Principles of Corporate Finance_ 12th Edition

290 Part Three Best Practices in Capital Budgeting

bre44380_ch11_279-301.indd 290 10/06/15 10:06 AM

As capacity is sold off, the supply of gargle blasters will decline and the price will rise.

An equilibrium is reached when the price gets to $6. At this point 2026 equipment has a

zero NPV:

NPV = −2.50 + __________6.00 − 5.50

.20

= $0 per unit

How much capacity will have to be sold off before the price reaches $6? You can check that

by going back to the demand curve:

Demand = 80 × (10 − price)

= 80 × (10 − 6) = 320 million units

Therefore Marvin’s expansion will cause the price to settle down at $6 a unit and will induce

first-generation producers to withdraw 20 million units of capacity.

But after five years Marvin’s competitors will also be in a position to build third generation

plants. As long as these plants have positive NPVs, companies will increase their capacity

and force prices down once again. A new equilibrium will be reached when the price reaches

$5. At this point, the NPV of new third-generation plants is zero, and there is no incentive for

companies to expand further:

NPV = −10 + 5.00 − 3.00__________

.20

= $0 per unit

Looking back once more at our demand curve, you can see that with a price of $5 the industry

can sell a total of 400 million gargle blasters:

Demand = 80 × (10 − price) = 80 × (10 − 5) = 400 million units

The effect of the third-generation technology is, therefore, to cause industry sales to expand

from 240 million units in 2038 to 400 million five years later. But that rapid growth is no pro-

tection against failure. By the end of five years any company that has only first-generation

equipment will no longer be able to cover its manufacturing costs and will be forced out of

business.

The Value of Marvin’s New Expansion

We have shown that the introduction of third-generation technology is likely to cause gargle

blaster prices to decline to $6 for the next five years and to $5 thereafter. We can now set

down the expected cash flows from Marvin’s new plant:

Year 0

(Investment)

Years  1–5 

(Revenue – Manufacturing

Cost)

Year  6, 7, 8, . . .  

(Revenue – Manufacturing

Cost)

Cash flow per unit ($) – 10 6  –  3  =  3 5  –  3  =  2

Cash flow (100 million

units, $ millions)

• 1,000 600  –  300  =  300 500  –  300  =  200

Discounting these cash flows at 20% gives us

NPV = −1,000 + ∑

t = 1

5

______^300

(1.20)t

+ ______^1

(1.20)^5

(

200 ____

.20

)

= $299 million