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Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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Answer to Challenge Question #1: a) By the end of two years, the Phlogiston process will be the norm resulting in no industry member having any kind of a competitive advantage. As such, the prices in the industry should stabilize around their long-term equilibrium values, which implies that project investments will have NPVs = 0. b) As above, the price should reflect the long-term equilibrium value, which will be lower than the current price of $1 (because of cheaper production costs). We know the cost of the plant is $100,000 and that capacity is 100,000 units. Since the plant has an indefinite life, the cash flow stream in infinite, or value = cash flow/r. Cash flow will be the unknown price (P) minus the cost ($0.85) times the 100,000 units. Thus, we know the following: 10 . 0 ) 85 . 0 $ ( * 100000 100000 $ - = P , which solves to P = $0.95. Another way to think about this is that in a competitive industry, ALL cost savings will be passed onto customers. Since the cost is declining by $0.05, then the price should decline by $0.05 from $1.00 to $0.95.
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