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Chapter 8 - Chapter 8 NPV and Corporate Strategy The...

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Chapter 8 NPV and Corporate Strategy
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The Economics of NPV Positive NPV projects arise from fundamentally good business decisions Must always check the economics behind a forecasted positive NPV project Some basic questions: 1. Why is this opportunity profitable? (i.e., why do prices exceed costs) 2. Why isn’t someone else already doing this? 3. What is our key competitive advantage? -technological superiority -low costs -marketing superiority 4. What are the barriers to entry/imitation by our competitors. Has anticipated entry been built into our forecasts?
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The Economics of NPV (continued) Economics Issues Finance is about examining the numbers, understanding whether a given set of projections is profitable Business decisions are less quantifiable, but more important. Ultimately intuition and judgment about marketplace conditions guide the numbers used to make decisions. Business choices and the accompanying projections must be accompanied by: (a) a sensitivity analysis (b) an analysis of all side effects arising from the decision
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The Economics of NPV (continued) Organizational Issues Managers tend to be overoptimistic about expected cash flows from projects. Many firms have elaborate controls in place to keep their spending in check Bonus schemes and promotion incentives often direct managerial incentives away from the pure NPV rule Figuring out a way to align individual incentives with the shareholders to maximize NPV is a major challenge in organizational design One way this has been accomplished is via Economic Value Added (EVA) compensation systems. More on this later
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Decision Trees and Sequential Business Choices Example Stewart Pharmaceutical Corp. is considering investing in developing a drug that cures the common cold A corporate planning group has recommended that the firm go ahead with the test and development phase This preliminary phase will last one year and cost $1 billion. The group believes that there is a 60% chance that tests will prove successful. If initial tests are successful, can go ahead with full-scale production. Investment will cost $1.6 bil. Production will occur over the next 4 years.
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Example (continued): NPV of full-scale production following successful test Investment Year 1 Years 2-5 Revenues $7,000 Variable Costs (3,000) Fixed Costs (1,800) Depreciation (400) Pretax profit $1,800 Tax (34%) (612) Net Profit $1,188 Cash Flow -$1,600 $1,588 75 . 433 , 3 $ 4 1 ) 10 . 1 ( 588 , 1 $ 600 , 1 $ = = + - = t t NPV
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Example (continued):
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