Chapter 11 - Investment, Strategy, and Economic Rents

CHAPTER 11
Investment, Strategy, and Economic Rents

Answers to Problem Sets

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

1. a. False. Economic rents are profits that more than cover the cost of capital.

b. True

c. True

d. False. Economic rents are earned when a firm has a special advantage
over its competitors.

Est. Time: 01- 05

2. At $5:

NPV of operating cash flow = [($5 – 5) × 500,000]) / .10

NPV of operating cash flow = $0

At this price the operating cash flows are insufficient to justify the initial cost.

At $10:

NPV of operating cash flow = [($10 – 5) × 500,000]) / .10

NPV of operating cash flow = $25 million

At this price the operating cash flows are still insufficient to justify the initial cost.

At $15:

NPV of operating cash flow = [($15 – 5) × 500,000]) / .10

NPV of operating cash flow = $50 million

At a competitive price of $15, the NPV of the OCF matches the initial cost so the
project breaks even on a financial basis.

Thus, $15 is the competitive price.

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Chapter 11 - Investment, Strategy, and Economic Rents

Est. Time: 01- 05

3. Most projects, if discounted at the appropriate risk-adjusted discount rate, will tend
to be zero NPV projects unless there is something specific the market cannot
duplicate. Thus, a large positive NPV result needs to be thoroughly reviewed.

If you have not already done so, you should seek professional opinions on the
real estate outlook as you may be overly optimistic. You might also check with the
appropriate individuals to determine if any future highway or development projects
are anticipated that could affect this property. Also evaluate the project based on
renting the building to determine if that would also result in a positive NPV.
Identify the key variables in each option that result in the positive NPV. Are those
variable forecasts reasonable; what if they are not? Once you have done this,
then consider whether buying or renting is your best alternative.

Est. Time: 01- 05

4. a. Since the copper can be sold forward through the futures contract we
discount at the risk-free interest rate:

PV = (100,000 × $5,500) / (1 + .005)

PV = $547.26 million

b-1. E(r) = rf + β(rm – rf)

E(r) = .005 + 1.2(.08 – .005)
E(r) = .095, or 9.5%

Eprice = Current price × 1 + E(r)

Eprice = $5,500 / 1.005 × (1 + .095)
Eprice = $5,992.54 per ton

b-2.The certainty-equivalent end-of-year price is the 1-year futures price of

$5,500 per ton.
 
Est. Time: 01- 05

5. The secondhand market value of older planes may be low enough to make up for
the plane’s higher fuel consumption. Also, the older planes can used on routes
where fuel efficiency is relatively less important.

Est. Time: 01- 05

6. The 757 must be a zero-NPV investment for the marginal user. Unless Boeing
can charge different prices to different users (which is precluded with a
secondary market), Delta will earn economic rents if the 757 is particularly well

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Chapter 11 - Investment, Strategy, and Economic Rents

suited to Delta’s routes (and competition does not force Delta to pass the cost
savings through to customers in the form of lower fares). Thus, the decision
focuses on the issue of whether the plane is worth more in Delta’s hands than in
the hands of the marginal user.
a. With a good secondary market and information on past changes in aircraft
prices, it becomes somewhat more feasible to ignore cash flows beyond the
first few years and to substitute the expected residual value of the plane.

b. Past aircraft prices may be used to estimate systematic risk (see Chapter 8).

c. The existence of a secondary market makes it more important to include the

abandonment option in the purchase analysis.

Est. Time: 06- 10

7. The key question is: Will Gamma Airlines be able to earn economic rents on the
Akron-Yellowknife route? The necessary steps include:
a. Forecasting costs, including the cost of building and maintaining terminal
facilities, all necessary training, advertising, equipment, etc.
b. Forecasting revenues, which includes a detailed market demand analysis
(what types of travelers are expected and what prices can be charged) as
well as an analysis of the competition (if Gamma is successful, how quickly
would competition spring up?).
c. Calculating the net present value.
The leasing market comes into play because it tells Gamma Airlines the
opportunity cost of the planes, a critical component of costs.
If the Akron-Yellowknife project is attractive and growth occurs at the
Ulaanbaatar hub, Gamma Airlines should simply lease additional aircraft.

Est. Time: 06- 10

8. The price of $1,200 per ounce represents the discounted value of expected
future gold prices. Hence, the present value of 1 million ounces produced 8
years from now should be:

PV = $1,200  1 million = $1.2 billion

Est. Time: 01- 05

9. Interstate rail lines can be expected to generate economic rents when they have
excess capacity that allows them to accommodate increased demand at low
cost. For example, an economic expansion accompanied by high fuel costs
would result in economic rents for interstate rail lines. Trucking companies have
the flexibility to expand capacity relatively quickly, but high fuel costs could tend

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Chapter 11 - Investment, Strategy, and Economic Rents

to limit the ability of trucking companies to compete effectively with interstate rail
lines that are relatively more fuel efficient.

Est. Time: 01- 05

10. First, consider the sequence of events:

 At t = 0, the investment of $25 million is made.

 At t = 1, production begins, so the first year of revenue and expenses is
recorded at t = 2.
 At t = 6, the patent expires and competition may enter. Since it takes one
year to achieve full production, competition is not a factor until t = 7. (This
assumes the competition does not begin construction until the patent
expires.)
 After t = 7, full competition will exist and thus any new entrant into the market
for BGs will earn the 9 percent cost of capital.

Next, calculate the cash flows:

 t0 = –$25 million
 t1 = $0
 t2-6 = 200,000 × ($100 – 65) = $7 million

After t6, the NPV of new investment must be zero. Hence, to find the selling
price per unit (P) solve the following for P:

0 = –$25,000,000 + [200,000 × (P – $65)] / 1.092 + … + [200,000 × (P –

$65)] / 1.0912
P = $85.02
 t7-12 = 200,000 × ($85.02 – 65) = $4.004 million

Finally, compute the net present value (in millions):

NPV = –$25 + $7 / 1.092 + $7 / 1.093 + … + $7 / 1.096 + $4.004 / 1.097+ … +

$4.004 / 1.0912
NPV = $10.69 million

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Chapter 11 - Investment, Strategy, and Economic Rents

Est. Time: 06- 10

11. The selling price after t = 6 now changes because the required investment is:
$25,000,000  (1 – 0.03)5 = $21,468,351

After t = 5, the NPV of new investment must be zero, and hence the selling price
per unit (P) is found by solving the following equation for P:

0 = –$21,468,351 + [$200,000 × (P – 65)] / 1.092 + … + [$200,000 × (P –

65)] / 1.0912
P = $82.19

Thus, for Years t = 7 through t = 12, the yearly cash flow will be:

200,000  ($82.19 – 65) = $3,438,000

Finally, the net present value (in millions) is:

NPV = –$25 + $7 / 1.092 + $7 / 1.093 + …+ $7 / 1.096 + $3.438 / 1.097 + …

+ $3.438 / 1.0912
NPV = $9.18, or $9,180,000

Est. Time: 06- 10

12. a. See the table below. The net present value is negative, so management
should not proceed with the Polyzone project.
t=0 t=1 t=2 t=3 t=4 t = 5-10
Investment –100
Production 0 0 40 80 80 80
Spread 0 1.20 1.20 1.20 1.20 .95
Net Revenues 0 0 48 96 96 76
Production 0 0 30 30 30 30
Costs
Transport 0 0 4 8 8 8

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Chapter 11 - Investment, Strategy, and Economic Rents

Other Costs 0 20 20 20 20 20
Cash Flow -100 -20 -6 38 38 18
NPV (at 8%) = -$4.40

b. See the table below. The net present value is $40.40 million, and so the
project is acceptable.
t=0 t=1 t=2 t=3 t = 4 t = 5-10
Investment –100
Production 0 40 80 80 80 80
Spread 0 1.20 1.20 1.20 1.10 .95
Net Revenues 0 48 96 96 88 76
Production 0 30 30 30 30 30
Costs
Transport 0 4 8 8 8 8
Other Costs 0 20 20 20 20 20
Cash Flow -100 -6 38 38 30 18
NPV (at 8%) = $40.40

c. See the table below. The net present value is $18.64 million, and so the
project is acceptable. However, the assumption that the technological
advance will elude the competition for ten years seems questionable.
t=0 t=1 t=2 t=3 t=4 t = 5-10
Investment –100
Production 0 0 40 80 80 80
Spread 0 1.20 1.20 1.20 1.10 .95
Net Revenues 0 0 48 96 88 76
Production 0 0 25 25 25 25
Costs
Transport 0 0 4 8 8 8
Other Costs 0 20 20 20 20 20
Cash Flow -100 -20 -1 43 35 23
NPV (at 8%) = $18.64

Est. Time: 06- 10

13. There are four components that contribute to this project’s NPV:
 The initial investment of $100,000.
 The depreciation tax shield. Depreciation expense is $20,000 per year for
five years and is valued at the nominal rate of interest.
 The after-tax value of the increase in silver yield. The PV of silver delivered
(with certainty) in the future is approximately today’s spot price so there is no
need to forecast the price of silver and then discount.
 The cost of operating the equipment is $80,000 per year for ten years and is
valued at the real company cost of capital because we do not assume any

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Chapter 11 - Investment, Strategy, and Economic Rents

future increase in cost due to inflation. We are concerned only with the after-
tax cost.

NPV = –$100,000 + [($100,000 / 5) × .35] × ((1 / .06) – {1 / [.06(1.06) 5]}) +

(10 × 5,000 × $40)(1 – .35) – $80,000(1 – .35) × ((1 / .06) –
{1 / [.06(1.06)10]})
NPV = $880,562.31

Est. Time: 11- 15

14. June 30 is the base period, so:

June 30, 2020 price = $100

The ticket price 6 months prior to this will be:

January 1, 2020 price = $100 / 1.10.5

January 1, 2020 price = $95.35

The prices would be the same for the DJIA.

Est. Time: 06- 10

15. At t0, there will be a $200,000 outflow to clear out the building.
At t1, there will be an outflow of $50,000 for property taxes.
At t2, the firm will receive $80,000 in net rent and $1 million reduced for price
declines and sales commission from the sale of the building.

Thus, the NPV is:

NPV = –$200,000 – $50,000 / (1.08) + [$80,000 + $1,000,000 × (1 – .02)2 ×
(1 – .05)] / 1.082
NPV = $604,509.60

Est. Time: 11- 15

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Chapter 11 - Investment, Strategy, and Economic Rents

16. Assumptions:
Initial cost occurs at t = 0.
Depreciation will not affect the cash flows since there are no taxes.
Annual revenues and costs occur at year end starting with t = 1.
Price per ton at t = 1 is 3% higher than the current price of $240 a ton in
real terms and will increase by 3% in real terms every year thereafter.
Cost per ton is constant at $120 in real terms.
Annual output is constant at 100,000 tons a year.
Annual interest rate is constant at 8% in real terms.
Assume net profit equals annual cash flow.
There are no costs to shut down the mine.
The additional output from this mine will have no effect on the current or
project market prices or on the expected costs.

Interest rate = 8%

NPV if
production
Annual Annual Net Profit ended with
Year Initial cost revenue cost (Cash flow) this year
0 -110,000,000 -110,000,000
1 24,720,000 12,000,000 12,720,000 -98,222,222
2 25,461,600 12,000,000 13,461,600 -86,681,070
3 26,225,448 12,000,000 14,225,448 -75,388,451
4 27,012,211 12,000,000 15,012,211 -64,354,027
5 27,822,578 12,000,000 15,822,578 -53,585,447
6 28,657,255 12,000,000 16,657,255 -43,088,550
7 29,516,973 12,000,000 17,516,973 -32,867,565
8 30,402,482 12,000,000 18,402,482 -22,925,277
9 31,314,556 12,000,000 19,314,556 -13,263,190
10 32,253,993 12,000,000 20,253,993 -3,881,672
11 33,221,613 12,000,000 21,221,613 5,219,914
12 34,218,261 12,000,000 22,218,261 14,043,091
13 35,244,809 12,000,000 23,244,809 22,590,159
14 36,302,153 12,000,000 24,302,153 30,864,096
15 37,391,218 12,000,000 25,391,218 38,868,467
16 38,512,955 12,000,000 26,512,955 46,607,345
17 39,668,343 12,000,000 27,668,343 54,085,240

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Chapter 11 - Investment, Strategy, and Economic Rents

Given these assumptions, the project will produce a positive NPV in Year 11 and
thereafter. Thus, if the mine is expected to operate for at least 11 years, then the
project should be accepted given the current set of assumptions.

However, before accepting the project, it would be beneficial to determine:

1) Why some mines are currently profitable while others are barely
breaking even
2) Why the costs per ton on the currently profitable firms are much higher
($150 to 200) than the projected $120 a ton cost for this mine
3) Why the sales price per ton is expected to increase by 3% annually in
real terms while the costs are expected to remain constant in real
terms.
4) Are there any alternative uses (underground storage, resale) for this
mine should a shut-down situation arise
5) What is the estimated quantity of calonium at this site

17. a. The NPV of such plants is likely to be zero, because the industry is
competitive and, after two years, no company will enjoy any technical
advantages. The PV of each of these new plants would be $100,000
because the NPV is zero and the cost is $100,000.

b. The PV of revenue from a new plant is:

PV = $100,000 = [100,000 tons  (Price – .85)] / .10

P = $.95

c. At t = 2, the PV of the existing plant will be:

PV = [100,000 tons  ($.95 – .90)] / .10

PV = $50,000

Therefore, the existing plant would be scrapped at t = 2 as long as scrap

value at that time exceeds $50,000, which it is expected to be.

d. No. Book value is irrelevant. NPV of the existing plant is negative

after Year 2.

e. Yes. Sunk costs are irrelevant. NPV of the existing plant is negative
after Year 2.

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Chapter 11 - Investment, Strategy, and Economic Rents

f. Phlogiston’s project causes temporary excess capacity. Therefore, the

price for the next two years must be such that the existing plant’s owners
will be indifferent between scrapping now and scrapping at the end of
Year 2. This allows us to solve for price in Years 1 and 2.

Today’s scrap value is $60,000. Also, today’s scrap value is equal to the
present value of future cash flows. Therefore:

PV = $60,000 = [100,000 × (Price – $.90)] / 1.10 + [100,000 × (Price –

$.90)] / 1.102 + $57,900 / 1.102
Price = $.97

Given this price, we can compute the PV of the new plant:

PV= {100,000 × [($.97 – .85) / 1.10 + ($.97 – .85) / 1.102 + ($.95 – .85) /
(.10 × 1.102)]} – $100,000
PV = $3,471

Est. Time: 11- 15

18. Aircraft will be deployed in a manner that will minimize costs. This means that
each aircraft will be used on the route for which it has the greatest comparative
advantage. Thus, for example, for Part (a) of this problem, it is clear that Route
X will be served with five A’s and five B’s, and that Route Y will be served with
five B’s and five C’s. The remaining C-type aircraft will be scrapped.
The maximum price that anyone would pay for an aircraft is the present value of
the total additional costs that would be incurred if that aircraft were withdrawn
from service. Using the annuity factor for 5 time periods at 10 percent, we find
the PV of the operating costs (all numbers are in millions):
Type X Y
A 5.7 5.7
B 9.5 7.6
C 17.1 13.3
Again, consider Part (a). The cost of using an A-type aircraft on Route X
(cost = price of A + 5.7) must be equal to the cost of using a B-type aircraft on
Route X (cost = price of B + 9.5). Also, the cost of using a B-type aircraft on
Route Y (price of B + 7.6) equals the cost of using a C-type on Route Y

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Chapter 11 - Investment, Strategy, and Economic Rents

(price of C + 13.3). Further, because five C-type aircraft are scrapped, the price
of a C-type aircraft must be $1.0, the scrap value. Therefore, solving first for the
price of B and then for the price of A, we find that the price of an A-type is $10.5
and the price of a B-type is $6.7. Using this approach, we have the following
solutions:
Usage Aircraft Value (in millions)
X Y Scrap A B C
a. 5A+5B 5B+5C 5C $10.5 $6.7 $1.0
b. 10A 10B 10C 10.5 6.7 1.0
c. 10A 5A+5B 5B+10C 2.9 1.0 1.0
d. 10A 10A 10B+10C 2.9 1.0 1.0

Est. Time: 11- 15

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Chapter 11 - Investment, Strategy, and Economic Rents

19. a. PV1-year old plant = $43.33 / 1.20 + $58.33 / 1.202

PV1-year old plant = $76.62

PV2-year old plant = $58.33 / 1.20

PV2-year old plant = $48.61

b. Given that the industry is competitive, the investment in a new plant to

produce bucolic acid must yield a zero NPV. First, we solve for the
revenues (R) at which a new plant has zero NPV.
0 1 2 3
1. Initial investment –100
2. Revenues net of tax .6R .6R .6R
3. Operating costs net of tax –30 –30 –30
4. Depreciation tax shield 40
5. Salvage value net of tax 15

Therefore:
NPV = 0 = –$100 + ($.6R – 30 + 40) / 1.20 + ($.6R – 30) / 1.202 +
($.6R – 30 + 15) / 1.203
R = $95.88

We can now use the new revenue to re-compute the present values of the
existing one- and two- year old plants. Recall that existing plants must use
the original tax depreciation schedule.

0 1 2 3
Initial investment -100
Revenues 95.88 95.88 95.88
Cash operating costs 50.00 50.00 50.00
Tax depreciation 33.33 33.33 33.33
Income pretax 12.54 12.54 12.54
Tax at 40% 5.02 5.02 5.02
Net income 7.52 7.52 7.52
After-tax salvage 15.00
Cash flow -100 40.86 40.86 55.86

PV1-year-old plant = $40.86 / 1.20 + $55.86 / 1.202

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Chapter 11 - Investment, Strategy, and Economic Rents

PV1-year-old plant = $72.84

PV2-year-old plant = $55.86 / 1.20

PV2-year-old plant = $46.55

c. Net salvage value 2-year-old plant = $50 – [(.4)  (50 – 33.33)]

Net salvage value 2-year-old plant = $43.33

d. Solving for a zero NPV:

0 1 2 3
1. Initial Investment -100
2. Revenues R R R
3. Operating Costs -50 -50 -50
4. Salvage Value +25

0 = –$100 + (R – 50) / 1.20 + (R – 50) / 1.202 + (R – 50 + 25) / 1.203

R = $90.60

With revenues of $90.60:

PV1-year-old plant = $40.60 / 1.20 + $65.60 / 1.202

PV1-year-old plant = $79.40

PV2-year-old plant = $65.60 / 1.20

PV2-year-old plant = $54.67

Est. Time: 11- 15

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