leading to higher commitments to purchase raw

materials. d. lowered variable labor costs per unit of output. e. installation of new machine tools that lower variable production costs per unit of output.

Answer: In general, factors that increase the level of fixed costs within a firm also increase its operating leverage. Therefore, event (b) reduces operating leverage while event (c) increases operating leverage. The opposite effect prevails for variable costs. Events (a) and (d) increase the contribution margin, and therefore reduce operating leverage. Event (e) affects both fixed and variable costs; the dominant effect is uncertain.

3. Consider two firms, one American and the other Japanese, using identical production processes; that is, they use the same equipment and hire the same number of workers. However, the Japanese firm follows a no-layoff policy, whereas the American firm is willing to alter its work force in line with changing market conditions. Which company will have the larger amount of operating leverage? Why? How will the difference in amounts of operating leverage affect their marketing and production decisions and strategies? Answer: The Japanese firm will have greater operating leverage. For their firm, labor is considered a fixed cost. Increased fixed costs increase operating leverage. The American firm has the option to adjust the level of labor according to changes in market conditions. This option comes at a cost. With a lower marginal cost of production, the Japanese firm will continue to produce when the Americans lose money in production. Since their marginal cost is lower, they will sell at a lower price and seek to aggressively capture market share; they will continue to produce as long as marginal revenue exceeds marginal costs, regardless of their overall profitability. The Japanese firm will emphasize sales growth since for them, with a low marginal cost of production, revenue and profit are virtually identical.

4. The CAPM and the APT argue that only systematic risk matters; risk that is diversifiable is irrelevant to the well-diversified investor. Yet this chapter has argued that total risk matters, not just systematic risk. Is there an inconsistency here? Explain. Answer: There is no inconsistency. The CAPM and APT argue that only systematic risk matters in determining the appropriate rates to be used to discount future cash flows. They do not demonstrate the effect of systematic and non-systematic risks on the cash flows themselves. This chapter makes the argument that total risk may affect the level of future cash flows, and thus is an appropriate risk consideration in capital budgeting.


5. What is the advantage of using certainty-equivalent cash flows instead of risk-adjusted discount rates to calculate the NPV of an investment project?Answer: Certainty equivalents are minimum fixed cash payments that would be accepted in lieu of risky cash flows; the decision maker is indifferent between a risky gamble and a particular fixed payoff. Each risky cash flow may be adjusted individually. Certain cash flows can be discounted at the risk-free rate. The present value thus derived is equivalent to the one derived from expected cash flows and risk-adjusted discount rates.

PROBLEMS1. Suppose that Bethlehem Steel has a current sales level of $2.5 billion, variable costs of $2

billion, and fixed costs of $400 million. If sales rise by 15 percent, how much will pre-tax profit increase in dollar terms? What will be the percentage increase in pre-tax profit? What explains the relationship between the percentage change in sales and the percentage change in pre-tax profit for Bethlehem?Answer: Currently, pretax profit = $2.5B ─ 2B ─ 0.4B = $0.1B. We assume that variable costs are proportional to sales. Sales in the new year are 2.5(1.15) = $2.875B. Costs are 2.0(1.15) = $2.3B. So, pretax profit = 2.875 ─ 2.3 ─ 0.4 = $0.175B, a 75% increase. This problem demonstrates the potential effects of operating leverage.

2. In early 1990, Boeing Co. decided to gamble $4 billion to build a new long-distance, 350-seat wide-body airplane called the Boeing 777. The price tag for the 777, scheduled for delivery beginning in 1995, is about $120 million apiece. Assume that Boeing’s $4 billion investment is made at the rate of $800 million a year for the years 1990 through 1994 and that the present value of the tax write-off associated with these costs is $750 million. Based on estimated annual fixed costs of $100 million, variable production costs of $90 million apiece, a marginal corporate tax rate of 34 percent and a discount rate of 14 percent, what is the break-even quantity of annual unit sales over the Boeing 777’s projected 15-year life? Assume that all cash inflows and outflows occur at the end of the year.Answer:

3. The recently opened Grand Hyatt Wailea Resort and Spa on Maui cost $600 million, about $800,000 per room, to build. Daily operating expenses average $135 a room if occupied and $80 a room if unoccupied (much of the labor cost of running a hotel is fixed). At an average room rate of $500 a night, a marginal tax rate of 40 percent, and a cost of capital of 11 percent, what year-round occupancy rate do the Japanese investors who financed the Grand Hyatt Wailea require to break even in economic terms on their investment over its estimated 40-year life? What is the likelihood that this investment will have a positive NPV? Assume that the $450 million expense of building the hotel can be written off straight line over a 30-year period (the other $150 million is for the land which is not depreciable) and that the present value of the hotel’s terminal value will be $200 million.Answer:

4. Conduct a sensitivity analysis for a project with the following characteristics. Each parameter can take on any of three different values but once a parameter value is selected, that value remains constant for the ten-year period. The discount rate is 10 percent and the project life is


ten years. Ignore taxes and depreciation.

Low Mean High

(1) Sales (units)(2) Price (per unit)(3) Variable cost (per unit)(4) Fixed cost(5) Initial investment

160$3,000

3,000100,000

1,000,000

500$3,750

3,000200,000

2,000,000

960$4,000

3,0004,000

4,000,000Answer: The problem implies that since PVIFA = 6.447, the discount rate is 8.9% per year. For the mean case,

E[NPV] = 2,000,000 + 6.447{ 500 (3750 3000) 200,000 }= $871,775

Sensitivity Analysis allows each variable individually to deviate from its mean value:

(e.g. 2,515,760 = 2,000,000 + 6.447{160(3750 3000) 200,000} Variable Low High Sales $2,515,760 $1,352,440 Price $3,289,400 $65,900 Variable Costs $871,775 $871,775 Fixed Costs $227,075 $2,161,175

5. American Fruit Co. is considering constructing a new plant to process frozen fruit juices. One plant would be capital intensive, the other much more labor intensive. Although the final decision would hinge on the relative cost of capital versus labor in the northern California area, management is curious about the behavior of the plants’ return on assets during a typical business cycle.a. Given the following information, calculate the break-even point in units of production for

the two plants. Answer: Q1 = F/(P ─ V) = 200,000/(2 ─ 1.50) = 400,000 units

Q2 = F/(P ─ V) = 600,000/(2 ─ 0.50) = 400,000 units

b. The economics department has prepared sales projections for three business scenarios: recession, normal, and recovery. Sales under each scenario are expected to be as follows: recession, 300,000 units; normal, 500,000 units; and recovery, 800,000 units. Calculate the return on assets for the two plants under these three scenarios. Answer: ROA = Return/Investment;for Plant 1 (Recession):Return = 300,000(2 ─ 1.5) ─ 200,000 = ─50,000ROA = ─50,000/1,000,000 = ─5%

Dollar Return ROA Recession ─50,000 ─5%Plant 1 Normal 0 0% Recovery 100,000 10%


Recession ─150,000 ─15%Plant 2 Normal 0 0% Recovery 300,000 30%

c. If the three scenarios are all equally likely, what will be the variance of the return on assets for plant 1? For plant 2? What would you advise American Fruit?

Plant 1 Plant 2

Fixed costVariable cost (per unit)Price (per unit)Investment

$200,000 1.50 2.00

1,000,000

$600,000 .50

2.00 1,000,000

Answer: E(ri) = Spiri

σ2i = S pi[ri─E(ri)]2Plant 1: E(r1) = 0.333(─5 + 0 + 10) = 1.667%

σ21 = 0.333(44.444 + 2.778 + 69.444) = 38.89σ1 = Ö38.89 = 6.24%

Plant 2: E(r2) = 0.333(─15 + 0 + 30) = 5.00%σ22 = 0.333(400 + 25 + 625) = 350σ2 = Ö350 = 18.71%Plant 2 has higher expected returns, but these returns bear more systematic risk than those of Plant 1. Also, Plant 2 is operationally more levered than plant 1. The manager needs to assess the contribution to portfolio risk of each of the projects, and to consider the risks of operating leverage in his decision. In particular, it seems that the portfolio risk and the total risk of plant 2 are greater; the additional expected return may or may not be enough to compensate the firm for bearing this risk.

6. For the following project, the chief financial officer has prepared a set of certainty-equivalent factors to adjust the cash flows for the estimated risk. The economics department has also prepared a set of risk-adjusted interest rates at which to discount the project’s cash flow. The project’s initial investment is $150,000 and the Treasury security rate is 8 percent

Year 1 2 3

Cash flows ($000)Certainty equivalents (finance department)Risk-adjusted rates (economics department)

$50

.982

10%

$75

.964

12%

$130

.947

14%

a. What is the NPV of the project from the finance department’s estimates? Answer: CE1(000’s) = 50(0.982) = 49.1 ┌───────────────────────────┐CE2 = 75(0.964) = 72.3 NPV = ─C0 + S CEt/(1 + rf)tCE3 = 130(0.947) = 123.1 └───────────────────────────┘


NPV(000’s) = ─150 + 49.1/1.08 + 72.3 /1.082 + 123.11/1.083= $55,177.

b. What is the NPV from the economics department’s estimates? Answer: PV(000’s) = 50/1.10 + 75/(1.12)2 + 130/(1.14)3 = $42,992

c. What would you advise the company to do?Answer: Accept the project because it has positive net present value. The finance department method (CEQ) may be more reliable if risk and time value are measured consistently and separately.

7. A gold mine is considering replacement of some machinery. The new conveyor belt will cost $5 million and lower the cost of removing ore from the mine by $4 per ton. The old belt can be scrapped for $500,000. The following table shows that the life of the new machine is uncertain, as is the annual amount of ore that will be moved:

Low Mean High

Tons per yearLife of new machine

200,0006 years

250,0009 years

350,00013 years

Conduct a sensitivity analysis of the NPV of the replacement project assuming a discount rate of 10 percent. Ignore taxes.

Answer: The analysis varies individual components while all others are valued at their means.NPV = ─4,500,000 + 4 ´ (Number of tons) ´ (PVIFA factor)NPV(mean) = ─4,500,000 + 4(250,000)(5.759) = 1,259,000

Low Mean High NPV(Low) NPV(High)Ton 200,000 250,000 350,000 $107,200 $3,562,600Life 6 9 13 ─145,000 2,603,000PVIFA(10%) 4.355 5.759 7.103 8. Teletech Co. wants to use a decision tree in evaluating a venture capital investment in cable TV.

The projected investment has a life of three years, and the associated after-tax cash flows ($000) and probabilities are as follows:

Year 1 Year 2

Cash flow: $100 P = .50 $200 P = .50

If cash flow in year 1 = $100Year 2 cash flow = $120 P = .60 = $9 P = .40If cash flow in year 1 = $200Year 2 cash flow = $250 P = .50 = $210 P = .50

Year 3

────────────────────────────────────────────────────────────────────If cash flow in year 2 = $120, can sell the investment for either $350 (P = .70) or $250. If cash flow in year 2 = $95, can sell the investment for either $125 (P = .60) or $75.

If cash flow in year 2 = $250, can sell the investment for either $475 (P = .80) or $275.

If cash flow in year 2 = $210, can sell the investment for either $140 (P = .50) or $110.

The initial investment for the firm is $500,000 after tax. The firm uses a cost of capital of 10 percent.

a. Construct a decision tree with the expected NPV of each alternative. Answer: Cash flows and probabilities are shown below:Time 1 Time 2 Time 3 NPV Prob

0.70 0.60 ┌────────── 350 ─46.96 0.21 ┌────────── 120 ───┤ 0.30 │ └────────── 250 ─122.09 0.09 0.50 │

┌──────── 100 ───┤ │ │ 0.60 │ │ 0.40 ┌────────── 125 ─236.66 0.12 │ └────────── 95 ───┤ 0.40 │ └────────── 75 ─274.23 0.08 │ ──┤ │ 0.80 │ 0.50 ┌────────── 475 245.30 0.20 │ ┌───────── 250 ───┤ 0.20 │ │ └────────── 275 95.04 0.05 │ 0.50 │ └──────── 200 ────┤ │ 0.50 │ 0.50 ┌────────── 140 ─39.44 0.125 └───────── 210 ───┤ 0.50 └────────── 110 ─61.98 0.125

b. What is the expected NPV of the best possible outcome? What is its probability? Answer: The best possible outcome has NPV(000’s) = $245.30. Its associated probability is 0.20.

c. What is the expected NPV of the worst possible outcome? What is its probability? Answer: The worst possible outcome has NPV(000’s) = ─$274.23. The probability of attaining this outcome is 0.08.

d. Should Teletech make the investment? Why or why not? Answer: Teletech should likely not make the investment since the expected net present value is negative.

9. Refer to the Starship project in Section 2. a. What would the break-even quantity be initially if the cost of capital for the project were

estimated at 14 percent rather than 10 percent? Answer:

I0 ─ D F

Q = ───────────────────── + ───── PVIFAr,n (P─V)(1─t) P─V

250 ─ 120 15Q = ───────────────────── + ─────── = 54.03 units. 5.2161 (2.7─1.5)(0.5) 2.7─1.5

b. What would the break-even quantity be if the Starship could be sold for only $2,000,000 each (assume a cost of capital of 10 percent)? Answer:

250 ─ 120 15Q = ───────────────────── + ─────── = 114.63 units.

6.1446 (2.0─1.5)(0.5) 2.0─1.5c. What would the break-even quantity be if cost overruns increased the initial investment

from $130,000,000 to $230,000,000? Answer:

350 ─ 120 15Q = ───────────────────── + ─────── = 74.89 units.

6.1446 (2.7─1.5)(0.5) 2.7─1.510. The following exhibit contains Beech’s estimates of demand, price, and fixed and variable costs

for the Starship under three alternative economic forecasts.

Variable (per year) Pessimistic Normal Optimistic

DemandPrice*

Fixed cost*

Variable cost*

502221.75

752.7151.50

1253.271.0

a. If all other variables are assumed to be at their expected value (normal forecast), how sensitive is the project’s NPV to changes in fixed cost? Use a cost of capital of 10 percent, tax rate of 35 percent, and project life of ten years. Answer: NPV = ─Inv + D + (Demand(Price─Var)─Fixed)(1─tax)(PVIFA)Normal Case: NPV = ─250 + 120 + (75(2.7─1.5)─15)(0.65)(6.1446)= $169.55M

Variable Pess Norm Opt NPV(Pess) NPV(Opt)Demand 50 75 125 49.73 409.19Fixed Cost 22 15 7 ─40.14 319.32b. How sensitive is the project’s NPV to changes in price?Answer: Variable Pess Norm Opt NPV(Pess) NPV(Opt)Price 2 2.7 3.2 141.59 201.50c. How sensitive is the project’s NPV to changes in variable cost? Answer: Variable Pess Norm Opt NPV(Pess) NPV(Opt)Var. cost 1.75 1.5 1.0 94.66 319.32 d. Which factor seems most important to the success of the plane?

Answer: Fixed costs can make the project unprofitable. The same greatest dollar variation in NPV, however, can be achieved by changing either demand or fixed costs.

e. Is the Starship a risky project? Explain. Answer: In the sense of total volatility, the project is risky. However, investors may be able to diversify this risk. In the sense of guaranteeing a positive NPV, the project is not very risky; only in one scenario will NPV become negative.

Chapter 6: Estimating the Project Cost of Capital

CHAPTER 6: QUESTIONS1. Show how the following events change the discount rate applicable to an expansion of an

existing restaurant chain. a. The covariance between restaurant sales and the market rate of return increases.

Answer: If the covariance between restaurant sales and the market return increases, then so must its beta, since ßi = cov(ri,rm)/σ2

m. The discount rate will also increase.

b. The riskless rate decreases. Answer: If the risk-free rate decreases and nothing else changes, there is no reason to believe that the beta of the firm will change. If the required rate of return on the market stays the same, a decrease in the risk-free rate effects an increase in the market risk premium; the change in the rate of return on the project depends on its beta. If ß>1, the rate of return on the project will decrease; if ß<1, the rate of return on the project will increase. Alternatively, if the required rate of return on the market drops in tandem with the risk-free rate (a likely prospect), the required rate of return on the project will fall.

c. Several other companies are planning to expand their chains. Answer: This action will likely reduce the expected cash flows from the project, but will have no effect on the discount rate applied to these cash flows.


2. A large manufacturer is evaluating the purchase of a smaller firm. The firm has the same required return as the manufacturer, estimated at 10 percent, yet its actual rate of return is about 8 percent. Although the project appears to have a negative NPV, company executives have considered the low cost of debt financing. Because the manufacturer has no existing debt outstanding, it may borrow at only 7 percent. Furthermore, interest deductibility and a tax rate of 50 percent lower the effective cost of debt to 3.5 percent. Because the cost of financing the acquisition with debt is much lower than the 8 percent expected return, the executives are considering going ahead with the acquisition. Comment. Answer: The acquisition may have positive net present value, but only because the present value of the financing benefits exceeds the present value of the investment losses incurred. If the manufacturer can use the interest tax shield, it should consider the financing aspects alone, and borrow for its own account. This proposal avoids the deadweight loss of the marginally undesirable acquisition project. The analysis fails because it assigns the cost of capital of the manufacturer to the smaller firm. Can the new debt be issued without recourse to the parent company? The answer to this question is critical to the determination of the value of the project.

3. Which of the following companies is likely to have a higher beta, and thus a higher cost of capital? a. An auto manufacturer who runs an assembly line with union workers. b. A “high-tech” auto manufacturer with a fully automated line requiring only a handful of

nonunion workers. Answer: The high-tech firm has greater fixed costs and operating leverage. The inflexible cost structure will cause greater swings in returns for a given market movement than those of its low-tech counterpart. The high-tech beta will also be higher, yielding a higher cost of capital.

4. What impact will each of the following events have on a firm’s weighted average cost of capital? a. The corporate tax rate is lowered.

Answer: WACC rises because the effective cost of debt, r(1 ─ t), rises.b. The firm increases its leverage.

Answer: If the firm was operating at an optimal capital structure, an increase in leverage will likely raise its WACC. If the firm were operating at a suboptimal capital structure, the effect is ambiguous.

c. The firm’s stock price falls dramatically. Answer: If the firm’s stock price falls, the value of the assets changes. However, from this information alone, we cannot know the change in the riskiness of the assets. Therefore, the impact on the WACC is uncertain.

d. New York City imposes a stamp tax on share issues floated there. Answer: This increases the cost of equity, and thus raises the WACC. If all projects are financed out of retained earnings, however, there will be no effect.


e. The government allows private investors to exclude up to $1,000 in dividends from taxable income. Answer: This action allows dividends a partially tax-free status, lowering the cost of equity and the WACC. At the same time, however, companies will use less retained earnings and will raise more new equity, forcing it to bear flotation costs.

f. The firm sells a division and replaces it with a less risky project. Answer: The lower risk project reduces the required rate of return on assets, and thereby reduces the required rate of return on equity, lowering the WACC. This observation does not suggest that firms should adopt less risky projects to lower their WACC; the WACC rule requires that firms minimize the WACC for a fixed investment policy.

5. Suppose a new investment opportunity offers a 14 percent rate of return. Is this an attractive project to an ongoing firm if the firm can finance the project with 100 percent debt at an 11 percent interest rate? Answer: What would the interest rate be if the project were financed on a stand-alone basis? If the firm can finance the project at 11%, it may be the case that the lender is considering the credit-worthiness of the firm as a whole, and not this individual project. The project’s expected return of 14% must be compared with its required rate of return according to the project risk alone. In other words, the cost of capital is not necessarily equal to the required rate of return.

6. A corporation has the following balance sheet (liabilities side):

Current liabilitiesLong-term debtPreferred stockCommon stockRetained earnings

$2,000 5,000 2,000 8,000 3,000 $20,000

Currently, the riskless interest rate is 8 percent; the corporate ta rate is 50 percent; the current price of a share of common stock is $20; and dividends have been level at $1 per share per year for many years.

Recently, company executives have considered expanding the existing business by acquiring a competitor. To do so, they must calculate the WACC of the firm and estimate the NPV of the acquisition. Because the acquisition is of the same risk as the firm, the WACC (unlevered equity cost) can be used.

A financial executive has used the following procedure to calculate the WACC. Debt and preferred are fixed claims offering a fairly secure constant return, and so their before-tax cost is assumed to equal the riskless rate. The dividend yield has held constant at about 5 percent, so this is used as the cost of new and retained equity. Finally, the balance sheet shows the firm to be composed of 25 percent debt, 10 percent preferred, 55 percent equity (common plus retained), and 10 percent current liabilities. Current liabilities are assumed to be costless; therefore the WACC is 4.55 percent.

Comment on this procedure.

Answer: The procedure is faulty for a number of reasons. Debt and preferred shares are not risk-free; the cost accorded these liabilities should equal the after-tax risk-adjusted return. Furthermore, although dividends have been constant at $1 per year, the share prices may have reflected capital gains or losses, providing a total rate of return much different than 5%. Flotation costs were ignored. WACC should be calculated with market values, not book values. Finally, current liabilities may not be costless.

7. “Our conglomerate recognizes that foreign investments have a very low covariance with our domestic operations and thus are a good source of diversification. We do not ‘penalize’ potential foreign investments with a high discount rate but, rather, use a discount rate just 3 percent above the prevailing riskless rate.” Comment. Answer: It is difficult to determine whether a penalty is being assessed or not. It can be argued that foreign operations in general should require a lower rate of return than similar domestic operations, but from the information given, we cannot determine the required rate of return for domestic operations. Odds are the systematic risk is lower for foreign operations because of low covariance with domestic assets. Foreign investments should be treated like U.S. investments when determining the appropriate cost of capital. It is unlikely that all foreign projects should require a rate of return equal to 3% over the risk-free rate.

8. A large food processor and distributor is considering expansion into a chain of privately owned sports shoe outlets. The food company wishes to estimate the risky discount rate for such investments so as to negotiate a fair price for the acquisition. Unfortunately, there are no stock exchange-listed sports shoe companies with a price history with which a “sports shoe outlet beta” can be estimated. However, executives are considering using the price history of another company to estimate the beta. Which of the following companies would be the most appropriate? Explain.a. Another large food company. b. A holding company for a football team.

c. A company that manufactures shoes. d. A chain of swimwear and surfboard stores in California.

Answer: An argument may be made for both C and D. Although C is not a perfect match, historical data from this company may provide a good estimate of beta. One could argue that choice D also contains common risk elements, since sport shoes may be considered a luxury sporting item, compared with shoes in general, which are considered necessary items. Since D’s business is restricted to California, however, one would want to consider the differences between California and national demand for sports shoes. Overall, the cost side is probably more correlated with C, while the revenue side is probably more correlated with D. Perhaps the ideal beta would be estimated by taking a mixture of these two.

9. When Gamma Company computes its cost of capital, it uses zero as the cost of retained earnings. a. Comment on this procedure.

Answer: Earnings retained as cash must earn the risk-free rate of return. Reinvested earnings must earn the rate of return commensurate with the risk of the investment. In no case will a zero required rate of return be appropriate.

b. How is this procedure likely to affect its investment decisions? Answer: This procedure will likely suggest that too many projects be accepted; it lowers the apparent WACC. Marginal projects accepted under this procedure will have negative NPV under the correct procedure.

10. Which investment is likely to have a higher degree of systematic risk, a copper mining project in Chile or an investment in a Brazilian auto plant whose output would be sold locally? Explain.Answer: The copper mining venture in Chile is likely to have a higher degree of systematic risk. The major element of systematic risk in any extractive project is related to variations in the price of the mineral being extracted, which is set in a world market. The world market price is in turn a function of worldwide demand, which itself is systematically related to the state of the world economy. By contrast, the return on an investment in a Brazilian auto plant whose output would be sold locally would be more highly correlated with the state of the Brazilian economy than with the U.S. or world economy. In general, a market-oriented project in an LDC—whose risk depends largely on the evolution of the domestic market in that country—is likely to have a relatively small systematic risk.

CHAPTER 6: PROBLEMS1. Ampex common stock has a beta of 1.4. If the risk-free rate is 8 percent, the expected market

return is 16 percent, and Ampex has $20 million of 8 percent debt, with a yield to maturity of 12 percent and a marginal tax rate of 50 percent, what is the weighted average cost of capital for Ampex?Answer:

2. Calvin Inc. earned $2.00 per share during the past year and has just paid a dividend of $.40 per share. Investors forecast that Calvin will continue to retain 80 percent of its earnings for

the next 4 years and that earnings will grow at 25 percent per year through year 5. The dividend payout ratio is expected to be raised in year 5 to 50 percent, reducing the dividend growth rate to 8 percent thereafter. If Calvin’s equity β is .9, the risk-free rate is 8.5 percent, and the market risk premium is 8 percent, what should its price be today?Answer: With an estimated 25% annual growth rate, Calvin’s forecast earnings for the next 5 years are $2.50, $3.13, $3.91, $4.88, $6.10. With a 20% dividend payout rate for the first 4 years and a 50% payout rate thereafter, this earnings stream yields dividends of $0.50, $0.63, $0.78, $0.98, $3.05. Note that the last term in the series is just $6.10 * 0.50. In year 6, the forecast dividend is $6.10 * 1.08 * 0.50 = $3.29. This dividend is projected to grow at the rate of 8% annually.

It is important in answering this question to consider the fact that the dividend payout rate changed in year 5 to 50%, from 20%. Hence, just taking the initial 40¢ dividend and multiplying it by (1.25)5 will not give you the correct answer.

To determine Calvin’s price today based on these expectations, we must next estimate Calvin’s cost of equity capital. Using the CAPM, this figure is

ke = rf + βe(rm - rf) = 8.5% + 0.9 * 8% = 15.7%The present value at 15.7% of the first 5 dividend payments is $3.42. The present value as of the end of year 5 of the dividend flows from year 6 on can be found using the dividend growth model, Po = DIV1/(ke - g). Substituting in the numbers previously calculated, we get

Po = DIV1/(ke - g) = $3.29/(0.157 - 0.08) = $42.73

The present value of this number of today is $42.73/(1.157)5 = $20.61. Adding the value of the two cash flows gives a price for Calvin’s stock today of $24.03.

Remember that you must discount the price as of the beginning of year 6 by (1.157)5 instead of (1.157)6. The former is correct because you are discounting it back 5 years, not 6 years.

3. As a financial analyst for National Engineering, you are required to estimate the cost of capital the firm should use in evaluating its heavy construction projects. The firm’s balance sheet data and other information are listed below. Assume the corporate tax rate is 35 percent.a. What is your estimate? What assumptions must you make to calculate this estimate?

Answer: The balance sheet liabilities (market values) along with the required after-tax rates of return are shown below:

Item Mkt Value (000’s) Req’d RateAccounts Payable $200 0.00%10-Year Debt 250 12% ´ (1 ─ 0.65) = 7.80%15-Year Debt 1000 15% ´ (1 ─ 0.65) = 9.75%1-Year Debt 250 11% ´ (1 ─ 0.65) = 7.15%Preferred Stock 450 4.50/22.50 = 20.00%Common Stock 4725 7% + 10% = 17.00%Total/Wtd Avg $6875 14.95%

Assumptions:i. Accounts payable have the same average risk as short-term debt, but no cost (i.e.

built into price).ii. Average price is a good estimate of current market value.iii. The riskiness of the firm has not changed substantially; the historical data provide

accurate estimates of future risk and return.

Note: Stock will normally earn a higher average return than preferred.b. What qualifications to this estimate should you mention in your report when National

applies this rate to its various projects?Answer: In using this estimate of the WACC, the firm should be careful not to apply this discount rate to projects whose risks are not comparable with that of the firm as a whole. Project required return rates depend on the market risk of the projects, not the overall risk or credit-worthiness of the firm.

Selected Balance Sheet Items Market Data

Market Value Yield (bonds)

BondsPreferred stockCommon stockRetained earnings

(see market data)$400,000$800,000$2,000,000

Bonds 8%, 10-year 12%, 15-year 21%, 1-yearCommon stock:

$250,000$1,000,000$250,000

12%15%11%

Average dividend growth (5 years) = 10%

Current dividend yield = 7%Price = $47.25Shares = 100,000Preferred stock:

$4.50 preferred dividendPrice = $22.50Shares = 20,000

4. A corporation’s securities have the following betas and market values:

BetaMarketValue

DebtPreferredCommon

.1

.41.5

$100,000 200,000 100,000

Calculate the following figures given a riskless interest rate of 10 percent and market risk premium of 5 percent:

a. discount rates for each security. Answer: Debt discount rate rD = 10 + 0.1(5) = 10.5%

Preferred discount rate rP = 10 + 0.4(5) = 12.0%Common discount rate rE = 10 + 1.5(5) = 17.5%

b. the asset beta for the corporation. Answer: The asset beta is the market-weighted average beta of the assets, which is equivalent to the market-weighted average beta of the liabilities (ratio terms in 000’s):

ßA = 0.1(100/400) + 0.4(200/400) + 1.5(100/400) = 0.60

c. the weighted average cost of capital.

Answer: WACC = 0.105(0.25) + 0.12(0.50) + 0.175(0.25) = 13.0%d. the discount rate for the unlevered assets.

Answer: The discount rate for unlevered assets whose business risk is the same as that of the firm as a whole is exactly equal to the weighted average cost of capital, or 13.0%.

5. As part of its efforts at diversification, the Sherbert theater organization, producer of Broadway plays, is considering acquiring a movie theater chain. A prime acquisition candidate is Consolidated Cinemas, currently owned by a conglomerate, Tryon. Although Tryon has given Sherbert what it feels is an accurate forecast of expected cash flows from the cinema chain, Sherbert would like to have its own estimate of the required rate of return to apply to these cash flows. The chief financial officer has acquired the following information on independently owned movie house chains:

Movie House Beta D/TA*

NCO Theater, Inc.Worldwide/GlobalScreen RocksUltimate Theater

1.70.50

2.50-.10

.40

.10

.50

.75a. Using a risk-free rate of 7.5 percent and a market risk premium of 8.5 percent, what is

your estimate of the cost of equity capital for Consolidated? Answer: We assume that the debt is risk-free, and that the betas shown in the table are equity betas. Then the asset betas can be found with the following equation: ßA

= ßE[E/TA], where TA = total assets = D + E. Asset betas appear below:NCO Theater, Inc. 1.70(1 ─ 0.40) = 1.020Worldwide/Global 0.50(1 ─ 0.10) = 0.450Screen Rocks 2.50(1 ─ 0.50) = 1.250

Ultimate Theater ─0.10(1 ─ 0.75) = ─0.025The average asset beta is 0.67375, so the required rate of return is 7.5 + 0.67375(8) = 12.89%.

b. What qualifications would you include with your estimate? Answer: The quality of the estimate is limited by the extent to which these four companies can serve as proxies for Consolidated Cinemas. The betas seem quite different, indicating that the assumption may be questionable. A second doubt concerns the source of the betas. If the betas were derived from historical relationships, are those relationships still valid? If they were derived from subjective data, what assumptions were made in the calculations?

6. Westcon is considering building a facility to tap thermal energy using wind power. Part of the project’s cost, $750,000, can be financed with a loan from the Federal Energy Commission at the below-market rate of 5 percent. The remainder, $250,000, can be financed with an industrial revenue bond at 10 percent. Current debt rates for Westcon are 15 percent. The project should generate pre-tax net profit of $425,000 a year for ten years. Westcon has a 40 percent tax rate, and the D/E ratio is .50. Westcon estimates that the project beta is 1.50 and forecasts a risk-free rate of 10 percent for the life of the project. The market rate is estimated to be 20 percent. a. Should Westcon undertake the project? b. Assuming the project is of the same risk as Westcon itself, would the project be

acceptable without the subsidies? Explain. Answer: This is a very difficult problem. Two sets of answers appear below. The first answer takes a simple approach to problem solution when annual cash flows are $1.5M and the tax rate is 40%. The first answer assumes that no debt is displaced.

The second answer analyzes the problem when cash flows are $300,000 per year, and the tax rate is 50%. The second solution assumes that debt is displaced, and demonstrates the equivalence of the WACC and the APV approach in decision-making.

Version 1We assume there is no investment tax credit and no depreciation. In the absence of favorable financing terms, cash flows include an initial outlay of $1M, and annual after-tax cashflows of $1.5M(1 ─ 0.40) = $0.9M. Since the project beta is 1.5, the required rate of return is rp = rf + ßp(rm ─ rf) = 10 + 1.5(10) = 25%. The present value of these cash flows is $3.213M ─ 1M = $2.213M.

a. We now add debt to the analysis. We assume debt is risk-free. From equation 9.11, we need to find the adjusted net present value (APV), which takes into account the present value of tax shields and favorable financing terms. Note that since the 15% debt rate applies to the company as a whole, we cannot use it in this project analysis.Assume that both loans (250K and 750K) will make annual interest payments and repay principal following the ten year project life. Tax savings in each year will then be: 250,000(0.10)(0.40) + 750,000(0.05)(0.40) = $25,000.

The present value of the tax savings (assuming these savings are risk-free) is $25,000[PVIFA(r=10%,10 yrs)] = $153,614.18 = $0.154M.

The FEC loan subsidy amounts to a subsidy of (0.10 ─ 0.05)(750,000) = $37,500 per year for 10 years. If this is risk-free, the present value is $230,421.27 = $0.230M.

APV = $2.213M + 0.154M + 0.230M = $2.597M.

Westcon should undertake the project (APV>0).b. If the project were the same risk as Westcon itself, it should likely be accepted. The

exact weighted average cost of capital of Westcon cannot be determined from the given information. However, as long as WACC<89.85%, the project should be accepted.

Version 2Assume that annual operating cash flows are $300,000, and the marginal tax rate is 50%. Ignore depreciation. These changes are reflected in some printings and not in others.

There are two basic approaches that you can take to solve this problem and they both give similar answers. One approach is to use the adjusted present value (APV) and value the project on an all-equity basis and then separately value the tax advantages of debt and the interest subsidy. The other approach is to use a weighted average cost of capital (WACC) ignoring the subsidized financing but taking into account the tax deductibility of debt and then separately value the interest subsidy.

APV Approach

APV = NPV of project if all-equity financed NPV of financing side-effects caused by project acceptance

APV = ─I0 + S CFi/(1 + k*)i + S Ti/(1 + r)i + S Si/(1 + r)i

where k* = the all-equity cost of capitalCFi = the after-tax operating cash flowTi = tax savings in period i resulting from the specific financing packageSi = before-tax dollar value of interest subsidies in period i resulting from project-specific financing

r = before-tax cost of unsubsidized debt

The latter two terms in the equation above are discounted at the before-tax cost of debt to reflect the relatively certain value of the cash flows resulting from interest tax shields and interest savings.

To apply the APV, we first have to calculate the all-equity cost of capital. This figure is k* = rf + ßa(rm ─ rf), where ßa is the asset beta for the project. Substituting in the numbers given in the problem yields k* = 25%.

The after-tax operating cash flows (we are ignoring depreciation in this problem) are $300,000 (1 ─ 0.50) = $150,000.

The debt capacity of the new project is $333,333, given Westcon’s target debt:equity ratio of 0.50. However, Westcon is adding $1 million in debt. This means that the new debt is displacing $666,667 in 15% debt elsewhere in Westcon’s capital structure.

The tax savings on the added debt equal the value of the interest write-off in the $1 million in new debt minus the lost tax shield on the $666,667 in 15% debt that is displaced by the new debt. That is, the interest tax shield is worth 0.5[750,000 ´ 0.05 + 250,000 ´ 0.10 ─ 0.15 ´ 666,667] = ─$18,750. The negative figure means that the tax shield on the displaced debt exceeds the tax shield on the low interest debt. This should not be surprising: consider what the tax shield would be on debt that carried a zero interest rate. Clearly, the benefits of the interest subsidy don’t show up in the form of a tax write-off; but they do show up in the interest subsidy figure.

The before-tax value of the interest subsidy is 750,000(0.15 ─ 0.05) + 250,000(0.15 ─ 0.10) = $87,500. Hence, the total value of the specific financing package, taking into account both the tax benefits of debt and the interest subsidy that Westcon receives, is $87,500 ─ $18,750 = $68,750.

Now we can calculate the APV:

APV = ─$1,000,000 + S 150,000/(1.25)i + S 68,750/(1.15)i

= ─$1,000,000 + 535,575 + 345,040 = ─$119,385.

The project is not acceptable, even with the financing subsidy.

WACC Approach

In this approach, we first value the project ignoring the financing subsidy. To do this, we must calculate the WACC ignoring the interest subsidy, which we use to discount the after-tax operating cash flows of $150,000 annually. Then, we estimate the value of the interest subsidy and subtract this figure from the project NPV.

To calculate the WACC, we must estimate the levered cost of equity capital, which requires that we calculate the levered equity beta. We can calculate the levered equity beta using the formula

ße = ßa[1 + (1 ─ t)D/E]

Assuming that the project’s debt capacity is the same as Westcon’s debt capacity, because the risks are assumed to be the same, we can substitute in the figures given in the problem and get

ße = 1.5[1 + 0.50 ´ 0.50] = 1.875.

The resulting cost of equity capital, given a debt:equity ratio of 0.50 is 28.75% (10% + 1.875 ´ 10%).

The WACC, ignoring the interest subsidy (which we will calculate separately) is

2/3 ´ 28.75% + 1/3 ´ 15.00% ´ 0.50 = 21.67%

The project NPV, discounted at the 21.67% WACC, equals

NPV = ─$1,000,000 + S 150,000/(1.2167)i = ─$405,163.

The NPV of the interest subsidy can be calculated using the following reasoning. Westcon must pay $62,500 in interest annually for the next ten years and then repay $1 million principal at the end of ten years. In return, Westcon receives $1,000,000 today. Given these cash inflows and outflows, we can calculate the loan’s NPV just as we would for any project analysis. Note, however, that unlike the typical capital budgeting problem we examined, the cash inflow occurs immediately, and the cash outflows later. The principle is the same, however. We now need to know the required return on this project and Westcon’s marginal tax rate.

The required return is based on the opportunity cost of the funds provided: the 15% rate that Westcon would have to pay to borrow $1M in the capital market. We are told that Westcon’s marginal tax rate is 50%. The after-tax required return will be 7.5% and the after-tax interest payments will be $37,500. Now we can calculate the NPV of Westcon’s financing bargain:

NPV = $1,000,000 ─ S $37,500/(1.075)i ─ $1,000,000/(1.075)10

= $1,000,000 ─ 699,696 = $300,304.

Alternatively, you could just calculate the present value of the ten-year annuity consisting of the annual after-tax interest savings of 0.50 ´ $87,500 = $43,750. This annuity, discounted at the 7.5% after-tax cost of debt financing, equals $300,304.

Adding together the project NPV with the financing NPV yields a total project value of ─$405,163 + $300,304 = ─$104,859. The WACC approach gives the same answer as the APV approach: the project is not acceptable.

Although in theory the two approaches should yield identical quantitative results, they don’t in practice. The difference stems from the slightly different effects of adjusting the numerator in one case for taxes and the denominator in the other case.

7. In analyzing the possible placement of their first fast-food fish restaurant overseas, the Gill Corp. has the following data:

Correlation of Rate of Returnon Common Stock Indexes, Last Ten Years

United States with

.44

.75

.75

.61

.27

FranceCanadaJapanUnited Kingdom

Italy

The CFO for Gill reasons that the beneficial effect of foreign diversification should be included in the financial analysis, by multiplying the risk of equity capital by this correlation. With a U.S. beta of 1.15, what would the project’s beta be under this system? Is this a defensible procedure to use?

Answer: Country Adjusted BetaFrance 0.506Canada 0.863Japan 0.633United Kingdom 0.702Italy 0.311The procedure is indefensible. While the diversification benefits of foreign investment are real and should be considered in project analysis, this ad-hoc procedure will not determine the appropriate project betas for capital budgeting purposes. The procedure seems to confuse country risk with project risk.

8. Tom Swift Company has a target capital structure of 40 percent debt and 60 percent equity. Its estimated beta is .9. Tom Swift is evaluating a new project that is unrelated to its existing lines of business. However, it has identified three proxy firms exclusively engaged in this line of business. The average beta for these firms is 1.2, and their debt ratios average 50 percent. Tom Swift’s new project has a projected return of 11.9 percent. The risk-free return is 10 percent and the market risk premium is 5 percent. All firms have a marginal tax rate of 40 percent. Tom Swift’s before-tax cost of debt is 13 percent. a. What is the unlevered project beta?

Answer: The project’s unlevered beta can be found with the relation:

ßa = ße { E/[(1─t)D + E] } = 1.2 (0.5/0.8) = 0.75.

b. What is the beta of the project if undertaken by Tom Swift, assuming the company maintains its target capital structure? Answer: Inverting the relation in (a):ße = ßa [ 1 + (1─t)D/E ] = 0.75 [1 + (0.60)(0.40)/(0.60)] = 1.05

c. Should Tom Swift accept the project? Answer: The required return is 10 + 1.05(5) = 15.25%. WACC = 12.27%. This exceeds the expected return of 11.9%. The project should be rejected.

9. The following are the beta estimates from Value-Line for several computer firms as well as the D/TA for the firms. Suppose the risk-free rate of return is 8 percent, the expected market return is 17 percent, and the tax rate is 35 percent.

Company Beta D/TA

AppleAmdahlBurroughsCommodore

1.701.551.001.50

0.31.24.14

CraySperryTandem

1.451.251.60

.05

.23

.03

a. What risk premium must these companies pay as a result of leverage?

Answer: Recall that ßa = ße { E/[(1─t)D + E] } ße D/TA ßa k* ke (ke─k*) PCTApple 1.70 0 1.70 23.30% 23.30% 0.00% 0.00% Amdahl 1.55 0.31 1.20 18.76% 21.95% 3.19% 14.54% Burroughs 1.00 0.24 0.83 15.45% 17.00% 1.55% 9.13% Commodore 1.50 0.14 1.35 20.19% 21.50% 1.31% 6.09% Cray 1.45 0.05 1.40 20.61% 21.05% 0.44% 2.08% Sperry 1.25 0.23 1.04 17.40% 19.25% 1.85% 9.62% Tandem 1.60 0.03 1.57 22.11% 22.40% 0.29% 1.29% The returns ra and re are calculated from the CAPM relationship, ri = rf + ß(rm─rf). The premium due to leverage is reflected by the difference in the last column

b. What proportion of their total equity cost is a result of financing? Answer: Proportional part of return represented by the leverage premium

PCTApple 0.00% Amdahl 14.54% Burroughs 9.13% Commodore 6.09% Cray 2.08% Sperry 9.62% Tandem 1.29% 10. In late 1984, Sonat, the Birmingham, Alabama-based, energy and energy services company,

ordered six drilling rigs that can be partly submerged from Daewoo Shipbuilding, a South Korean shipyard. Daewoo agreed to finance the $425 million purchase price with an 8.5-year loan, at an annual interest rate of 9 percent paid semiannually. The loan principal is repayable in 17 equal semiannual installments ($25 million every six months). At the time the loan was arranged, the market interest rate on such a loan would have been about 16 percent. If Sonat’s marginal tax rate (federal plus state corporate taxes) was 50 percent at the time, how much would this loan be worth to Sonat?Answer:

Chapter 7: Corporate Strategy and the Capital Budgeting Decision

CHAPTER 7: QUESTIONS1. One highly recommended approach to picking stocks is to select companies that have

dominant market shares or, better yet, monopolies in their businesses. Do you think this approach to picking stocks is likely to be successful? Why?Answer:

2. With the advent of cable television, various new stations are entering into the broadcasting market. Many are attempting to serve a specialized segment of viewers: the all-movie channel, all-sports, all-music. Assume that you acquired sufficient financial backing to enter this market. What segment do you feel is not yet being served? In what way could you differentiate your product to add value—value for which the customer would be willing to pay a price? Answer: Answers will vary. For example, given a vocal minority that believes television rots prepubescent brains (and necessarily, therefore, postpubescent ones), one could imagine a latent demand for quality educational television. While educational television has suffered in the past from low budgets and no-name educators, the educational channel of the future might feature Eddie Murphy giving lectures on futures trading and Michael Douglas teaching the power of the invisible hand (“Greed is good.”). One could imagine nonfinancial classes as well. To add value to the concept, we should be prepared to erect significant barriers to entry. For example, we could contract with guilty stars who feel that education should be stressed; they can provide low cost labor. Advertisers will feel that they can target their audiences much more accurately. One could offer “video transcripts” or examinations through the mail to viewers who wish to learn more or less thoroughly at a more or less rapid pace. We could create a video-tape distribution system through an existing movie production house to video stores and book stores. We might also establish ourselves as a purchaser of quality educational video materials; subcontractors would thereby help us build and maintain our educational videotape library; these reserves would be difficult for a competitor to match. Finally, we might secure proprietary government subsidies to develop courses in comparative economic systems.

3. One of the competitive advantages mentioned in the chapter is the experience of a firm’s managers. GM is trying to diversify away from producing only automobiles and has been acquiring a financial interest in firms in other product areas. To what other lines of business might GM’s managerial experience be applicable? Do you think GM is likely to be successful in a diversification strategy? Why?Answer: If the hypothesis is correct, GM’s managers should be able to extract value from their managerial services in many ways. Knowledge specific to the automobile industry may be applicable to the production of other types of heavy machinery and transporting devices. Experience in a market constantly threatened from the outside may be valuable in serving other threatened markets. Finally, an understanding and expertise in automotive distribution channels may transfer to other products with similar distribution characteristics. However, GM had unsatisfying experiences with


the acquisition of Hughes and EDS. If their management of the auto business is not stellar, how can they expect to provide a comparative advantage outside the auto business?

4. Describe the investments made by the following companies mentioned in the chapter that enabled them to pursue their business strategies: Dell Computer, Nalco Chemical, Canon, Southwest Airlines.Answer: Answers will vary. For example, the author makes extensive use of Post-It Notes, manufactured by 3M. These notes temporarily adhere to research papers and pages of the instructor’s manual, and provide varying capacity for poignant comments. 3M’s advantage is effectively guaranteed by three factors: technical innovation, brand-name recognition and patent protection. Competitive responses are many in number. For example, competition could wait for the patent to expire, and then flood the market with similar note sheets. In the patent process, 3M must divulge key information pertinent to the manufacture of Post-It Notes. With any luck for 3M, they will have made Post-It Notes obsolete by that time. Other competitive responses might address the function served rather than 3M’s solution to the problem. For example, one might be able to develop ink that disappears under exposure to ultraviolet light (for temporary notes on manuscripts) or “Corners”, non-adhesive sheets of paper cut to fit over the corners of manuscript pages and provide space for comments. Corners might be produced at a lower cost than 3M Post-It Notes.

5. One of the more successful strategies in retailing has been the development of “designer label” lines of apparel. In what ways does a designer suit differ from its equivalent purchased from a discount chain? Is this the result of advertising, quality, or some other factors? Answer: It is possible that no qualitative differences exist between designer and generic labels; clearly, generic producers will extol this view. However, several factors may make the designer product superior. For example, the advertising expense may be taken as a signal of superior quality; a well-reputed company or designer is willing to stake its good name on the performance of the product. In the event of a product failure, the designer company may be willing to recall the product and live up to its claims; a generic manufacturer may opt for bankruptcy instead. Finally, image creation may lead to a perceptive differentiation of the designer product. If the customer truly believes she is happier, shouldn’t she be willing to pay more for the product?

6. Each community has some monopoly suppliers. Common instances are the regulated monopolies: utilities, cable TV systems, local radio and TV stations. Other companies are monopolies through other means: fast-food franchises, newspapers, car dealerships. Which monopolies in your community are profitable? Why? Answer: An example in Los Angeles is afforded by the L.A. Times. Although the Times has nominal competitors, none seem to effectively serve all areas of the Los Angeles market. Part of the L.A. Times’ success may have resulted from its ability to develop and maintain a large marketing and distribution system; the prospect of duplication likely appears daunting to potential competitors. However, some


competitors have managed to target and serve particular areas like Orange County and the San Fernando Valley; papers there are geared toward local news.

Economies of scale in production would be hard to match with smaller production runs. Also, the costs of contacting and persuading advertisers to use an alternative medium would be high; with an initially small circulation base, solicitation would be costly (lower acceptance rates per sales agent), and discounts would likely have to be offered to encourage advertisers (reducing short-run revenue). Finally, although the L.A. Times is profitable, margins are not likely to attract many competitors.

7. Suppose a capital goods manufacturer brings out a new, more efficient machine. a. If the manufacturer holds a patent on this machine, who is likely to benefit the most from

it? Explain. Answer: In a typical scenario, the manufacturer is likely to benefit most from the patent. However, in the process of securing the patent, the manufacturer is forced to divulge critical information to justify the issuance of a patent. If competitors can produce close substitutes different enough to avoid the scrutiny of patent law enforcement, then the manufacturer will enjoy little benefit from the patent. Perhaps he would be better off not obtaining a patent in this situation.

b. Who will benefit most from this machine if the technology underlying the machine is not proprietary? Explain. Answer: If the technology is not proprietary, replicating firms will benefit most; they will not have to incur the attendant research, development and legal costs associated with developing the new product and securing a patent. Consumers will benefit.

c. What are some of the things the manufacturer can do to earn higher returns from this machine even without patent protection?Answer: The manufacturer has likely reduced the marginal cost of innovation through his development of a patentable product. While a particular product may be copied, and his current competitive advantage is usurped, he has likely made it possible to develop a later proprietary technology from which he can reap greater rewards.

8. How sustainable is a competitive advantage based on technology? On low cost labor? On economies of scale?Answer: Technology A competitive advantage based on technology may be sustainable if the technology is not easily reproducible. However, competitors can often usurp the advantages of innovation by offering look-alike imitations of the parent product.

Low Cost Labor A competitive advantage based upon access to low-cost labor likely cannot be sustained. Competitors often have the same access to these labor markets.

Economies of Scale Competitive advantage based on economies of scale are often difficult to capture. Given a finite market size, duplication of production levels may drown both the incumbent and the competing firm. In some cases, however, strategic


acquisitions can often give a smaller firm access to the same economies of scale a larger firm might enjoy. As markets grow, more competitors can take advantage of the scale economies.

9. Goodyear Tire and Rubber Company, the world’s number 1 tire producer, is competing in a global tire industry. To maintain its leadership, Goodyear has invested over $1 billion to build the most automated tire-making facilities in the world and is aggressively expanding its chain of wholly owned tire stores to maintain its position as the largest retailer of tires in the United States. It has also invested heavily in research and development to produce tires that are recognized as being at the cutting edge of world-class performance. Based on product innovation and high advertising expenditures, Goodyear dominates the high-performance segment of the tire market; it has captured nearly 90 percent of the market for high-performance tires sold as original equipment on American cars and is well represented on sporty imports. Geography has given Goodyear and other American tire manufacturers a giant assist in the U.S. market. Heavy and bulky, tires are expensive to ship internationally. a. What barriers to entry has Goodyear created or taken advantage of?

Answer: Goodyear has erected several barriers to entry. First, Goodyear’s control of a critical distribution channel locks out competition. Learning curve ascension and large production runs gain access to economies of scale. Investment in technological production facilities offers valuable options on future production technology; often, computerized production facilities need only be reprogrammed, and not completely refit. Goodyear has integrated vertically, securing proprietary access to important distribution channels. Significant investments in research and development signal to clients that Goodyear intends to innovate and make tires for many years to come. A reputational barrier is difficult to erode. Finally, by exhaustively serving a well-defined niche, Goodyear discourages competitive entry.

b. Goodyear has production facilities throughout the world. What competitive advantages might global production provide Goodyear? Answer: Since tires are bulky and expensive to ship relative to their profit margins, Goodyear has found it advantageous to locate production facilities near the ultimate points of sale. This reduces the marginal distribution costs, and provides a significant barrier to competitive entry. Goodyear can exploit product and process advantages across a broader market area.

c. How do tire-manufacturing facilities in Japan fit in with Goodyear’s strategy to create shareholder value? Answer: Japan is a leading automobile producer, with an eye on quality and consistency. To Japanese auto producers, without a comparative advantage in tire production, Goodyear seems a natural tire supplier. The action also serves as a warning to potential Japanese competitors like Bridgestone in the U.S. By locating production facilities in Japan, Goodyear reduces its marginal costs of production as well. Also, Japanese auto producers want to upgrade their top notch models; Goodyear can supply tires for these cars also. Finally, Goodyear wants to service Japanese car companies producing in the U.S. By selling tires to the Japanese


manufacturers in Japan, Goodyear can gain their confidence and later U.S. business.

d. In early 1988, Japan’s Bridgestone Corp. acquired Firestone Tire & Rubber Co. What possible motives might Bridgestone have had for this acquisition?Answer: Bridgestone may have thought that synergistic gains could accrue from the merger. A few explanations are possible. The combined entity may be able to keep Japanese customers who are now building up to 2M cars annually in the U.S. Or, if Goodyear were charging quasi-monopolistic prices, Bridgestone may have been able to offer Firestone the opportunity to capture some of these rents. For example, Bridgestone provided Firestone access to a tough Japanese market it might not have been able to enter alone. Also, R&D expenditures can be amortized over a larger base; the merger provides a means to enter the U.S. market quickly, and on a large scale.

e. How will Bridgestone’s acquisition of Firestone affect Goodyear? How might Goodyear respond to this move by Bridgestone? Answer: It seems the acquisition would affect Goodyear adversely (see part (d)). Goodyear might counter-attack with price cuts in Japan, innovation, guarantees, or any number of responses. It must sustain its current competitive advantages and seek to develop new ones.

10. Borden, already the world’s largest dairy company, has made over 40 acquisitions in recent years to become the world’s largest producer of pasta and the second-largest snack seller in the United States. Its basic strategy is to string together a network of regional pasta, dairy, and snack food companies to try to take advantage of various operating and marketing efficiencies. a. What operating and marketing efficiencies might Borden be able to take advantage of

through its acquisition strategy? Answer: First, by acquiring small niche products, Borden builds an image of capturing and serving entire small markets well. It enjoys efficiencies of scope in manufacturing, and is able to save advertising expenditures by swallowing up competitors. However, the main advantage seems to be an effective distribution system that allows Borden to drop new products onto the truck; it can distribute new novelty grocery and snack products quickly, effectively, and cheaply.

b. What valuable options does Borden’s acquisition strategy create? Answer: Borden creates advantages of pre-emptive entry through its acquisition strategy. Small competitors may buckle at the thought of competing with Borden’s distribution system, while Borden retains the low cost option to add new products to its distribution network. Large competitors may find the individual niches too small for effective and profitable entry. Access to the capital markets may be easier and cheaper for a large company; a small competitor would suffer a financing cost disadvantage. Also, Borden retains the ability to quickly introduce or discontinue new products without disrupting its distribution channels (a first-mover


advantage).

c. Borden’s brand of processed lemon juice, ReaLemon, was the first in the market. What advantages might Borden be able to realize by being the pioneer in this business?

Answer: Besides entering the market first, Borden immediately adopted large-scale production facilities, efficient distribution, and a reputation for quality. ReaLemon attracted a premium of 50% over identical competing brands because as the pioneer, it benefited from consumer risk aversion: lemon juice doesn’t cost very much and you don’t buy it very often, so why take a chance with an untried brand? Also, supermarkets don’t want to allocate shelf space to more than one brand for a small product. Competitors who considered entry likely found these barriers insurmountable.

11. Premier Industrial Corporation is a Cleveland-based distributor of extremely humdrum products—nuts and bolts, batteries, circuit breakers, and lubricating oil. When other distributors peddle the same products, they operate on thin margins and aspire to get rich on volume. Hence, they tend to carry only the fast-moving items. Premier, by contrast, carries just about every type of component and delivers small orders in an incredibly short time. Most of its profits come from the small maintenance and repair accounts that competitors regard as a nuisance. The average order size is $100 (competitor orders average $400), and Premier gets referrals from other distributors who don’t want to be bothered by small orders. Premier’s pre-tax margins run to around 18 percent, in contrast with competitor margins of about 1 to 2 percent. a. What is Premier’s strategy for creating value?

Answer: The strategy is manifold. Identify superior products that are reliable and easy to use; this serves as a quality assurance for retailers. Locate hard-to-find and specialty items; other distributors prefer to ignore this seemingly low-profit end of the business. Create a large enough selection of hardware products that allow the distributor to become the “Sears of industrial accounts.” No competitor will find it profitable to copy on a small scale, and the market may not be large enough to support two major competitors. Finally, build-in valuable options for future expansion in the distribution of electronics components and employ computer-based marketing strategies.

b. Why does Premier have such high profit margins for its industry?Answer: High profit margins resulted from the strategy points outlined in (a). In particular, it is never necessary to cut price to increase sales; Premier provides a unique high quality service to its retail customers. Margins persist because of Premier’s ability to sustain its competitive advantages.

12. For each of the following companies, assess the sustainability of its competitive advantage. a. Analog Devices, which develops specialized applications for analog semiconductors, has

invested countercyclically to cash in on business upturns. The results: 80 percent faster growth and 50 percent higher profitability than the rest of the semiconductor industry.


Answer: For more information, consult the Harvard Business Review, September-October 1986, p. 53-58, “Sustainable Advantage” by Pankaj Ghemawat. The answers below are taken from that article.

Unsustainable. Existing competitors seem set to copy Analog’s investment policy, and new ones—notably the Japanese—are invading its profitable niches.

b. Nike’s leadership in athletic shoes is built on cheap Far Eastern labor and massive investments in product development and marketing. Over the five years between 1981 and 1986, Nike averaged three times the profitability and four times the growth of the rest of the U.S. shoe industry. Answer: Unsustainable. Competitors are busy cloning Nike’s strategy. Reebok International, for one, sources 95% of its shoes from South Korea, spends heavily on product styling, and has won endorsements from rock stars as well as athletes. Reebok’s sales and profits expanded fivefold in 1985, while Nike’s actually declined. Also, the market is large enough to support new competitors.

c. Lincoln Electric has been the leader in the electric welding industry ever since John Lincoln invented the portable arc welder in 1895. Since then, technological change has been incremental. Lincoln has integrated backward, customizing its production machinery and holding annual worker turnover to under 3 percent. It has grown more rapidly than its competitors, partly by sharing its cost reductions with customers.

Answer: Sustainable. As the product pioneer, Lincoln had a first-mover advantage; that lead has proved durable because of the incremental nature of technological change. Lincoln also has kept its experience proprietary by integrating backward, customizing its production machinery, and holding annual worker turnover under 3%. Finally, it has continued to invest in experience by sharing cost reductions with customers. Competitors complain publicly that they have trouble matching Lincoln’s prices, let alone undercutting them. (See Chapter 11 for a discussion of Lincoln’s incentive system.)

d. DuPont is a leading producer of titanium dioxide, largely thanks to a production process based on low-cost feedstock that gives it a 20 percent cost advantage over competitors’ processes. Mastering the cheaper feedstock technology can be accomplished only by investing $50 million to $100 million and several years of testing time in an efficiently scaled plant. Answer: Sustainable. Thanks to a production process based on low-cost feedstock, DuPont enjoyed a 20% cost advantage over competitors’ processes. Mastering the cheaper feedstock technology was a black art—it could be accomplished only by investing $50 million to $100 million and several years of testing time in an efficiently scaled plant. The cost and risk of this alternative kept DuPont’s competitors from trying to imitate its demonstrably superior technology.

e. Tandem Computer pioneered fault-tolerant computers for processing transactions. Although the cost of adding additional processing capability once a system is up and


running is relatively low, customers must first make sizable and irrecoverable system-specific upfront investments in software and training. Answer: Sustainable. Tandem has gained preferential access to demand for upgrades and replacements because changeovers from one system to another are very costly.

13. For the past two decades, Cincinnati Milacron, the largest U.S. machine tool manufacturer, has led the U.S. machine tool industry in both R&D and the size of its sales and service network, activities that account for about a third of the value added by the industry. In the 1980s it moved into robotics in a big way. How does this move fit into its strategy for creating value?Answer: The strategy clearly creates value if Cincinnati Milacron can apply proprietary cost-saving technologies to the production of robotic equipment. Alternatively, the strategy may be a competitive survival response to an unavoidable manufacturing trend; it may preserve rather than add value. If Cincinnati Milacron cannot benefit from production knowledge, its ties with clients and consistent reputation for innovation will combine to add value from the marketing side of the operation.

14. Super-Valu Stores, Inc., is the nation’s largest and most efficient grocery wholesaler and distributor. For example, Super-Valu has cut costs by raising storage density in its warehouses while minimizing the time and travel distance it takes workers to find and retrieve the goods. Using as many as 1,400 separate measurements, the company has been collecting data for over ten years on how both workers and wares move throughout the system. Industrial engineers have measured the capacity of each rack layout in each warehouse down to the square inch. A computer assigns “slot positions” to the incoming merchandise and tells the workers the order in which to pick cases for delivery. The data are then fed into a simulation program that analyzes and optimizes the productivity and storage capacity of various warehouse arrangements, given the merchandise to be stored. a. What is Super-Valu’s strategy for creating value?

Answer: Value creation seems to stem principally from Super-Valu’s ability to use the wholesale grocery business as a base to integrate vertically. It has the ability to put an aggressive retailer on equal footing with big grocery chains, and allows the small retailer to specialize in retail. In particular, Super Value provides market evaluation, site selection, design, wholesaling, and retail counseling services to the small retailer. Together with the retailers, Super-Valu has been able to help capture small markets and build solid reputations. Also, its own efficiencies in warehousing and delivery offer savings to the entire distribution channel.

b. How sustainable is Super-Valu’s competitive advantage?Answer: The advantages seem to be sustainable. While competitors may be able to duplicate Super-Valu’s strategies in other markets, they likely will find attacks on existing markets unprofitable. To the extent that Super-Value can retain its innovative edge, it can be assured that their competitive posture will remain intact.


15 Avis has invested a large amount of money to spread the message that “We’re Number Two and trying harder.” Number One in the rental car industry, of course, is Hertz. How did Avis’s investment in this advertising message fit in with its strategy for creating value? (Hint: Against whom is Avis really competing for market share?)Answer: Avis implanted in the consumer’s mind that if they didn’t rent from Hertz they should rent from “Number Two” and forget about the others. Avis gave the appearance of competing directly against Hertz. However, Avis’ real target was not Hertz, but Budget Rent-a-Car, National and other rental cars who, at the beginning of the campaign, approximated Avis’ market share.

CHAPTER 7: PROBLEMS1. Suppose the United States imposes a $10 per barrel tariff on imported refined oil products.

a. What is the short-run profit outlook for American refineries? What is the long-term profit outlook?

Answer: If a $10-a-barrel tax were levied on imported refined products, domestic refined product prices would be elevated above the world level by $10 a barrel compared with just $5 a barrel for crude oil. In such a case, distributors of refined products would be forced to pay a price equal to the world price plus the tax for their supplies. This would widen profit margins for U.S. refineries and shift the mix of imports toward crude oil and away from refined products. Before-tax profit margins for domestic oil refiners would rise by the amount of the tax.

Although tariffs would raise profits for the U.S. refining industry in the short run, the industry’s long-run prognosis would be troublesome. The higher current profits would draw more capital into the industry, capacity would expand, and prices and profits would decline over time until once again the profitability of the refining industry was no greater than that of any other industry.

b. Suppose that eight years after imposing this tariff, the United States revokes it. What is likely to happen to the refining industry at that time?Answer: If at a later date the U.S. government decided to eliminate the tariff, the refining industry would be stuck with an enormous amount of excess capacity, prices would fall, and many firms would go bankrupt as the industry downsized. This actually describes what happened after the entitlement program, which was a subsidy for refiners, was ended.

2. Wal-Mart, the discount merchandiser, began by putting large stores in small Sunbelt towns that its competitors had neglected. The company then wrapped its stores in concentric rings around regional distribution centers.a. What was Wal-Mart’s original strategy for creating value?

Answer: The strategy requires domination of small markets, reinforced with efficient distribution technologies.


b. How sustainable is the company’s competitive advantage?Answer: The advantage is potentially sustainable. Competitors may find little profit potential from tapping these limited markets. Even if they can, they would have to create an equally efficient distribution system to compete with Wal-Mart.

c. How is growth in its markets likely to affect Wal-Mart’s strategy? Answer: Growth may provide a greater incentive for competitive entry; rewards increase while costs remain the same. Wal-Mart may be able to retain its exclusionary access by expanding and cutting prices even further.

d. More recently, Wal-Mart has invested huge sums of money in a telecommunications system that links its stores together and accumulates information instantaneously on store-by-store sales of each item in stock . How might this investment create a competitive advantage for Wal-Mart?Answer: Wal-Mart may be able to retain its exclusionary access by expanding and cutting prices even further.

3. Suppose General Motors’s worldwide profit breakdown is 85 percent in the United States, 3 percent in Japan, and 12 percent in the rest of the world. Its principal Japanese competitors earn 40 percent of their profits in Japan, 25 percent in the United States, and 35 percent in the rest of the world. Suppose further that through diligent attention to productivity and substitution of enormous quantities of capital for labor (e.g., Project Saturn), GM manages to get its automobile production costs down to the level of the Japanese. a. Who is likely to have the global competitive advantage? Consider, for example, GM’s

ability to respond to a Japanese attempt to gain U.S. market share through a sharp price cut. Answer: Even if GM manages to get its costs down to the level of its Japanese competitors, it will still face a competitive disadvantage because of asymmetrical market shares. Suppose the Japanese cut their prices in order to gain market share in the U.S. If GM responds with its own price cuts, it will lose profit on 85% of its sales. By contrast, the Japanese will lose profit on only 25% of their sales. This puts GM in a bind: If its responds to this competitive intrusion with a price cut of its own, the response will hurt GM more than the Japanese.

b. What are the possible competitive responses of GM to the Japanese challenge? Answer: GM could reduce its costs still further through some major technological breakthroughs, by cutting domestic wages and benefits, or by sourcing more parts and components abroad. It could also improve its product differentiation in ways that are valued by auto buyers. Alternatively, GM could cut price in Japan.

c. How would you recommend that GM deal with the Japanese competition? Answer: GM is actively engaged in various cost cutting activities and this activity should continue regardless of what the Japanese do; it is not directly tied to their behavior. The second response—better product differentiation—is problematic given GM’s past history. The third alternative is the one to focus on. The correct place for GM to retaliate against a Japanese competitive intrusion in the U.S. would


appear to be Japan, where their competitors earn 40% of their profits. This response would hurt the Japanese more than it would hurt GM. But in order to make this retaliatory threat credible, GM would have to build up its Japanese market position, a tall order for any U.S. firm.

4. More and more Japanese companies are moving in on what once was an exclusive U.S. preserve: making and selling the complex equipment that makes semiconductors. World sales are between $3 billion and $5 billion annually. The U.S. equipment makers already have taken a beating in Japan. Their share of the Japanese market, serviced by exports, has slumped to 30 percent in 1988 from a dominant 70 percent in the late 1970s. Because sales in Japan are expanding as rapidly as 50 percent a year, Japanese concerns have barely begun attacking the U.S. market. But U.S. experts consider it only a matter of time. a. What are the possible competitive responses of U.S. firms?

Answer: The two classic responses are price cuts and innovation. Like GM’s problem in the solution above, American firms may never be able to match the Japanese cost advantage. The Wall Street Journal (01/09/85, p.34) reports that “U.S. semiconductor manufacturers think they are better prepared than the machine tool makers were. Several already are setting up manufacturing plants in Japan to compete more effectively.” As in question 2, one should retaliate in the competitor’s big market, not in one’s own market.

b. Which one(s) would you recommend to the head of a U.S. firm? Why? Answer: The firm might be advised to match price on current production and concentrate on the next wave in semiconductors. The firm should strive to strategically build a competitive advantage in the revised technology and completely overwhelm the market when the technology becomes current. It should concentrate on a regular process of innovation and erection of barriers to entry, protecting themselves against the incipient erosion of these barriers brought on by Japanese competitors.

5. Airbus Industrie, the European consortium of aircraft manufacturers, buys jet engines from U.S. companies. According to a recent story in the Wall Street Journal, “as a result of the weaker dollar, the cost of a major component (jet engines) is declining for Boeing’s biggest competitor.” The implication is that the lower price of engines for Airbus gives it a competitive advantage over Boeing. Assess the validity of this statement. Will Airbus now be more competitive relative to Boeing? Answer: For US sales, assuming that all components are US, there will be no net effect. The cost of supplies is lower for all inputs, but the price at which the products are sold will reflect the deflated currency value as well. However, assuming that part of the components or labor is European, Airbus will be at a relative disadvantage when it discovers that it cannot earn as much (in the European currency equivalent) as it did before. In general, the weaker dollar should make Boeing exports more lucrative.

6. Nordson Co. of Amherst, Ohio, a maker of painting and glue equipment, exports nearly half its output. Customers value its reliability as a supplier. Because of an especially sharp run-up


in the value of the dollar against the French franc, Nordson is reconsidering its decision to continue supplying the French market. What factors are relevant to reaching a decision? Answer: The problem tells us that customers value Nordson’s reliability as a supplier. If Nordson cuts and runs in France, other customers will take it as a signal as to how it is likely to respond elsewhere when the going gets tough. This will hurt Nordson’s sales to customers in other countries.

7. Tandem Computer, a U.S. maker of fault-tolerant computers, is thinking of shifting virtually all the labor-intensive portion of its production to Mexico. What risks is Tandem likely to face if it goes ahead with this move?

Answer: Tandem faces several risks:a. Quality Control - Tandem may not be able to insure the same quality standards from

equipment produced at the Mexican plant.b. Delivery Time - Tandem may not have access to an efficient delivery network because of

problems or misunderstandings concerning the Mexican transport systems.c. Production Disruptions - Actions taken by labor or the Mexican government may affect

adversely factor costs or revenues from production.d. Exchange Risk - Tandem runs the risk that the peso becomes expensive relative to the

dollar, or that Mexico experiences high inflation without devaluation of the peso.8. Germany’s $28 billion electronics giant, Siemens AG, sells medical and telecommunications

equipment, power plants, automotive products, and computers. Siemens has been operating in the United States since 1952, but its U.S. revenues account for only about 10% of worldwide revenues. It intends to expand further in the U.S. market. a. According to the head of its U.S. operation, “The United States is a real testing ground.

If you make it here, you establish your credentials for the rest of the world.” What does this statement mean? How would you measure the benefits flowing from this rationale for investing in the United States?

b. What other advantages might Siemens realize from a larger American presence? 9. Kao Corporation is a highly innovative and efficient Japanese company that has managed to

take on and beat Proctor & Gamble in Japan. Two of Kao’s revolutionary innovations include disposable diapers with greatly enhanced absorption capabilities and concentrated laundry detergent. However, Kao has had difficulty in establishing the kind of market-sensitive foreign subsidiaries that P&G has built. a. What competitive advantages might P&G derive from its global network of

market-sensitive subsidiaries? b. What competitive disadvantages does Kao face if it is unable to replicate P&G’s global

network of subsidiaries?10. Jim Toreson, chairman and CEO of Xebec Corporation, a Sunnyvale, California,

manufacturer of disk-drive controllers, is trying to decide whether to switch to offshore production. Given Xebec’s well-developed engineering and marketing capabilities, Toreson could use offshore manufacturing to ramp up production, taking full advantage of both low-wage labor and a grab bag of tax holidays, low-interest loans, and other government largess.


Most of his competitors seemed to be doing it: The faster he followed suit, the better off Xebec would be, according to the conventional discounted cash flow analysis, which showed that switching production offshore was clearly a positive NPV investment. However, Toreson is concerned that such a move would entail the loss of certain intangible strategic benefits associated with domestic production. a. What might be some strategic benefits of domestic manufacturing for Xebec? Consider

the fact that all its customers are American firms and that manufacturing technology—particularly automation skills—is the key to survival in this business. Answer: In the short run, these benefits include better quality control, better communication with customers, and the ability to adapt quickly to changing markets. In the long run, a domestic manufacturing facility would give Xebec a laboratory in which to apply the latest thinking about automated production. By working with the production process on a daily basis, Xebec would have a better sense of the wider potential of the technology, of possible applications it might not otherwise consider. For example, by running a highly-automated manufacturing operation next door to the engineering group, Xebec could provide production-related input in the early stages of product design, something that offshore production managers can rarely do. With successfully automated production, Xebec’s new disk drives could be offered with a price and quality level to match those of potential competitors from Japan or anywhere else.

b. What analytic framework can be used to factor these intangible strategic benefits of domestic manufacturing (which are intangible costs of offshore production) into the factory location decision? Answer: The intangible strategic benefits of domestic manufacturing can be factored into the factory location decision by using a variant of the option-pricing framework. By investing in domestic manufacturing Xebec creates for itself a series of opportunities to invest capital in the future so as to increase the profitability of its existing product lines and benefit from expanding into new products, markets or new process technologies. Whether Xebec exercises these growth options depends upon what happens in the future. The value of these growth options depend on several factors:

1. The length of time the project can be deferred. Factory automation allows Xebec to wait a longer time before responding to changes in the marketplace (because automation permits it to respond so quickly once it decides to respond). The investment in automation will also provide Xebec with a set of long-lasting skills.

2. The risk of the project. The riskier the investment the more valuable is an option on it. Thus, an investment in automation is likely to be especially valuable since it so risky.

3. The level of interest rates. The higher the interest rate the more valuable are projects that contain growth options.

4. The proprietary nature of the option. An exclusively owned option is clearly more valuable than one that is shared with others.


Valuing an investment in automation that embodies discretionary follow-up projects requires an expanded NPV rule that considers the attendant options. More specifically, the value of the option equals the expanded NPV from investing in the project using discounted cash flow analysis plus the value of the discretion associated with undertaking the project.

c. How would the possibility of radical shifts in manufacturing technology affect the production location decision? Answer: The possibility of radical shifts in manufacturing technology would increase the benefits from investing in factory automation in the United States. The phrase “radical shifts” implies that the project is high risk, which increases the option component of value. For example, companies that in the mid-1970s made the transition from electro-mechanical manually operated machine tools to automatic, electronically controlled ones, were subsequently able to exploit the revolution in capabilities—much higher performance at much lower cost—of the microprocessors and microcontrollers that became available in the early 1980s. For these companies, their operators, maintenance personnel, and process engineers were already familiar and comfortable with electronic technology so that it was a relatively simple task to retrofit powerful microelectronics when they became available. Companies that had deferred investment in the emerging electronic technology were not able to participate in the great technological advances in microelectronics; they had not acquired an option in this new process technology.

d. Xebec is considering producing more sophisticated drives, which require substantial customization. How does this possibility affect its production decision?

Answer: The more customization is required, the more important it is to work closely with the customer. To meet the exacting needs of customers, there must be close personal contact between Xebec’s engineering and production staff and representatives of the purchasing company, something all but impossible to achieve over 10,000 miles and with severe language and cultural barriers. It is also difficult to coordinate the efforts of marketing, engineering, design and manufacturing people when they are spread around the globe. This increases the value of domestic production facilities.

e. An alternative sourcing option is to shut down all domestic production and contract to have Xebec’s products built for it by a foreign supplier in a country like Japan. What might be some potential advantages and disadvantages of foreign contracting vis-a-vis manufacturing in a wholly owned foreign subsidiary?Answer: The opposite of the answer for (a) is the potential for lower cost. However, the time delay in transportation and innovation could cost Xebec both market share and its technical edge.

chapter 2: capitalbudgeting principles and techniquesleeds-faculty.colorado.edu/donchez/fnce...

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