Download Class 2

Investment Strategy
April 11, 2007 (LA)
or April 5, 2007 (OCC)
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Strategic Issues raised by NPV
 Sources
of NPV
 Sequencing of decisions
 Dealing with uncertainty
 Open questions
– the discount rate
– affecting the market value for investors
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Sources of Present Values
 Michael
Porter’s analysis (e.g. Competitive
Strategy, 1980)
–
–
–
–
–
Competitors
Suppliers
Customers
Substitutes
Potential entrants
 No
advantage lasts forever in competitive
markets
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Sequencing of Decisions
 Most
investments can be developed in a
sequence of stages where the investment
strategy can be refined or the project
abandoned
Good result
 Decision trees useful
Good result
Expand
Test Market
Bad result
Bad result
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Close Down
Stewart Pharmaceuticals
The Stewart Pharmaceuticals Corporation is considering
investing in developing a drug that cures the common cold.
 A corporate planning group, including representatives from
production, marketing, and engineering, has recommended
that the firm go ahead with the test and development phase.
 This preliminary phase will last one year and cost $1 billion.
Furthermore, the group believes that there is a 60% chance
that tests will prove successful.
 If the initial tests are successful, Stewart Pharmaceuticals can
go ahead with full-scale production. This investment phase
will cost $1.6 billion. Production will occur over the next 4
years.

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Decision Tree for Stewart
Pharmaceutical
The firm has two decisions to make:
To test or not to test.
To invest or not to invest.
Success
Test
Invest
NPV = $3.4 b
Do not
invest
NPV = $0
Failure
Do not
test
NPV  $0
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Invest
NPV = –$91.46 m
Stewart Pharmaceutical: Test?
 Let’s
move back to the first stage, where the decision
boils down to the simple question: should we invest?
 The expected payoff evaluated at date 1 is:
Expected
payoff
Payoff
Payoff
 Prob.
  Prob.
  
 


 sucess given success   failure given failure
Expected
payoff



 .60  $3,433.75  .40  $0  $2,060.25
• The NPV evaluated at date 0 is:
NPV  $1,000 
$2,060.25
 $872.95
1.10
So we should test.
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Dealing with Uncertainty
 We
have implicitly been dealing with
expected cash flows - each cash flow
represents a probability-weighted average
of likely outcomes
 Alternatives methods are to deal with
several alternatives (scenario analysis) or to
identify critical assumptions (sensitivity
analysis)
 Break-even points may assist evaluation
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Break-Even Analysis
 Accounting
break-even analysis
Accounting Breakeven 
 Present-value
Fixed Costs  Depreciati on
Gross M arg in
break-even analysis
EAC  Fixed Costs * (1  Tc )  Depreciati on * Tc
Pr esent  Value Breakeven 
Gross M arg in * (1  Tc )
 Example
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Examples of PV vs Real Options
Value of motel is costing $9.7 million expected
worth $10 million at 10% yields NPV of $300,000
 $10 million is expected value of two equally likely
outcomes, $11 and $9 million, future will reveal
information about true value of motel
 Management could wait one year to take
advantage of this information
 This value of project with option to postpone is
.5*($1.3)/1.1 = $ .591 million (since no bad
outcome) so option value is $ .591 - $ .300 =
$.291 million

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Management options
Abandon
Contract
Switch
Wait
Expand
Growth
Currently Invested: React to Bad News
Not Currently Invested
Currently Invested: React to Good News
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Real Options and Investment
 Growth
options
– May increase size of investment later
 Timing
options
– Delay and learn more about opportunities
 Switching
options
– Change nature or use of invested assets
 Option
to expand or contract (scale)
 Abandonment options
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
Open Questions
 How
do we actually choose the discount
rates?
 If we make positive net present value
decisions, how will they affect our share
price?
 Can the market understand every possible
strategy -- should we play out a strategy
even though our share price suffers?
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007
For Class 11 and Following Week
 Read
Chapters 9 and 10 and work problems
for next week
 Work on Part 3 of group project (due April
25 (LA) or April 24 (OCC)) and identify
any questions or problems requiring
assistance from instructor
 Read handout on Sheet 2 “Continuing
Values” assumptions for PVFIRM05
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007