Investment Decisions:: Look Ahead and Reason Back

CHAPTER 5 Investment
Decisions:
Look Ahead and Reason
Back
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● Investments imply willingness to trade dollars in the present for dollars in the future.
Wealth-creating transactions occur when individuals with low discount rates (rate at
which they value future vs. current dollars) lend to those with high discount rates.
● Companies, like individuals, have different discount rates, determined by their cost
of capital. They invest only in projects that earn a return higher than the cost of
capital.
● The NPV rule states that if the present value of the net cash flow of a project is
larger than zero, the project earns economic profit (i.e., the investment earns more
than the cost of capital).
● Although NPV is the correct way to analyze investments, not all companies use it.
Instead, they use break-even analysis because it is easier and more intuitive.
● Break-even quantity is equal to fixed cost divided by the contribution margin. If
you expect to sell more than the break-even quantity, then your investment is
profitable.
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website for classroom use. ©Kamira/Shutterstock Images 2
• continued
● Avoidable costs can be recovered by shutting down. If the benefits of

shutting down (you recover your avoidable costs) are larger than the
costs (you forgo revenue), then shut down. The break-even price is
average avoidable cost.
● If you incur sunk costs, you are vulnerable to post-investment hold-up.
Anticipate hold-up and choose contracts or organizational forms that
minimize the costs of hold-up.
● Once relationship-specific investments are made, parties are locked
into a trading relationship with each other, and can be held up by their
trading partners. Anticipate hold-up and choose organizational or
contractual forms to give each party both the incentive to make
relationship-specific investments and to trade after these investments
are made.
Title?
● In summer 2007, Bert Matthews was contemplating purchasing a 48-unit

apartment building.
• The building was 95% occupied and generated $550,000 in annual profit.
• Investors expected a 15% return on their capital
• The bank offered to loan Mr. Matthews 80% of the purchase price at a rate
of 5.5%
● Mr. Matthews computed the cost of capital as a weighted average
of equity and debt.
.2*(15%) + .8*(5.5%) = 7.4%
• Mr. Matthews could pay no more than $550,000/7.4% = $7.4 million and still break
even.
● Mr. Matthews decided not to buy the building. A good decision – one year later,
the cost of capital was 10.125% and Mr. Matthews could offer only $5.4 million
for the building.
● This story illustrates both the effect of the bursting credit bubble on real estate
valuations and, more importantly, the relevant costs and benefits of investment
decisions.
Background: Investment Profitability
● All investments represent a trade-off between

possible future gain and current sacrifice.
● Willingness to invest in projects with a low rate of
return, indicates a willingness to trade current dollars
for future dollars at a relatively low rate.
• This is also known as having a low discount rate (r).
• Individuals with low discount rates would willingly
lend to those with higher discount rates.
• Discounting helps you figure out if future gains are
larger than current sacrifice.
Compounding
● To understand discounting, let’s first look at

compounding:
(future value, k periods in the future) = (present value) x (1 + r)K
● Example: If you invest $1 (present value) today at a

10% (r), then you would expect to have $1.10 in one
year.
• In two years, $1 becomes $1.21 = $1.10 x (1+.1)
● A good compounding rule of thumb:
“Rule of 72”: If you invest at a rate of return r,
divide 72 by r to get the number of years it takes to
double your money
Discounting
● Discounting (the inverse of compounding):

Present value = (future value, k periods in the future)
(1 + r)k
● Example: At a 10% r, $1 is worth:
• Next year: ($1)/1.1 = $0.91
• Two years: ($0.91)/1.1 =$0.83
● Discussion: If my discount rate is 10%, would I lend
to or borrow from someone with a discount rate of
15%?
• What does this say about behavior?
Example: Nashville Pension Obligations
● The city of Nashville uses discounting to decide how

much to save for future pension obligations.
● For a pension that pays out $100,000 in 20 years,
with a discount rate of 8.25% Nashville must save:
• $100,000/(1.0825)20 =$20,485
• If the city invests the $20,485 and earns 8.25%, then the
savings will compound in 20 years – unrealistic!
• Somewhat of high savings rate that may not be returned;
however, a high savings rate means less current spending,
which is politically popular
• A more realistic (but less popular) discount rate would be
6.5%, which would lead to saving $28,380 now.
Determining the Profitability of Investments
● Remember the simple rule: discount the future benefits of an

investment, and compare them to the current cost.
● Companies use discount rates, which are determined by cost
of capital.
• A company’s cost of capital is a blend of debt and equity, its
“weighted average cost of capital” or WACC
● Time is a critical element in investment decisions
• Cash flows to be received in the future need to be discounted to
present value using the cost of capital
● The NPV Rule: if the present value of the net cash flows is
larger than zero, then the project earns more than the cost of
capital.
9
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The NPV Rule In Action
● Consider two projects that each require an initial

investment of $100
• Project 1 returns $115 at the end of the first year
• Project 2 returns $60 at the end of the first, and $60 at the
end of the second
• The company’s cost of capital is 14%
• Project 1 earns more than the cost of capital. Project 2 does not.
NPV and Economic Profit
● Projects with a positive NPV create economic profit.

● Only positive NPV projects earn a return higher than
the company’s cost of capital.
● Projects with negative NPV may create accounting
profits, but not economic profit.
● In making investment decisions, choose only
projects with a positive NPV.
Another Method: Break-Even Quantities
● The break-even quantity is the amount you need to

sell to just cover your costs
• At this sales level, profit is zero.
● The break-even quantity is:
Q=FC/(P-MC)
FC: fixed costs P: price MC:marginal cost
• (P-MC) is the “contribution margin” – what’s left
after marginal cost to “contribute” to covering fixed
costs
Break-Even Example: Nissan Truck
● Nissan’s popular truck model, the Titan, had only two years
remaining on its production cycle. Redesigning the “Titan” would
cost $400M.
• Cost of capital was 12%, implying annual fixed cost of $48M
• Contribution margin on each truck is $1,500
• Break-even quantity is 32,000 trucks
• The decision to redesign or not came down to a break-even analysis
● Nissan had a 3% share of the market, implying only 12,000 Titan
sales per year – not enough to break even.
● Instead they decided to license the Dodge Ram Truck, which would
reduce the fixed cost of redesign, and a lower break-even point.
● After the Government took over Chrysler, Nissan reconsidered.
Deciding Between Two Technologies
● In 1983, John Deere was in the midst of building a Henry-

Ford-style production line factory for large 4WD tractors
• Unexpectedly, wheat prices fell dramatically reducing
demand for large tractors
● Deere decided to abandon the new factory and instead
purchased Versatile, a company that assembled tractors in
a garage using off-the-shelf components
● Deere chose one manufacturing technology over another
• A discrete investment decision – the factory had big FC and
small MC, Versatile had small FC but bigger MC
John Deere: Right Decision?
● Was purchasing Versatile the right choice?

● It depends… on how much John Deere expected to sell.
• Suppose the capital-intensive technology would
involve $100 FC and $10 MC
• Suppose Versatile’s technology had $50 FC and $20 MC
• To determine break-even quantity (point of indifference),
solve for the quantity that equates the costs: $150 for 5
units
• If you expect to sell less than 5 units, choose the
low-MC technology
• If you expect to sell more than 5 units, choose the
low-FC technology
John Deere Lesson
● John Deere made the right decision by acquiring

Versatile; however, the Antitrust Division of he U.S.
Department of Justice challenged the acquisition as
anticompetitive.
● John Deere and Versatile were only two of 4 firms
selling 4WD tractors in North America.
Break-Even Advice
● Remember this advice: Do not invoke break-even

analysis to justify higher prices or greater output.
● Managers sometimes believe they must raise prices
to cover fixed costs or they must sell as much as
possible to make average costs lower
● These are extent decisions though!
• They require marginal analysis, not break-even
The Decision to Shut-Down
● Shut-down decisions are made using break-even

prices rather than quantities.
• The break-even price is the average avoidable cost
per unit
• Profit = (Rev-Cost)= (P-AC)(Q)
● If you shut down, you lose your revenue, but you get
back your avoidable cost.
• If average avoidable cost is less than price, shut down.
● Determining avoidable costs can be difficult.
• To identify avoidable costs firms use Cost Taxonomy
Cost Taxonomy
● Example: FC=$100, MC=$5, and you produce 100 units/year

● How low of a price before you shut down? IT DEPENDS
● It depends on which costs are avoidable
• Long-run: fixed costs become avoidable so they are included
in the shutdown price
• Short run: they are unavoidable and should not be included
in the shutdown price Costs
Avoidable Unavoidable
Costs or “Sunk” Costs
Fixed Costs Variable Costs

(avoidable in long run) (avoidable in short run)
Sunk Costs and Post-Investment Hold Up
● Always remember the business maxim “look ahead

and reason back.” This can help you avoid potential
hold up.
● Before making a sunk cost investment, ask what you
will do if you are held up.
● What would you do to address hold up?
Sunk Costs and Post-Investment Hold Up Example
● National Geographic can reduce shipping costs by

printing with regional printers.
• To print a high quality magazine, the printer must buy a
$12 million printing press.
• Each magazine has a MC of $1 and the printer would print
12 million copies over two years.
• The break-even cost/average cost is $7 = ($12M / 2M
copies) + $1/copy
• BUT once the press is purchased, the cost is sunk and the
break-even price changes.
• Because of this the magazine can hold up the printer by
renegotiating the terms of the deal – because the price of
the press is unavoidable, and sunk, the break-even price
falls to $1, the marginal cost.
Vertical Integration
● One possible solution to post-investment hold-up is vertical

integration.
● Example: Bauxite mine and alumina refinery
• Refineries are tailored to specific qualities of ore
• The transaction options are:
• Spot-market transactions
• Long-term contracts
• Vertical integration
– Vertical integration refers to the common ownership of two firms in separate
stages of the vertical supply chain that connects raw materials to finished goods
• Discussion: How is vertical integration a solution to hold up?
● Contractual view of marriage

• Long-term contracts induce higher levels of relationship-specific
investment

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CHAPTER 5 Investment

● Avoidable costs can be recovered by shutting down. If the beneﬁts of

● In summer 2007, Bert Matthews was contemplating purchasing a 48-unit

● All investments represent a trade-off between

● To understand discounting, let’s first look at

● Example: If you invest $1 (present value) today at a

● Discounting (the inverse of compounding):

● The city of Nashville uses discounting to decide how

● Remember the simple rule: discount the future benefits of an

● Consider two projects that each require an initial

● Projects with a positive NPV create economic profit.

● The break-even quantity is the amount you need to

● In 1983, John Deere was in the midst of building a Henry-

● Was purchasing Versatile the right choice?

● John Deere made the right decision by acquiring

● Remember this advice: Do not invoke break-even

● Shut-down decisions are made using break-even

● Example: FC=$100, MC=$5, and you produce 100 units/year

Fixed Costs Variable Costs

● Always remember the business maxim “look ahead

● National Geographic can reduce shipping costs by

● One possible solution to post-investment hold-up is vertical

● Contractual view of marriage

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