Principles of Corporate Finance_ 12th Edition

Chapter 11 Investment, Strategy, and Economic Rents 291

bre44380_ch11_279-301.indd 291 10/06/15 10:06 AM

It looks as if Marvin’s decision to go ahead was correct. But there is something we have
forgotten. When we evaluate an investment, we must consider all incremental cash flows.
One effect of Marvin’s decision to expand is to reduce the value of its existing 2034 plant.
If Marvin decided not to go ahead with the new technology, the $7 price of gargle blasters
would hold until Marvin’s competitors started to cut prices in five years’ time. Marvin’s deci-
sion, therefore, leads to an immediate $1 cut in price. This reduces the present value of its
2034 equipment by

24 million × ∑

t = 1

5

______1.00

(1.20)t

= $72 million

Considered in isolation, Marvin’s decision has an NPV of $299 million. But it also reduces
the value of existing plant by $72 million. The net present value of Marvin’s venture is, there-
fore, 299 – 72 = $227 million.

Alternative Expansion Plans

Marvin’s expansion has a positive NPV, but perhaps Marvin would do better to build a larger
or smaller plant. You can check that by going through the same calculations as above. First
you need to estimate how the additional capacity will affect gargle blaster prices. Then you
can calculate the net present value of the new plant and the change in the present value of the
existing plant. The total NPV of Marvin’s expansion plan is

Total NPV = NPV of new plant + change in PV of existing plant

We have undertaken these calculations and plotted the results in Figure 11.3. You can see how
total NPV would be affected by a smaller or larger expansion.
When the new technology becomes generally available in 2044, firms will construct a
total of 280 million units of new capacity.^19 But Figure 11.3 shows that it would be foolish

◗ FIGURE 11.3

Effect on net present value of alternative

expansion plans. Marvin’s 100-million-unit

expansion has a total NPV of $227 million

(total NPV = NPV new plant + change in PV

existing plant =  299  –  72  = 227). Total NPV

is maximized if Marvin builds 200 million

units of new capacity. If Marvin builds 280

million units of new capacity, total NPV is

• $144 million.

100 200 280

600

400

200

–144

–200

NPV new plant

Present value, millions of dollars

Change in PV

existing plant

Addition to capacity, millions of units

Total NPV of

investment

0

(^19) Total industry capacity in 2044 will be 400 million units. Of this, 120 million units are second-generation capacity, and the remain-
ing 280 million units are third-generation capacity.