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Solution for Principles of Corporate Finance 7E CH11_mini_word_ans

By Gordon Reyes,2014-10-31 03:54
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Solution for Principles of Corporate Finance 7E CH11 mini word answer

    ECSY-COLA IN INGLISTAN

    Principles of Corporate Finance th Edition 7

    Richard A. Brealey and Stewart C. Myers

     Libby Flannery prepared the attached spreadsheet to analyze the NPV of Ecsy-Cola’s proposed investment in Inglistan. With the inputs suggested in the mini-case, NPV

    is very slightly negative on a $20 million outlay.

     Libby was conscious of the spreadsheet’s simplifying assumptions. First, there was no provision for working capital. Second, the project cash flows were projected as a perpetuity. The project, if successful, would generate cash returns for a long time, but not forever. On the other hand, the 25 per cent nominal discount rate handed down from

    1Ecsy-Cola’s headquarters seemed unreasonably high – was there a fudge factor built in?

    At least the discount rate should be converted to real terms, since the revenue and cost projections did not incorporate inflation. At a 22 per cent discount rate (assuming an

    2inflation rate of roughly 3 per cent), NPV increased to about $3 million. [Calculate this

    NPV by changing the discount-rate input on the spreadsheet. All NPVs reported below are calculated at a 22 per cent rate.]

     This calculation looked better, but should Libby recommend investing now or later? A year’s wait would give a better assessment of potential sales. Libby performed a

    sensitivity analysis, assuming for simplicity that the optimistic and pessimistic probabilities were each 25 per cent:

     1 See Ch. 9, pp. 235-237. 2 All cash flows were expressed in U. S. dollars, so Libby used the approximate dollar inflation rate in 2004. The inflation rate in local currency (the Inglestanian groupee) was higher than 3 per cent, but this difference would be offset, on average, by a decline in the groupee-dollar exchange rate. See Ch. 28, Section 28.2.

    ? R. A. Brealey and S. C. Myers, 2002

     Steady-State Sales Probabilty NPV at year 1

    Optimistic 80 million .25 + $20.5

    Most Likely 50 .50 + $ 3.1

    Pessimistic 20 .25 - $ 14.2

    Of course, if potential sales were only 20 million liters per year, Ecsy-Cola would not invest, so the NPV in this case would be zero, not - $11 million. Thus the payoff to waiting would be:

Expected NPV, invest in year 1 = .25 ; 20.5 + .50 ; 3.1 + .25 ; 0 = + $6.7 million

This suggested a “wait and see” strategy.

     The problem with that strategy was potential competition. If steady-state sales turned out higher than now expected 80 million liters per year, for example then

    Sparky-Cola, or some other competitor, would surely enter. The high cash flows for the optimistic case were not sustainable in the long run, so the optimistic-case NPV, while no doubt positive, was less than $20.5 million.

     Libby realized that investing right away, and establishing the Ecsy-Cola brand in Inglistan before her competitors could act, gave her best chance of generating a significant positive NPV. In the optimistic scenario, competition would come sooner or later, but Ecsy-Cola would have a head start and probably the largest market share. If Ecsy-Cola was just breaking even (earning its cost of capital), competitors would have no incentive to enter.

     Libby had to weigh the competitive advantages of investing immediately against the possibility of a costly mistake. Therefore she refocused her analysis on establishing the minimum potential size of the market. If NPV at that minimum was at least zero, or perhaps an acceptably small negative number, she resolved to invest right away.

? R. A. Brealey and S. C. Myers, 2002

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