Principles of Corporate Finance_ 12th Edition

Chapter 11 Investment, Strategy, and Economic Rents 287

bre44380_ch11_279-301.indd 287 10/09/15 10:02 PM

which is identical to Table 11.1 except for the forecasted spread, which would shrink to $.95
by the start of year 5. Now the NPV was negative.
The project might have been saved if production could have been started in year 1 rather
than 2 or if local markets could have been expanded, thus reducing transportation costs. But
these changes were not feasible, so management canceled the project, albeit with a sigh of
relief that its analysis had not stopped at Table 11.1.

❱ TABLE 11.2 What is the competitive spread to a European producer? About $.95

per pound of polyzone. Note that European producers face no transportation costs.

Compare Table 11.1 (figures in $ millions except as noted).

Investment

Transport

Other costs

Net revenues

Production costs

Production (millions of pounds per year)

Spread ($ per pound)

Cash flow

NPV (at r = 8%) = 0

100

0

0

0

0

2100

0.95

0

0.95

0

0

0

20

220

0

0.95

30

38

0

20

212

40

30

76

0

20

126

0.95

80

Year 0 Year 1 Year 2 Years 3–10

❱ TABLE 11.3 Recalculation of NPV for polyzone investment by U.S. company

(figures in $ millions except as noted). If expansion by European producers forces

competitive spreads by year 5, the U.S. producer’s NPV falls to –$9.8 million. Compare

Table 11.1.

Investment

Transport

Other costs

Net revenues

Production costs

Production (millions of pounds per year)

Spread ($ per pound)

Cash flow

NPV (at r = 8%) = 2 9.8

Year 0 Year 1 Year 2 Year 3 Year 4 Years 5–10

100

0

0

0

0

2100

1.20

0

0

0

0

20

220

1.20

0

30

48

4

20

26

1.20

40

30

96

8

20

38

1.20

80

30

88

8

20

30

1.10

80

30

76

8

20

18

0.95

80

● ● ● ● ●

This is a perfect example of the importance of thinking through sources of economic rents.
Positive NPVs are suspect without some long-run competitive advantage. When a company
contemplates investing in a new product or expanding production of an existing product, it
should specifically identify its advantages or disadvantages over its most dangerous competi-
tors. It should calculate NPV from those competitors’ points of view. If competitors’ NPVs
come out strongly positive, the company had better expect decreasing prices (or spreads) and
evaluate the proposed investment accordingly.

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