CHAPTER 14 Making Long-Term Investment Decisions SOLUTIONS FOR 14.46, 50, 51, 52, 53, 54, 63, 64, 66, 67, 68, 69, 70, 71, 76, 77, 78 HAVE LINKS TO EXCEL SOLUTIONS AND TEMPLATES ANSWERS TO REVIEW QUESTIONS 14.1 A consumption decision sacrifices current resources for current uses, needs, or enjoyment. An investment decision sacrifices current resources for hopefully greater future uses, needs, or enjoyment. 14.2 Discounted cash flow (DCF) methods forecast current and future cash flows. Rather than simply summing positive and negative cash flows over time, DCF methods “discount” future cash flows to reflect the current amount(s) that would have to be invested to achieve future amount(s) if the opportunity rate (or discount rate) were earned each period. 14.3 The two major factors affecting strategic investment decisions are uncontrollable future events and competitors’ actions. 14.4 These companies attempted to make investment decisions consistent with their strategic goals. RealNetworks wanted to be sure that it was on the cutting edge of music distribution technology, so it entered a joint venture with music production companies while at the same time investing in new, possibly superior, but unproved technology. Time Warner wanted to be sure that it had a strong position in the potentially immense Chinese movie distribution business, so it built a state-of-the-art cinema complex that would set a high standard for competitors to meet. Benetton wanted to insure that its socially responsible image was identified with its clothing, so it tackled world hunger within the context of building its brand image. 14.5 Organizations Can Plan For Uncontrollable External Events In Several Ways. First, Buy Insurance To Cover Possible Losses. Second, Make Contingency Plans That Can Be Implemented Quickly In The Event Of Either Catastrophes Or Opportunities. Third, Train Employees To Recognize The Early Signs Of Imminent Changes. 14.6 Due Diligence Investigations Can Uncover Legal And Environmental Liabilities. Furthermore, Due Diligence Can Identify Differences In Legal Obligations Across Jurisdictions Or Countries. Due Diligence Might Also Uncover Unexpected Opportunities.14.7 Financial records about the past are not much help if future events are unprecedented, such as possible impacts of genetic engineering. However, financial records can provide insights into the cash flows from similar events that have occurred previously. Clearly, assessing and pricing the risks of future, uncontrollable events, based on past experience, is how insurance companies make profits. 14.8 Creative employees, particularly in brainstorming sessions, often are able to identify unforeseen future events and think "outside of the box." Their ability to assess probabilities of occurrence, however, might be limited because humans are notoriously poor intuitive statisticians. We can be greatly affected by various biases that either inflate or deflate probabilities inappropriately. Experienced consultants should be able to both draw on past experiences to identify possible future events and assess their likelihood of occurrence – at least as “unlikely” or “highly likely.” Some consultants, known as “futurists” make their living doing this type of forecasting. 14.9 Several great advantages of using news, government, foundation, and industry analyses are (a) low cost and (b) relative lack of bias. Of course, the low cost of these data might be offset by high cost of effective analysis, which is even more important. Bias is unavoidable in human reporting and analysis, but generally external sources of information will be unbiased with respect to a particular strategic investment. 14.10 Three approaches covered in this text to modeling the effects and probabilities of future events are sensitivity analysis, scenario analysis, and expected value analysis. Other approaches include mathematical modeling and Monte Carlo simulations. Sensitivity and scenario analyses are covered in Chapter 12. 14.11 Expected value analysis first requires the analyst to predict outcomes of a decision, depending on the realization of specific future events. For example, an agricultural analyst would predict crop yields given alternative long-run weather forecasts. Second, the analyst must assess the probabilities or likelihoods of each future event. Continuing the agriculture example, long-run weather forecasts are based on understanding past weather patterns, and meteorologists attach probabilities to their forecasts based on past experience. Third, the analyst weights each possible outcome by the probability of the future event that drives it, sums the weighted outcomes, and obtains the expected value. 14.12 The expected market growth is computed by multiplying each possible growth by its probability of occurrence and summing, as follows. Expected growth = 0.10 x 0.30 + 0.02 x 0.70 = 0.044 = 4.4% 14.13 The strict meaning of this expected market growth rate of 4.4% is that, if conditions remain constant, over a long period of time market growth will average 4.4%. Conditions never remain constant, so a more realistic interpretation of this figure is that it is a degree of belief about future market growth. In this simplified example, only two rates of growth are predicted, and the expressed probabilities of each rate are such that the expected value is somewhat pessimistic. That is, this analysis says that the actual growth rate is more likely to be low than high. 14.14 Sometimes individual investments are affected by other investments. That is, an organization might experience synergies (or “complementarity”) from investing in groups or bundles of investments simultaneously. Synergies could arise from scale of investment (e.g., reduced costs of analysis and implementation) and also from organizational and process changes that create impacts that are more than the sum of individual parts. For example, organizations have found that implementing TQM or JIT can have benefits, but implementing both simultaneously has even greater benefits because of related changes in employee knowledge, motivation, and empowerment. 14.15 First, analysts forecasted the future market size over the investment horizon (row 2) using the expected growth rate from Exhibit 14-8. Second, analysts applied the predicted market share of 20 percent (row 3) to the market size to forecast company sales over time (row 4). Third, analysts applied one minus the gross margin ratio to forecasted sales to obtain cost of goods sold (row 5) and subtracted this from sales to obtain gross margin (row 6). This appears to involve an unnecessary step, but it preserves the appearance of a typical income statement. 14.16 Depreciation is a non-cash expense that is necessary for computing operating, taxable income, and tax payments. However, depreciation understates cash flow and is added back to after-tax income to compute after-tax operating cash flow. 14.17 Sometimes quantitative analyses cannot capture all of the relevant features of an investment decision. This can be especially true when strategic decisions confront unfamiliar conditions and quantitative analyses reflect past, possibly irrelevant experience. Overriding quantitative analysis on the basis of qualitative factors is not the same as making decisions on a hunch or by the seat of the pants because qualitative factors can reflect sound opinions and judgments. 14.18 Strategy implies competition. If a firm acts in a perfectly competitive market, its or its competitors’ actions, by definition, do not affect demand or a firm’s profitability. However, in smaller, less competitive markets, competitors’ actions can affect demand and profitability. For example, suppose you are considering purchasing a fast-food franchise from Burger King. Would it matter to you if a competitor is considering purchasing a franchise from McDonalds and locating next door? of course it would. The fascinating field of game theory is devoted to understanding how competitors act in these less than perfectly competitive situations. 14.19 Real option value (ROV) analysis models management flexibility to change the nature or structure of an investment. Traditional net present value (NPV) analysis unrealistically presumes that managers would commit to an investment and never change it, regardless of future events. When management does have flexibility to change (defer, scale-up, terminate, etc.) an investment, ROV is a more realistic and descriptive approach to strategic investment analysis. ROV is an important refinement of traditional NPV analysis. 14.20 ROV analysis might give different advice than traditional NPV analysis because ROV analysis can explicitly measure the value of flexibility to change a strategic investment. Traditional NPV analysis is incorrect if management has flexibility to modify an investment. 14.21 Correctly comparing two investment alternatives requires that they have equal investment lives. When two investments have unequal lives, analysts must make judgments about how to equalize them. One approach, followed by the ShadeTree analysts, is to extend the life of the shorter investment. This is usually not terribly difficult for relatively short investments and small differences in lives. Equalizing investment lives is more difficult when investment lives are long and greatly different. 14.22 The value of a real option is derived by comparing the expected net present values of the several forms or structures of the strategic investment. For example, the comparison of the expected net present value of making an investment now versus waiting for better information reveals the value of the option to wait, which might be positive or negative. 14.23 Enforcing ethical investment practices requires that one can (a) clearly define ethical investment practices, (b) observe investment practices and (c) have the will and legal or political power to enforce ethical investment practices. Recent mutual fund scandals in the U.S. demonstrate difficulties in all three areas. We now have a sharper definition of ethical mutual fund investment practices (e.g., no late or personal trading allowed by mutual fund managers). We also have the technology to better observe mutual fund investment practices, but more transparency is probably needed. However, some allege that the SEC was aware of unethical practices by mutual funds but did nothing of substance to curb them because of political concerns for the well-being of the industry. 14.24 Individuals might misstate strategic investment information because of personal bias, unwillingness to admit mistakes, or desire to maintain compensation based strategy-related incentives. 14.25 Internal controls support ethical investment practices by instituting incentives, communication, oversight, reporting, and approvals that regulate activities. Internal auditing also supports ethical investment practices by creating a climate of compliance and by detecting violations. ANSWERS TO CRITICAL ANALYSIS 14.26 The NPV method does exclude many factors that are difficult or impossible to quantify. Nevertheless, it is a useful method for wisely allocating resources, and it aligns the allocation of resources with the interests of those who provide capital to the organization (e.g., stockholders). One would be wise to supplement NPV analysis with qualitative information and exploration of sources of risk via sensitivity and scenario analyses. 14.27 The statement is generally true. Investments should be made that are consistent with the company's strategy. Sometimes a deal comes along that is too good to pass up. In such a case and as long as the investment does not conflict with company goals and values, a company might depart from its strategic plan (or revise the plan to accommodate the investment). 14.28 Routine machine replacement decisions probably have little flexibility and ROV analyses might not reveal many sources or values of flexibility. However, a major strategic change such as replacing mass production with flexible JIT has important, long-run implications. Such a decision is likely to have inherent flexibility itself. One would expect ROV analysis to be particularly important here. 14.29 The answer depends on the project. Imagine replacing computers with new models. This replacement may have little effect on cash flows aside from the cost of acquiring and installing the computers and the training of employees. All things considered, cash flow estimates can be made reasonably accurately. However, the cost of capital for an organization is difficult to estimate because it requires knowing the opportunity costs of the investors. Analysts use discount rates based on market indicators of risk, returns and interest rates, but these might be poor proxies for true opportunity costs of capital. This problem is exacerbated in organizations that do not have publicly traded stock. All numbers are more difficult to estimate in strategic decisions than in replacement decisions, but the amount and timing of cash flows can be particularly to estimate. As difficult as it is to estimate the cost of capital, the market rates of return provide at least starting positions for making such estimates. So one's answer does change when considering strategic versus replacement decisions. The amount and timing of cash flows are generally the most problematic numbers in strategic decisions, whereas the cost of capital is generally the most problematic number in replacement decisions. 14.30 The company probably used qualitative criteria (e.g., Is the project consistent with company goals and values? Is the project politically or environmentally risky? Does the project fit with the company’s capabilities? Will it create competitive advantages?) and possibly payback period. However, if one has the information to compute payback, one is nearly done with NPV analysis, so no economy of effort would be realized. Most likely, the company used qualitative criteria to screen projects to a more manageable number. 14.31 Environmental impact studies are likely to be very important in defense, electronics, chemicals, rubber, bio-tech, and construction industries, among others. Such studies are not likely to be important in consulting, law, and financial services industries. Due diligence identifies ‘skeletons in the closet.’ One should perform both due diligence and discounted cash flow analyses. They are complements, not substitutes. (They are required for IPOs--initial public offerings and a very good idea in all organizations as the Enron scandal taught us.) 14.32 The executive is favoring the short run at the expense of the long run. The executive might be protecting his or her bonus, promotion opportunities, or ability to move to another job that are based on current, reported profits. It is not obvious that the executive is protecting stockholders by keeping current profits high at the expense of future profits; the reverse might be true. 14.33 Both companies are exhibiting the belief in “doing well by doing good.” Some argue that such activities are wastes of stockholder money and that charity should be exercised by stockholders not managers. On the other hand, doing well by doing good might be a shrewd business decision to differentiate the company and appeal to a customer group that is willing to pay premium prices for the company’s products. It is also possible that pursuing multiple goals (doing well and doing good) is not a bad thing. 14.34 RealNetworks’ decisions appear to be more covertly strategic than Time Warner’s. However, both were aimed at creating and maintaining competitive advantages. RealNetworks invested in an option by buying equity in innovative but risky technology. One must assume that its joint venture contract with others had an escape clause so that RealNetworks could legally and ethically withdraw. 14.35 Every strategic plan should have an exit plan, keyed to comparisons of planned and actual performance. Solutions might vary greatly, but possible themes include (a) taking local partners, (b) promoting and advertising more effectively, or (c) selling to the major competitor. 14.36 Many regard variation in outcomes as an indication of risk. Sensitivity analysis identifies sources of possible variation in outcomes. Scenario analysis builds plausible causes and effects that could result in different model parameters and outcomes. Adding a risk premium to the discount rate is conservative by requiring higher expected cash flows for projects identified as riskier, but does not identify either sources of risk that might be manageable or flexibility in managing investments. Therefore, adding a risk premium might lead to rejecting projects that might be acceptable if the sources of risk were better understood and managed. 14.37 The most important part of NPV analysis is forecasting future cash flows. ABC analysis should identify how a project or activity consumes resources. Cash flows from a new project might be modeled better using ABC than more traditional costing methods. However, one must be careful to distinguish between the use of already committed costs and the need to acquire new resources. The former probably is not a relevant cash flow, whereas the latter probably is. 14.38 This major investment program is only looking at the plant, property, and equipment side of the investment. A more flexible, JIT production method might not be successful when managed in an organization set up for mass production. Therefore, the benefits from the change probably have been overstated and the costs necessary to support the new system have been understated. 14.39 Depreciation can be an important part of NPV analysis because it is an expense for operating and taxable income, which determines the tax payment. Depreciation is certainly not a source of funds, per se. However, as a deduction for tax purposes, it reduces cash outflows for taxes. Although depreciation is itself not a cash flow, it is a determinant of cash flow through its affect on tax payments. 14.40 ROV analysis can be very complex, but careful analysis can identify the important complexities and sources of management flexibility. No model can or should try to mirror the complexities of the real world; however, ignoring management flexibility, which traditional NPV does, is not a beneficial simplification. Making the ROV analysis tractable will force analysts to focus on only the most important complexities. 14.41 Hiring from competitors is common practice. However, the individuals who are likely to have intimate strategic knowledge (as opposed to operating knowledge) often sign “non-compete” contracts which forbid them from working for another company in the same industry for some period of time. For example, it is common for CEOs to change jobs, but it is very rare that they take executive positions within the same industry. Asking someone to violate a non-compete contract is unethical and probably illegal, and one should wonder whether anyone who would agree to do so would be a trusted employee. SOLUTIONS TO EXERCISES For purposes of presentation, all present value factors have been rounded to three places. The answers reflect present values computed by calculator or computer, which are more accurate than computing present values using the rounded present value factors. 14.42 (15 min) Strategic investments a. Routine – Personal computers have a technological life of 3 to 4 years, so replacing them on this schedule is not a strategic decision. However, one could argue that failing to replace them could place the university at a strategic disadvantage in attracting new students and faculty. b. Strategic – Although Microsoft has routinely purchased innovations, this just illustrates that Microsoft is routinely strategic, looking for competitive advantages. c. Strategic – Again, Southwest Airlines is routinely strategic, and basing maintenance facilities in Mexico creates a cost advantage over competitors who have maintenance done in higher cost locales. Several other major US airlines have recently imitated Southwest and have created maintenance bases in Mexico. d. Strategic – GE has long had a strong commitment to in-house education and training, and GE clearly believes it has a competitive advantage as a result. 14.43 (15 min) Strategic investments a. Routine – StorageTek believed that becoming a JIT manufacturer was an imperative to keep up with competitors. Therefore, this probably did not confer any competitive advantage, although it was necessary. b. Routine – Procter & Gamble routinely seeks to manage its costs more effectively. Using ABM can be an effective approach, but it is unlikely that it creates competitive advantages, because all competitive companies are acting similarly. c. Routine – IBM continuously investigates new products. Perhaps a particular proposal might revolutionize a particular industry and create significant competitive advantages. Indeed, one of IBM’s indicators of new product success is the number of patents awarded. d. Strategic – Whole Foods set out to demonstrate its superiority to its smaller rival, Wild Oats, by locating a major store in the rival’s hometown. This caused Wild Oats to launch a new strategic effort to expand its store locations even more rapidly than Whole Foods. Wild Oats appears to have overextended itself and has retrenched, leaving Whole Foods even stronger. 14.44 (15 min) Uncontrollable external events External events Competitors’ actions Level3 Economic downturn Political instability Also install cable Invest in wireless internet Chrysler-Daimler Price of oil Global warming Also develop fuel cell Political action to resist fuel economy and pollution reduction regulations Motorola Economic downturn Solar flare radiation Develop cheaper, land-based system Partnerships to expand system coverage Merck/Schering-Plough Aging population Population health Develop rival drugs Influence FDA approval process 14.45 (15 min) Uncontrollable external events External events Competitors’ actions Texas Federal or court decisions Crime rates Similar states’ decisions drive up costs Drug treatment programs reduce drug-related crimes Community Hospital Population growth 100-year flood Improve hospital facilities Block construction in flood zone California Economic downturn Population growth Private or other states’ colleges tuition rates Increased corporate training Qwest Economic conditions Political constraints against offshoring Similar actions by other telecomm companies Union counteractions 14.46 (15 min.) Using forecasts in NPV analysis ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.47 (10 min.) Evaluating qualitative factors a. Qualitative factors include: alternative projects that the city could undertake with the funds, public pressures for the community center or other projects, the ability to properly equip and staff the expanded community center, the types of activities that fit the expansion, disruption to existing activities during construction. b. If qualitative factors are believed to be valued at least at $ 5,754, they would make the project financially viable. This is a subjective evaluation, but so is assuming that they have zero value. 14.48 (15 min.) Using forecasts in NPV analysis Discount rate (a) 8% Discount rate (b) 4% End of year Cost savings 1 $ 10,000 2 12,000 3 14,000 4 16,000 5 18,000 (a) Net present value = $ 54,672 (b) Net present value = $ 61,628 14.49 (10 min) Evaluating qualitative factors a. Qualitative factors include: improved employee morale and retention, improved access by patients, increased quality and frequency of care, contributions to reduced traffic congestion and air pollution. b. If these qualitative factors are valued to be worth at least $70,000 - $54,672 = $15,328, the project would be financially viable. 14.50 (30 min.) Basic DCF analysis using Excel Discount rate 10% Present Value End of Year Initial cash flows for year: 0 1 2 3 4 Discount Factor @ 10.0% 1.000 0.909 0.826 0.751 0.683 a. $ (6,000) now $(6,000) $(6,000) b. $ 2,500 one year from now 2,273 $2500 c. $ 3,000 two years from now 2,479 $3000 d. $ 2,500 three years from now 1,878 $ 2,500 e. $ 2,000 four years from now 1,366 $2,000 f. Net present value using SUM $1,996 $(6,000) $2,500 $3,000 $2,500 $2,000 g. Net present value using NPV $ 1,996 h. Internal rate of return using IRR 25.2% ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.51 (30 min.) Basic DCF analysis using Excel Discount rate 8% Present Value End of Year Initial cash flows for year: 0 1 2 3 4 Discount Factor @ 8.0% 1.000 0.926 0.857 0.794 0.735 a. $ (5,000) now $ (5,000) (5,000) b. $ 1,500 one year from now $ 1,389 1,500 c. $ 2,000 two years from now $ 1,715 2,000 d. $ 1,700 three years from now $ 1,350 1,700 e. $ 1,500 four years from now $ 1,103 1,500 f. Net present value using SUM $ 556 (5,000) 1,500 2,000 1,700 1,500 g. Net present value using NPV $ 556 h. Internal rate of return using IRR 12.9% ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.52 (30 min.) DCF analysis using Excel Discount rate 7% Present Value End of Year Initial cash flows for year: 0 1 2 3 4 5 Discount Factor @ 7.0% 1.000 0.935 0.873 0.816 0.763 0.713 a. $ (5,000) now $ (5,000) $ (5,000) b. $ 1,000 one year from now $ 935 1,000 c. $ 1,000 two years from now $ 873 1,000 d. $ 1,000 three years from now $ 816 1,000 e. $ 1,000 four years from now $ 763 1,000 f. $ 1,000 five years from now $ 713 1,000 g. Net present value using SUM $ (900) (5,000) 1,000 1,000 1,000 1,000 1,000 h.Net present value using NPV (900) i. NPV using PV (900) j. Internal rate of return using IRR 0.0% k. Payback period 5 years 5 years using NPER l. Annual NCF to make a zero NPV $ 1,219 using Solver and the solution to part "I" m. Initial cost to make a zero NPV $ (4,100) using Solver and the solution to part "I"; also = $5,000 - $900 (NPV); could be interpreted as additional fee to create 7% IRR ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.53 (20 min) Payback period a. Payback period for Exercise 14-50 Annual NCF Cumulative NCF Unrecovered Investment cost Payback year 0 (6,000) (6,000) year 1 2,500 $ 2,500 (3,500) 1.00 year 2 3,000 5,500 (500) 1.00 year 3 2,500 8,000 2,000 0.20* year 4 2,000 10,000 4,000 Payback 2.20 years *0.20 = $500/$2,500, where $500 is the amount required to hit the payback amount of $6,000. b. Payback period for Exercise 14-51 Annual NCF Cumulative NCF Unrecovered Investment cost Payback year 0 (5,000) (5,000) year 1 1,500 $ 1,500 (3,500) 1.00 year 2 2,000 3,500 (1,500) 1.00 year 3 1,700 5,200 200 0.88* Payback 2.88 years *0.88 = $1,500/$1,700, where $1,500 is the amount required to hit the payback amount of $5,000. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.54 (30 min) DCF analysis of a bond using Excel Coupon rate 10% Discount (market) rate 7% Present Value End of Year Initial cash flows for year: 0 1 2 3 4 5 Discount Factor @ 7.0% 1.000 0.935 0.873 0.816 0.763 0.713 a. $ (5,000) now $ (5,000) $(5,000) b. $ 500 one year from now $ 467 500 c. $ 500 two years from now $ 437 500 d. $ 500 three years from now $ 408 500 e. $ 500 four years from now $ 381 500 f. $ 500 five years from now $ 356 500 g. $ 5,000 five years from now $ 3,565 5,000 h. Net present value using SUM $ 615 (5,000) 500 500 500 500 5,500 i. Net present value using NPV $ 615 j. Internal rate of return using IRR 10.0% ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.55 (20 min) Modeling competitors’ actions Original market $ 200,000 Market growth 100% Market share (a) 25% Market share (b) 10% Gross margin ratio 30% (a) Sales revenue $ 100,000 Cost of sales 70,000 Gross margin $ 30,000 (b) Sales revenue $ 40,000 Cost of sales 28,000 Gross margin $ 12,000 14.56 (25 min) Modeling competitors’ actions Current mall sales $ 80,000,000 Decline during renovation -25% Growth after renovation (a) 20% Growth after renovation (b) 5% Sales tax rate 3% (a) Mall revenues during renovation $ 60,000,000 Mall revenue growth 12,000,000 Total mall revenue 72,000,000 Sales tax rate 3% City sales tax revenue $ 2,160,000 (b) Mall revenues during renovation $ 60,000,000 Mall revenue growth 3,000,000 Total mall revenue 63,000,000 Sales tax rate 3% City sales tax revenue $ 1,890,000 14.57 (20 min) Decision tree and expected NPV Decide now 1st Decision Competitor? 2nd Decision NPV Outcome Best Choice Pr = Continue ($28,058) no 40% Yes Terminate ($15,556) YES Invest Pr = Continue $15,063 YES 60% No Invest now or not Terminate ($15,556) no Don't invest $0 Expected value of best decision if decide now $2,816 14.58 (20 min) Decision tree and expected NPV Wait one year Outcome Competitor? 2nd Decision NPV Outcome Best Choice Pr = Invest ($17,410) no 40% Yes Don't invest $0 YES Don't decide yet Pr = Invest $15,712 YES 60% No Don't invest $0 no Expected value of best decision if wait one year $9,427 14.59 (15 min.) Real option value a. The value of the option to wait is the difference of the expected NPVs of the best decisions = $9,427 - $2,816 = $6,611. b. The economic meaning of this figure, $6,611, is that Fish Taco Co should be willing to pay up to $6,611 for the right to defer its investment decision by one year. If the company wants the owner of the property to take it off the market and hold it for a year, Fish Taco should be prepared to compensate the owner for postponing the sale. Fish Taco would pay the property owner no more than $6,611 for the option on the property. 14.60. (20 min.) Ethical investment practices Unethical or Illegal Ethical or Legal a. Paying a fee to a third party who understands local market conditions and can streamline interactions with government regulators A bribe that is prohibited by law A legal business intermediary or consultant b. Restating the expected salvage value of an investment An attempt to improperly justify a non-viable project A legitimate re-estimate c. Obtaining information about a competitor’s planned actions Illegal industrial espionage Legitimate competitor analysis d. Not giving close supervision to subordinates who make investment plans or decisions Turning a “blind eye” to unethical practices that benefit the organization in the short run Decentralized management of autonomous business units e. Not modeling an adverse scenario of future events Not wanting to hear bad news Scenario might be improbable and unlikely 14.61 (30 -45 min) Codes of ethical investment practices Solutions will vary, but consider the following extract from DuPont’s principles of investment in biotechnology: “DuPont is committed to comprehensive stewardship of biotechnology as we leverage it for beneficial use long term. We believe in a prudent approach that includes caution and care - that is, we will carefully consider the wishes of society, protection of the environment and need for increased productivity as we develop biotechnology products and/or license our technology. This belief comes from our agricultural and industrial experience over the past 200 years.” (http://www.dupont.com/biotech/difference/principles.html) The cited website then goes on to detail its eight biotech principles: 1. Commitment to food/feed safety 2. Environmental focus 3. Conserving biodiversity 4. Transparency of information 5. Engaging stockholders 6. Advocating independent research 7. Contributing to developing economies 8. Formalizing access to genetic resources 14.62 (30 – 45 min) Internal controls and investment practices A search on key words “internal control” and “investment” will generate numerous articles. Solutions will vary. Internal controls help assure that the investment decision is based on accurate information and the appropriate discount rates. At a minimum, internal controls improve the accuracy of information from the past that analysts rely on to make decisions about the future. Internal controls also help assure that the actual investment amounts are in accordance with those projected. Finally, internal controls provide feedback about whether the project’s cash flows meet expectations. Such feedback can help managers avert disaster by changing activities or even pulling the plug on the investment. SOLUTIONS TO PROBLEMS 14.63 (30 min) Use forecasts in net present value analysis Data input Investment cost $ 2,900,000 Investment life 7 years Straight line depreciation $ 400,000 per year Quality benefits, yrs 4 - 7 2,100,000 Salvage value 100,000 Tax rate 35% Discount rate 18% b. This appears to be a strategic investment in more flexible manufacturing capability. c. Applying high discount rates to risky projects is a shorthand approach to modeling risk. It might not capture all the sources of risk as well as sensitivity or scenario analyses would. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.64 (25 min) Use forecasts in net present value analysis Data input Investment cost $ 950,000 Investment life 3 years Straight line depreciation $ 300,000 per year Salvage value 50,000 Tax rate 35% Discount rate 16% Existing space 12,500 sq ft Existing rental cost $ 3.00 per sq ft New space 12,500 sq ft New rental cost $ 4.00 per sq ft End of Year 0 1 2 3 Investment cost $ (950,000) Sales $ 900,000 $1,400,000 $ 600,000 Unit, batch, product costs 750,000 400,000 350,000 SG&A 40,000 75,000 35,000 Rent of existing space 37,500 37,500 37,500 Rent of new space 50,000 50,000 50,000 Depreciation 300,000 300,000 300,000 Income before tax (277,500) 537,500 (172,500) Tax (97,125) 188,125 (60,375) Income after tax (180,375) 349,375 (112,125) After tax salvage 50,000 Add back non-cash and committed expenses SG&A 40,000 75,000 35,000 Rent of existing space 37,500 37,500 37,500 Depreciation 300,000 300,000 300,000 Net Cash flow $ (950,000) $ 197,125 $ 761,875 $ 310,375 NPV $ (15,023) b. This is an undesirable project because the NPV is negative. However, the margin is not large and might be very sensitive to changes in the discount rate and cash flow forecasts. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls (also see notes and alternative solution at this link) 14.65 (30 min) Assess the effects of the discount rate in net present value analysis Responses will vary. This problem is based on an actual case in a large automotive company. The report should comment on the inappropriately high discount rate and the games playing that is occurring on both sides. Finance should find ways other than raising the discount rate to deal with overly enthusiastic project proponents. For example, project proponents could be given incentives that reward them if investments turn out better than predicted and penalize them if they turn out worse. As to this project, both production managers and finance staff should reevaluate the project using realistic data and discount rates. The president of the division should take into account the nonfinancial quality and reputation benefits that the project could create in making the decision. It may be that with realistic numbers, the project has a negative NPV but should be accepted because of the factors (e.g., nonfinancial factors) not captured by the discounted cash flow analysis. Problem 14.66 (40 min) Equipment replacement, DCF analysis, and non-financial factors Data input New equipment cost, including installation and training $120,000 Salvage value of new equipment - New equipment useful life 4 years Salvage value of old equipment - Annual increase in contribution margin 25,000 Annual operating cost savings 16,000 Income tax rate 40% Discount rate 10% Investment analysis End of Year Initial cash flows for year: 0 1 2 3 4 Investment cost $(120,000) Proceeds from sales of equipment - - Annual operating income items Increase in contribution margin $ 25,000 $25,000 $25,000 $25,000 Operating cost savings 16,000 16,000 16,000 16,000 Depreciation expense (30,000) (30,000) (30,000) (30,000) Change in operating income 11,000 11,000 11,000 11,000 Tax on change in income (4,400) (4,400) (4,400) (4,400) After-tax change in income 6,600 6,600 6,600 6,600 Add back depreciation expense 30,000 30,000 30,000 30,000 After-tax operating cash flow (120,000) 36,600 36,600 36,600 36,600 Present values of cash flows (120,000) $ 33,273 30,248 27,498 24,998 Net present value using SUM (3,983) a. Net present value using NPV (3,983) ($3,983) using PV b. Internal rate of return using IRR 8.5% c. From a financial point of view, the proposed new equipment flunks the test. It doesn’t flunk by much, but the IRR of 8.5% is less than the 10% discount rate and the NPV is negative. If the proposed new equipment increases customer goodwill in ways that are not captured by the DCF analysis, then the investment could be a good deal for the company. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls Problem 14.67 (40 min) Equipment replacement, DCF analysis, and sensitivity analysis d. Perhaps the greatest uncontrollable factor is the price of energy. If the price of energy were to fall substantially (seems unlikely), then the cost savings might not be as great as projected in this analysis. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.68 (40 min) Equipment replacement, DCF analysis, and salvage values c. One answer is “no.” If the $20,000 salvage drops to zero, then the NPV turns negative (subtract $20,000 x the year 4 PV factor from the NPV of $9,327). Estimating salvage values is difficult. If the financial viability of a project depends on estimating the correct salvage value, then perhaps the project should not be done. d. The salvage value is affected by the market for the equipment four years from now which depends on its functionality, obsolescence and the cost of various energy sources. In view of the uncertainty about energy, a prudent investor should probably take a conservative view about the salvage value of energy equipment. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.69 (40 min) Equipment replacement, DCF analysis, and salvage values d. Revenue is highly uncertain and depends on the number of workers at these construction sites, how well they like Sudden’s products, and competition. The cost of products is also a factor as is the cost of operating the truck and the labor cost. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.70 (60 min) Model the effects of competitors’ actions in net present value analysis ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls b. Clearly an entry by MacBurger would make the investment by Healthy Noodles unattractive. However, the expected NPV is 0.5 x $32,284 + 0.5 x $(8,051) = $12,116, which indicates a better than even chance of a profitable investment. c. Either making or not making the investment is risky. If management is confident about its analyses and its probability assessment, this is probably a reasonable risk to take now, but further analysis is warranted (see the next two problems). 14.71 (60 min) Model the effects of competitors’ actions in net present value analysis a. Extracted from spreadsheet models. b. This analysis shows that the best decision for Healthy Noodles if MacBurger enters the market is to terminate the investment because the NPV is less negative than continuing the investment. c. The expected value of investing now, but terminating if MacBurger enters, = 0.5 x $ 32,430 + 0.5 x $(8,333) = $12,048, which is a bit less than the previous expected NPV found in problem 14.70. The next problem examines the value of the option to wait. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.72 (40 min) Apply real option value analysis a. Decsion trees Real Option Analysis 1st Decision Competitor? 2nd Decision NPV Outcome Best Choice Decide now Pr = Continue ($17,535) no 50% Yes Terminate ($8,333) YES Invest Pr = Continue $32,430 YES 50% No Invest now or not Terminate no Don't invest $0 Expected value of best decision if decide now $12,048 Real Option Analysis Outcome Competitor? 2nd Decision NPV Outcome Best Choice Wait one year Pr = Invest ($8,051) no 50% Yes Don't invest $0 YES Don't decide yet Pr = Invest $32,284 YES 50% No Don't invest $0 no Expected value of best decision if wait one year $16,142 b. The expected NPV of waiting a year is greater than the NPV of investing now because this analysis recognizes that Healthy Noodles would not invest if it learns that MacBurger has entered the market. c. The value of the real option to wait a year = $16,142 - $12,048 = $4,094. d. The economic meaning of the amount in part “c” is that Healthy Noodles should be willing to pay up to $4,094 for the option to defer its planned investment. The owner of the property would demand some compensation to take it off the market for a year, and Healthy Noodles would be willing to pay up to $4,094 for that real option. 14.73 (40 min) Apply real option value analysis 14.73 (continued) b. Unreal Networks must measure three sets of probabilities: the probability of technology success, the probability of Apple’s download service success, and the probability of the music industry’s legal success. All of these might be estimated from the rates of success of similar, past activities. If Unreal cannot find enough similar activities on which to base probability estimates (as seems likely), it might rely on “degree of belief,” which can be even more subjective than using past probabilities. Unreal Networks also must measure the impacts of each (binary) outcome on net cash flows (e.g., investment costs, annual net cash flows) over the life of the activity. These can be derived from sales and cost estimates (see chapter 11) that are modified (subjectively?) for each outcome. This is similar to the scenario analysis described in chapter 12. Lastly, Unreal must measure its cost of capital, which itself is a challenge – and composes a large part of corporate finance. Some will proxy the opportunity cost of capital by the weighted average (historical) cost of capital, but looking backwards is not terribly satisfying. Others might use the capital asset pricing model (CAPM) or estimates by Ibbotson, but these also have theoretical problems. c. Sources of risk include external and internal forces, such as those discussed in chapter 1. Unreal Networks should consider each of these forces and their likely impacts on probabilities, profits, and the discount rate. Most likely, the company could create most likely, best, and worst case scenarios to summarize these effects. Clearly, supporting major strategic decisions like this should (does?) require a lot of work and judgment. d. Qualitative factors to consider might include the competence and trustworthiness of the management and technical staff of the target, start-up company. Unreal also should consider the impact of terminating its current venture on its reputation as a business partner. 14.74 (25 min) Evaluate ethical issues in strategic investment analysis a. Helen's first revision of the proposal was unethical if she did not also disclose that the estimates were only remotely possible. She should have communicated all information accurately and objectively. b. George's conduct was unethical. He has a responsibility not to let conflicts of interest affect the reporting of data. If he has a conflict of interest, he should advise all users of his data about such conflicts. c. First, see what existing company policy covers ethical situations. If there is such a policy, then follow it. Otherwise, Helen should take this issue to the next level above George. Also, the company may have an ombudsperson who deals with these issues. As a next to last resort, she should take her problem to the Board of Directors, in general, and the Audit Committee of the Board, in particular. As a last resort, Helen should resign, leaving a written explanation of her reasons with a trusted officer of the company. 14.75 (25 min) Evaluate ethical issues in strategic investment analysis a. All investment analysis is partly qualitative in nature. Investments should be selected for fit with strategic goals and ethical investing practices. NPV is important, but not the only important measure of an investment. b. Ciruli’s preference for her cousin’s project has the appearance of bias because it has a lower NPV. Part of the risk of any project is the quality of design and management. Her cousin’s design might make project Bassa less risky. However, Ciruli should be very careful to disclose her family relationship and she should seek another opinion. c. Ciruli should use techniques of sensitivity analysis and scenario analysis to evaluate sources of risk in the two projects. SOLUTIONS TO CASES 14.76 (60+ min) Liquid Chemical, Part 1: expected net present value analysis ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls a. Walsh’s two alternative choices are to (a) continue to make containers and perform maintenance internally or (b) outsource container manufacturing and maintenance. The major uncontrollable event is demand for containers, which could be 2,000, 3,000, or 4,000 containers per year. b. Financial model. c. The decision does not appear to be sensitive to 4-point changes in the 10% discount rate in the data input (C6). (You don’t want to do this by hand!) Discount rate NPV of Internal operations NPV of outsourced operations Difference 10% $ 3,354,573 $ 4,109,806 $(755,233) 6% 3,731,075 4,422,070 (690,995) 14% 3,035,451 3,844,776 (809,324) 14.77 (30 minutes) Liquid Chemical, Part 2: Real option value analysis b. As shown in the decision tree, the value of the real option to wait is $322,576. Permanently outsourcing a fundamental operation is a major decision. Before deciding, Walsh should require Dyer to perform sensitivity and scenario analyses of the decisions. ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls 14.78 (60+ min) Reunion City: Real option value analysis ..HMS 4e Excel SolutionsHMS 4e chapter 14 solutions.xls Because the real option value is negative, $(8,577,000), Reunion City should not wait to learn WalMart’s action. b. Sensitivity to changes in probabilities of WalMart’s actions Prob. if delay Prob. if act now ROV 75% 20% $(8,577,000) 50% 20% (6,018,000) 75% 50% (4,127,000) 20% 20% (2,948,000) 75% 75% (419,000) Some combination of a very low probability of WalMart’s moving in if Reunion City delays (e.g. 0%) and a larger probability of WalMart’s moving in now (e.g., 30%) changes the ROV to a positive figure. However, the business meaning of a low probability of WalMart’s moving in after a delay must mean that WalMart does not find the location appealing (or less likely, that WalMart waits to learn from Reunion City). Looking only at these probabilities, it seems unlikely that Reunion City would be better off waiting a year. c. Other factors that might be important are revitalization of the city, more employment and the attendant ripple effect, and the possibility of attracting more business, jobs, and sales taxes to the city. The city also should investigate the sensitivity of the ROV model to changes in other parameters. e. Presentations will vary, but they should highlight assumptions, features of the ROV model, sensitivity of the model, qualitative factors, and a recommendation. Solution Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533
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