Principles of Corporate Finance Global Edition Ebook
Chapter11: Investment, Strategy, and Economic Rents
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To illustrate some of the problems involved in predicting economic rents, let us leap forward several years and look at the decision by Marvin Enterprises to exploit a new technology. 18
One of the most unexpected developments of these years was the remarkable growth of a completely new industry. By 2032 annual sales of gargle blasters totaled $1.68 billion, or 240 million units. Although it controlled only 10% of the market, Marvin Enterprises was among the most exciting growth companies of the decade. Marvin had come late into the business, but it had pioneered the use of integrated microcircuits to control the genetic engineering processes used to manufacture gargle blasters. This development had enabled producers to cut the price of gargle blasters from $9 to $7 and had thereby contributed to the dramatic growth in the size of the market. The estimated demand curve in Figure 11.2 shows just how responsive demand is to such price reductions. p. 305
Table 11.4 summarizes the cost structure of the old and new technologies. While companies with the new technology were earning 20% on their initial investment, those with first-generation equipment had been hit by the successive price cuts. Since all Marvin's investment was in the 2028 technology, it had been particularly well placed during this period. Rumors of new developments at Marvin had been circulating for some time, and the total market value of Marvin's stock had risen to $460 million by January 2033. At that point Marvin called a press conference to announce another technological breakthrough. Management claimed that its new thirdgeneration process involving mutant neurons enabled the firm to reduce capital costs to $10 and manufacturing costs to $3 per unit. Marvin proposed to capitalize on this invention by embarking on a huge $1 billion expansion program that would add 100 million units to capacity. The company expected to be in full operation within 12 months. FIGURE 11.2 The demand “curve” for gargle blasters shows that for each $1 cut in price there is an increase in demand of 80 million units.
Size and cost structure of the gargle blaster industry before Marvin announced its expansion plans.
Note: Selling price is $7 per unit. One unit means one gargle blaster. p. 306
Before deciding to go ahead with this development, Marvin had undertaken extensive calculations on the effect of the new investment. The basic assumptions were as follows: 1. The cost of capital was 20%.
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11-3 Marvin Enterprises Decides to Exploit a New Technology—an E...
Marvin's competitors greeted the news with varying degrees of concern. There was general agreement that it would be five years before any of them would have access to the new technology. On the other hand, many consoled themselves with the reflection that Marvin's new plant could not compete with an existing plant that had been fully depreciated. Suppose that you were Marvin's financial manager. Would you have agreed with the decision to expand? Do you think it would have been better to go for a larger or smaller expansion? How do you think Marvin's announcement is likely to affect the price of its stock? You have a choice. You can go on immediately to read our solution to these questions. But you will learn much more if you stop and work out your own answer first. Try it.
Forecasting Prices of Gargle Blasters
Up to this point in any capital budgeting problem we have always given you the set of cash-flow forecasts. In the present case you have to derive those forecasts. The first problem is to decide...