Chapter 5 Investment Decisions: Look Ahead and Reason Back

1. Chapter 5Investment Decisions: Look Ahead and Reason Back

2. Chapter 5 – Summary of main points • Investments imply willingness to trade dollars in the present for dollars in the future. Wealth-creating transactions occur when individuals with low discount rates (rate at which they value future vs current dollars) lend to those with high discount rates. • Companies, like individuals, have different discount rates, determined by their cost of capital. They invest only in projects that earn a return higher than the cost of capital. • The NPV rule states that if the present value of the net cash flow of a project is larger than zero, the project earns economic profit (i.e., the investment earns more than the cost of capital). • Although NPV is the correct way to analyze investments, not all companies use it. Instead, they use break-even analysis because it is easier and more intuitive. • Break-even quantity is equal to fixed cost divided by the contribution margin. If you expect to sell more than the break-even quantity, then your investment is profitable.

3. Chapter 5 – Summary (cont.) • Avoidable costs can be recovered by shutting down. If the benefits of shutting down (you recover your avoidable costs) are larger than the costs (you forgo revenue), then shut down. The break-even price is average avoidable cost. • If you incur sunk costs, you are vulnerable to post-investment hold-up. Anticipate hold-up and choose contracts or organizational forms that minimize the costs of hold-up. • Once relationship-specific investments are made, parties are locked into a trading relationship with each other, and can be held up by their trading partners. Anticipate hold-up and choose organizational or contractual forms to give each party both the incentive to make relationship-specific investments and to trade after these investments are made.

4. Introductory anecdote • In summer 2007, Bert Matthews was contemplating purchasing a 48-unit apartment building. • The building was 95% occupied and generated $550,000 in annual profit. • Investors expected a 15% return on their capital • The bank offered to loan Mr. Matthews 80% of the purchase price at a rate of 5.5% • Mr. Matthews computed the cost of capital as a weighted average of equity and debt. • .2*(15%) + .8*(5.5%) = 7.4% • Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break even. • Mr. Matthews decided not to buy the building. A good decision – one year later, the cost of capital was 10.125% and Mr. Matthews could offer only $5.4 million for the building. • This story illustrates both the effect of the bursting credit bubble on real estate valuations and, more importantly, the relevant costs and benefits of investment decisions.

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

6. Determining investment profitability • The current/future trade-off can be calculated by, • Compounding • Xt+1=(1+r) Xt • Xt+s=(1+r)sXt • Discounting (the opposite of compounding) • Xt+1/(1+r)= Xt • Xt+s/(1+r)s= Xt • Discussion: If my discount rate is 10%, would I lend to or borrow from someone with a discount rate of 15%? • What does this say about behavior?

7. Present value and investment decisions • Companies also have discount rates, which are determined by cost of capital. • A company’s cost of capital is a blend of debt and equity, its “weighted average cost of capital” or WACC • Time is a critical element in investment decisions • cash flows to be received in the future need to be discounted to present value using the cost of capital • The NPV Rule: if the present value of the net cash flows is larger than zero, the project if profitable.

8. The NPV rule in action • For this example the company’s cost of capital is 14% • To determine profitability, discount future inflows and outflows to compare with the initial investment – here $100

9. NPV and economic profit • Projects with a positive NPV create economic profit. • Only positive NPV projects earn a return higher than the company’s cost of capital. • Projects with negative NPV may create accounting profits, but not economic profit. • In making investment decisions, choose only projects with a positive NPV.

10. Background: break-even quantities • The break-even quantity is the amount you need to sell to just cover your costs • At this sales level, profit is zero. • The break-even quantity is Q=FC/(P-MC), where FC are fixed costs, P is price, and MC is marginal cost • (P-MC) is the “contribution margin” – what’s left after marginal cost to “contribute” to covering fixed costs

11. Decision making example: Nissan truck • Nissan’s popular truck model, the Titan, had only two years remaining on its production cycle. Redesigning the “Titan” would cost $400M. • Cost of capital was 12%, implying annual fixed cost of $48M • Contribution margin on each truck is $1,500 • Break-even quantity is 32,000 trucks • The decision to redesign or not came down to a break-even analysis • Nissan had a 3% share of the market, implying only 12,000 Titan sales per year – not enough to break even. • Instead they decided to license the Dodge Ram Truck, which would reduce the fixed cost of redesign, and a lower break-even point. • After the Government took over Chrysler, Nissan reconsidered

12. Deciding between two technologies • In 1983, John Deere was in the midst of building a Henry-Ford-style production line factory for large 4WD tractors • Unexpectedly, wheat prices fell dramatically reducing demand for large tractors • Deere decided to abandon the new factory and instead purchased Versatile, a company that assembled tractors in a garage using off-the-shelf components • A discrete investment decision – the factory had big FC and small MC, Versatile had small FC but bigger MC • Remember this advice: Do not invoke break-even analysis to justify higher prices or greater output.

13. The decision to shut-down • Shut-down decisions are made using break-even prices rather than quantities. • The break-even price is the average avoidable cost per unit • Profit = Rev-Cost= (P-AC)(Q) • If you shut down, you lose your revenue, but you get back your avoidable cost. • If average avoidable cost is less than price, shut down. • Determining avoidable costs can be difficult. • To identify avoidable costs firms use Cost Taxonomy

14. Cost Taxonomy

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

16. Sunk costs and post-investment hold up • National Geographic can reduce shipping costs by printing with regional printers. • To print a high quality magazine, the printer must buy a $12 million printing press. • Each magazine has a MC of $1 and the printer would print 12 million copies over two years. • The break-even cost/average cost is $7 = ($12M / 2M copies) + $1/copy • BUT once the press is purchased, the cost is sunk and the break-even price changes. • Because of this the magazine can hold up the printer by renogiating the terms of the deal – because the price of the press is unavoidable, and sunk, the break-even price falls to $1, the marginal cost.

17. Sunk costs and post-investment hold up (cont.) • Always remember the business maxim “look ahead and reason back.” This can help you avoid potential hold up. • Before making a sunk cost investment, ask what you will do if you are held up. • What would you do to address hold up? • One possible solution to post-investment hold-up is vertical integration.

18. Vertical integration • Example: Bauxite mine and alumina refinery • Refineries are tailored to specific qualities of ore • The transaction options are: • Spot-market transactions • Long-term contracts • Vertical integration • Vertical integration refers to the common ownership of two firms in separate stages of the vertical supply chain that connects raw materials to finished goods • Discussion: How is vertical integration a solution to hold up? • Contractual view of marriage • What is the hold-up problem?