Principles of Corporate Finance_ 12th Edition

282 Part Three Best Practices in Capital Budgeting

bre44380_ch11_279-301.indd 282 10/06/15 10:06 AM

◗ FIGURE 11.1

Beginning in year 6,

the department store’s

income fails to cover

the rental charge.

Year

1 2 3 4 5 6 7 8 9 10

7

8

9

10

Dollars, millions

Rental charge

Income

it would be foolish to make a lousy department store investment just because you are opti-

mistic about real estate prices. You would do better to buy real estate and rent it out to the

highest bidders. The converse is also true. You shouldn’t be deterred from going ahead with

a profitable department store because you are pessimistic about real estate prices. You would

do better to sell the real estate and rent it back for the department store. We suggest that you

separate the two bets by first asking, “Should we open a department store on this site, assum-

ing that the real estate is fairly priced?” and then deciding whether you also want to go into

the real estate business.

Let us look at another example of how market prices can help you make better decisions.

Kingsley Solomon is considering a proposal to open a new gold mine. He estimates that the

mine will cost $500 million to develop and that in each of the next 10 years it will produce

.1 million ounces of gold at a cost, after mining and refining, of $1,150 an ounce. Although

the extraction costs can be predicted with reasonable accuracy, Mr. Solomon is much less

confident about future gold prices. His best guess is that the price will rise by 5% per year

from its current level of $1,500 an ounce. At a discount rate of 10%, this gives the mine an

NPV of –$35 million:

NPV = −500 +

.1(1,575 − 1,150)

_______________

1.10

+

.1(1,654 − 1,150)

___

(1.10)^2

+... +

.1(2,443 − 1,150)

___

(1.10)^10

= −$35 million

Therefore the gold mine project is rejected.

Unfortunately, Mr. Solomon did not look at what the market was telling him. What is the

PV of an ounce of gold? Clearly, if the gold market is functioning properly, it is the current

price, $1,500 an ounce. Gold does not produce any income, so $1,500 is the discounted value

EXAMPLE 11.2 ● Opening a Gold Mine