Chap011.pdf

Chapter 11 - Investment, Strategy, and Economic Rents

Chapter 11 Investment, Strategy, and Economic Rents Multiple Choice Questions

1. One way to uncover forecasting errors in NPV estimates is by looking at: I) Book values II) Liquidating values III) Market values A. I only B. II only C. III only D. I and II only

2. A new grocery store cost $50 million in initial investment. It is estimated that the store will generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be sold for $60 million. What is the NPV of the project at a discount rate of 10%? A. $2.42 million B. $10 million C. $6.21 million D. None of the above

3. A new grocery store cost $50 million in initial investment. It is estimated that the store will generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be sold for $55 million. What is the NPV of the project at a discount rate of 10%? A. $2.42 million B. $5 million C. $3.1 million D. None of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

4. A rental property is providing 13% rate of return. Next year's rent is expected to be $1.0 million and is expected to grow at 3% per year forever. What is the current value of the property? A. $7.7 million B. $10 million C. $33.3 million D. none of the above

5. A building is appraised at $1 million. This estimate is based on a forecast of net rent of $100,000 per year discounted at 10% [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of repair and maintenance costs and taxes. Suppose the building is currently in disrepair and it takes one year and $250,000 to bring it into rent able condition. How much would you be willing to pay for the building today? A. $1,000,000 B. $681,818 C. $750,000 D. None of the above

6. USGOLD Company has an opportunity to invest in a gold mine. The initial investment is $250 million. The mine is estimated to produce 100,000 ounces of gold per year for the next ten years. The extraction cost of gold per ounce is $150 and it is expected to remain at that level. The current price of gold is $600 per ounce and it is expected to increase by 4% per year for the next 10 years. What is the NPV of the project at a discount rate of 10%? (Ignore taxes.) A. $ - 3.8 million. B. $240.8 million. C. $257.8 million. D. None of the above.

7. Suppose the current price of gold is $600 per ounce. The price of gold is expected to grow at 4% per year for the foreseeable future. If the appropriate discount rate is 10%, then the current value of gold per ounce is: A. Less than $600 per ounce B. $600 per ounce C. Greater than $600 per ounce D. Not enough information

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Chapter 11 - Investment, Strategy, and Economic Rents

8. Suppose the current price of gold is $650 per ounce. The price of gold is expected to grow at 5 % per year for foreseeable future. If the appropriate discount rate is 8%, the present value of gold is: A. Less than $650 per ounce B. Greater than $650 per ounce C. $650 per ounce D. None of the above

9. Suppose the current price of gold is $600 per ounce and the price of gold is expected to increase at a rate of 5% per year for the foreseeable future. What is the current value of 0.2 million ounces of gold to be produced each year for the next five years (the discount rate is 8% per year)? A. $600 million B. $521.64 million C. $690.86 million D. None of the above

10. Goldsmith labs recover gold from printed circuit boards. It has developed new equipment for the purpose. The following data is given. (1.) Equipment costs $250,000 (2.) It will cost $200,000 per year to run (3.) It has an economic life of 5 years and is depreciated using straight-line method (4.) It will recover 300 ounces of gold per year (5.) The current price of gold is $600 per ounce and it expected to increase at a rate 4% per year for the foreseeable future (6.) The tax rate is 30% (7.) The cost of capital is 8% What is NPV of the equipment? A. $430,400 B. $520,510 C. $470,400 D. None of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

11. The formula Po = Pt/((1 + r)^t) holds good for assets which: I) Pay no dividends II) Are traded in a competitive market III) Cost nothing to hold A. I only B. I and II only C. I,II, and III D. II and III only

12. Investing in gold is like: I) Investing in a stock that pays quarterly dividends II) Investing in a stock that pays annual dividends III) Investing in Treasury bonds IV) Investing in a stock that pays no dividends A. I only B. II only C. I,II, and III only D. IV only

13. When you are using futures prices to estimate the cash flows of a project the discount rate used is: I) The cost of capital for the firm II) The cost of capital for the project III) The risk free rate A. I only B. I and II only C. III only D. II only

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Chapter 11 - Investment, Strategy, and Economic Rents

14. When futures prices are used to estimate cash flows, the estimates are: I) Present value of future cash flows II) Certainty equivalents III) Same as the estimates using spot prices A. I only B. II only C. III only D. I and III only

15. The present value of risky cash flows is calculated as follows: I) estimate the expected cash flows and discount these at a rate that is consistent with the risk of the cash flows II) estimate the certainty-equivalent cash flows and discount these at the risk-free rate III) estimate the expected cash flows and discount these at the risk-free rate A. I only B. II only C. I and II only D. III only

16. Use of certainty-equivalent cash flows is advantageous in the following ways: I) there is no need to estimate future prices II) there is no need to estimate the discount rate III) there may be large errors introduced because prices in a competitive market fluctuate randomly A. I only B. II only C. I and II only D. I, II and III

17. Economic rents are: A. Returns that are in excess of the opportunity cost of capital B. Returns that are equal to the opportunity cost of the capital C. Returns that are less than the opportunity cost of capital D. None of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

18. The following are some of the competitive advantages that can last longer: I) patents II) brand names III) economies of scale A. I only B. II only C. I and II only D. I, II and III

19. The following are some of the competitive advantages that can last longer: I) proprietary technology II) protected markets with high barriers to entry by other firms III) strategic assets that competitors cannot easily duplicate A. I only B. II only C. I and II only D. I, II and III

20. Which of the following is an example of a strategic asset? A. trucks B. diesel engine C. rail road containers D. rail road lines

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Chapter 11 - Investment, Strategy, and Economic Rents

21. As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii) each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is $114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the present value of a steam ship? A. $190,152 B. $251,326 C. $609,486 D. None of the above

22. As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii) each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is $114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the annual revenue from a cargo ship? (Assume that salvage values are independent of use and there are no taxes.) A. $80,000 B. $105,000 C. $115,000 D. None of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

23. As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii) each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is $114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the annual revenue from a cargo ship? (Assume that salvage values are independent of use and there are no taxes.) If the cost of carrying cargo by sailing ship were $70,000 per year, what would be the present value of a steamship? A. $114,091 B. $152,814 C. $215,000 D. None of the above

24. NPVs can be thought of as the present value of: A. economic rents B. profits C. revenues D. none of the above

25. A positive NPV for a new project is reliable only if it is based on: A. forecast of cash flows B. Michael Porter's theories C. identifiable sources of economic rents D. none of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

26. You have inherited a run-down house in Chicago. There is an active market in properties of this type, and similar properties are selling for $100,000. If rented out, the cash returns are expected to be $12,000 per year forever. If the appropriate discount rate is 15%, how much is the house worth? A. $80,000 B. $100,000 C. $180,000 D. None of the above

27. You have inherited 100 acres of Iowa farmland. There is an active market in this type of land and other similar properties are selling for $10,000 per acre. If planted with corn, the net cash flows are expected to be $800 per acre forever. If the discount rate is 10%, how much is the land worth per acre? A. $10,000 B. $8,000 C. $18,000 D. None of the above

28. When the markets become competitive, economic rents: A. Increase B. Decrease C. Remain the same D. Tend to be zero

29. In order to better understand a proposed positive net present value project, managers should: A. Recheck all calculations. B. Assume there are no forecast errors. C. Identify sources of economic rent. D. Evaluate other similar projects the company has undertaken in the past.

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Chapter 11 - Investment, Strategy, and Economic Rents

30. The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.50. Assuming that the competition will never catch up and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. Zero B. +$500,000 C. +$250,000 D. +$50,000

31. The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in three years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. $500,000 B. $210,648 C. +$250,000 D. None of the above

32. The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in five years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. $500,000 B. $210,648 C. $299,061 D. None of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

33. The annual demand (in millions) for baseballs is given by the equation: Demand = 10 * (4-price). If the price of baseballs is $1.50, what is the demand for baseballs? A. 10 million B. 15 million C. 25 million D. None of the above

34. The annual demand (in millions) for golf balls is given by the equation: Demand = 6 * (5price). If the price of a golf ball is $3, what is the demand for golf balls? A. 8 million B. 12 million C. 18 million D. None of the above

35. Allen Technology Company is currently valued at $400 million. It is proposing a new plant with a net present value of $200 million. But the new plant will reduce the value of the existing plant by $50 million. What is the value of the company if it takes up the new plant? A. $600 million. B. $200 million. C. $550 million. D. None of the above.

36. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the discount rate is 20%, what is the value of the plant at the end of year-1? A. $76,569 B. -23,400 C. 48,600 D. None of the above

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Chapter 11 - Investment, Strategy, and Economic Rents

37. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year-1 is $80,000, would you scrap the plant at the end of year-1? A. Yes B. No C. Need more information D. Don't know

38. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year is $66,700, would you scrap the plant at the end of year one? A. Yes B. No C. Depends on the net present value D. Need more information

39. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the discount rate is 20%, what is the value of the plant at the end of year-2? A. $48,600 B. $-51,600 C. Zero D. None of the above

40. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value at the end of year-2 is $60,000, would you scrap the plant at the end of year-2? A. Yes B. No C. Don't know D. Need more information

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Chapter 11 - Investment, Strategy, and Economic Rents

41. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value at the end of year-2 is $40,000, would you scrap the plant at the end of year-2? A. Yes B. No C. Don't know D. Need more information

42. The strategy of deliberately slowing down the rate at which new products are introduced by well established and technologically advanced firms is: A. a good strategy that maximizes economic rents B. a dangerous strategy as it provides opportunities for other firms to introduce new products C. a good strategy because firms only have a limited number of good projects D. all of the above

43. In a highly competitive market, how will a firm most likely produce positive economic rents? A. A new marketing plan that will gain market share from competitors B. Renegotiation of financing terms with the firm's funding sources C. The introduction of new technology that creates manufacturing efficiencies D. All of the above

44. What is the NPV of a project in a perfectly competitive environment? A. Positive B. Negative C. Zero D. Cannot be determined

True / False Questions

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Chapter 11 - Investment, Strategy, and Economic Rents

45. If an asset is worth more to others than it is to you, you should always attempt to buy it from them. True False

46. Frequently the financial manager can observe market values for real assets e.g. real estate values, values of precious metals etc. However, they have no place in the capital budgeting analysis. For that purpose discounted cash flow is the only proper tool. True False

47. Since gold is held as an investment but pays no cash dividends, today's price equals the present value of its forecasted future price. True False

48. The expected rise in the price of a mineral less extraction costs should equal the cost of capital. True False

49. For a stock that pays no dividends, today's price is the present value of next year's price. True False

50. The NPV of an investment is the discounted value of the economic rents that it is expected to produce. True False

51. In order to generate a positive NPV project, a firm must have competitive advantage. True False

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Chapter 11 - Investment, Strategy, and Economic Rents

52. The cash forecasts for positive NPV projects are more reliable, if the managers of the firm are able to identify the economic rents associated with the projects. True False

53. According to Michael Porter, managers can secure a competitive advantage for their firm within its industry in three ways. They are: by cost leadership, by product differentiation, and by focusing on a particular market niche. True False

54. In evaluating a project, it is necessary to consider its effect upon the sales of the firm's existing products. True False

55. If a firm expects long-run economic rents from a particular project, the company is considering the effects of competition. True False

56. Sometimes the losses on existing plants may completely offset the gains from new technology. True False

57. The total NPV of a new plant is equal to the NPV of the new plant plus the change in the present value of the existing plant. True False

58. In a competitive market, a firm can earn high economic rents. True False

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Chapter 11 - Investment, Strategy, and Economic Rents

59. Stealing market share is the best way to create economic rents in a competitive market. True False

60. Price cutting in a competitive market will never lead to the creation of economic rents.

True False

Short Answer Questions

61. Briefly explain how investing in gold is like investing in a stock that pays no dividends?

62. Briefly explain the concept of "economic rent."

63. Briefly explain the two ways in which PVs of cash flows can be estimated.

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Chapter 11 - Investment, Strategy, and Economic Rents

64. Why are economic rents important to a manager?

65. Briefly explain the main difference between the capital budgeting process and the strategic planning process.

66. Discuss how you would react if you were presented with a project that had a high positive NPV.

67. Briefly explain the effect of building new manufacturing plants on the existing plants.

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Chapter 11 - Investment, Strategy, and Economic Rents

68. What is the total net present value (NPV) of an expansion plan?

69. Briefly explain the effect of competition on economic rents

70. Briefly explain the advantage and the disadvantage of a high salvage value for a project.

71. State the difference between capital budgeting and strategic planning.

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Chapter 11 - Investment, Strategy, and Economic Rents

72. Explain the economic concept that prevents economic rents from occurring.

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Chapter 11 - Investment, Strategy, and Economic Rents

Chapter 11 Investment, Strategy, and Economic Rents Answer Key

Multiple Choice Questions

1. One way to uncover forecasting errors in NPV estimates is by looking at: I) Book values II) Liquidating values III) Market values A. I only B. II only C. III only D. I and II only

Type: Medium

2. A new grocery store cost $50 million in initial investment. It is estimated that the store will generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be sold for $60 million. What is the NPV of the project at a discount rate of 10%? A. $2.42 million B. $10 million C. $6.21 million D. None of the above NPV = -50 + 5/1.1 + 5/(1.1^2) + 5/ (1.1^3) + 5/ (1.1)^4 + 65/(1.1^5) = +6.21

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

3. A new grocery store cost $50 million in initial investment. It is estimated that the store will generate $5 million after-tax cash flow each year for five years. At the end of 5 years it can be sold for $55 million. What is the NPV of the project at a discount rate of 10%? A. $2.42 million B. $5 million C. $3.1 million D. None of the above NPV = -50 + 5/1.1 + 5/(1.1^2) + 5/(1.1^3) + 5/(1.1 ^4) + 60/(1.1^5) = +3.1

Type: Medium

4. A rental property is providing 13% rate of return. Next year's rent is expected to be $1.0 million and is expected to grow at 3% per year forever. What is the current value of the property? A. $7.7 million B. $10 million C. $33.3 million D. none of the above Value = 1.0/(.13 - .03) = 10 million

Type: Medium

5. A building is appraised at $1 million. This estimate is based on a forecast of net rent of $100,000 per year discounted at 10% [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of repair and maintenance costs and taxes. Suppose the building is currently in disrepair and it takes one year and $250,000 to bring it into rent able condition. How much would you be willing to pay for the building today? A. $1,000,000 B. $681,818 C. $750,000 D. None of the above Price: (1,000,000 - 250,000)/(1.1) = $681,818

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

6. USGOLD Company has an opportunity to invest in a gold mine. The initial investment is $250 million. The mine is estimated to produce 100,000 ounces of gold per year for the next ten years. The extraction cost of gold per ounce is $150 and it is expected to remain at that level. The current price of gold is $600 per ounce and it is expected to increase by 4% per year for the next 10 years. What is the NPV of the project at a discount rate of 10%? (Ignore taxes.) A. $ - 3.8 million. B. $240.8 million. C. $257.8 million. D. None of the above. NPV = -250 +(0.1)(600)(10) - (PV of $15 million per year at a 10% discount rate); NPV = -250 + 600 - 92.2 = $257. 8 million

Type: Medium

7. Suppose the current price of gold is $600 per ounce. The price of gold is expected to grow at 4% per year for the foreseeable future. If the appropriate discount rate is 10%, then the current value of gold per ounce is: A. Less than $600 per ounce B. $600 per ounce C. Greater than $600 per ounce D. Not enough information

Type: Medium

8. Suppose the current price of gold is $650 per ounce. The price of gold is expected to grow at 5 % per year for foreseeable future. If the appropriate discount rate is 8%, the present value of gold is: A. Less than $650 per ounce B. Greater than $650 per ounce C. $650 per ounce D. None of the above

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

9. Suppose the current price of gold is $600 per ounce and the price of gold is expected to increase at a rate of 5% per year for the foreseeable future. What is the current value of 0.2 million ounces of gold to be produced each year for the next five years (the discount rate is 8% per year)? A. $600 million B. $521.64 million C. $690.86 million D. None of the above Current value = (0.2)(5)(600)= 600 million

Type: Difficult

10. Goldsmith labs recover gold from printed circuit boards. It has developed new equipment for the purpose. The following data is given. (1.) Equipment costs $250,000 (2.) It will cost $200,000 per year to run (3.) It has an economic life of 5 years and is depreciated using straight-line method (4.) It will recover 300 ounces of gold per year (5.) The current price of gold is $600 per ounce and it expected to increase at a rate 4% per year for the foreseeable future (6.) The tax rate is 30% (7.) The cost of capital is 8% What is NPV of the equipment? A. $430,400 B. $520,510 C. $470,400 D. None of the above -250,000 + [PV of (0.3)(50,000) for 5 years at 8%] + (5)(900)(600)(1 - 0.3) - PV of (1 - 0.3)(200,000) for 5 years at 8% = -250,000 + 59,890 + 900,000 - 279,490 = 430,400

Type: Difficult

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Chapter 11 - Investment, Strategy, and Economic Rents

11. The formula Po = Pt/((1 + r)^t) holds good for assets which: I) Pay no dividends II) Are traded in a competitive market III) Cost nothing to hold A. I only B. I and II only C. I,II, and III D. II and III only

Type: Medium

12. Investing in gold is like: I) Investing in a stock that pays quarterly dividends II) Investing in a stock that pays annual dividends III) Investing in Treasury bonds IV) Investing in a stock that pays no dividends A. I only B. II only C. I,II, and III only D. IV only

Type: Medium

13. When you are using futures prices to estimate the cash flows of a project the discount rate used is: I) The cost of capital for the firm II) The cost of capital for the project III) The risk free rate A. I only B. I and II only C. III only D. II only

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

14. When futures prices are used to estimate cash flows, the estimates are: I) Present value of future cash flows II) Certainty equivalents III) Same as the estimates using spot prices A. I only B. II only C. III only D. I and III only

Type: Medium

15. The present value of risky cash flows is calculated as follows: I) estimate the expected cash flows and discount these at a rate that is consistent with the risk of the cash flows II) estimate the certainty-equivalent cash flows and discount these at the risk-free rate III) estimate the expected cash flows and discount these at the risk-free rate A. I only B. II only C. I and II only D. III only

Type: Medium

16. Use of certainty-equivalent cash flows is advantageous in the following ways: I) there is no need to estimate future prices II) there is no need to estimate the discount rate III) there may be large errors introduced because prices in a competitive market fluctuate randomly A. I only B. II only C. I and II only D. I, II and III

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

17. Economic rents are: A. Returns that are in excess of the opportunity cost of capital B. Returns that are equal to the opportunity cost of the capital C. Returns that are less than the opportunity cost of capital D. None of the above

Type: Medium

18. The following are some of the competitive advantages that can last longer: I) patents II) brand names III) economies of scale A. I only B. II only C. I and II only D. I, II and III

Type: Easy

19. The following are some of the competitive advantages that can last longer: I) proprietary technology II) protected markets with high barriers to entry by other firms III) strategic assets that competitors cannot easily duplicate A. I only B. II only C. I and II only D. I, II and III

Type: Easy

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Chapter 11 - Investment, Strategy, and Economic Rents

20. Which of the following is an example of a strategic asset? A. trucks B. diesel engine C. rail road containers D. rail road lines

Type: Easy

21. As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii) each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is $114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the present value of a steam ship? A. $190,152 B. $251,326 C. $609,486 D. None of the above PV(steamship) = 114,091 + PV(10,00010%,15 years) = 114,091 + 76,061 = 190,152

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

22. As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii) each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is $114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the annual revenue from a cargo ship? (Assume that salvage values are independent of use and there are no taxes.) A. $80,000 B. $105,000 C. $115,000 D. None of the above PV(steamship) = 114,091 + PV(10,00010%,15, years) = 114,091 + 76,061 = 190,152 EAC = 190,152/7.6061 = 25,000; revenues = EAC + costs = 25,000 + 80,000 = 105,000

Type: Difficult

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Chapter 11 - Investment, Strategy, and Economic Rents

23. As a 19th century economist, you are faced with the following problem. The world's shipping fleet consists of steamships and sailing ships. Each can be used to carry cargo or passengers. The ships have similar sailing capacities but differ in their annual operating costs as follows:

Assume: (i) Fares are competitively determined, (ii) demand is not expected to change, (iii) each vessel has a life of 15 years, (iv) current salvage value of either ship (sailing or steam) is $114,091, and (v) Cost of capital is 10%, (vi) no taxes. What is the annual revenue from a cargo ship? (Assume that salvage values are independent of use and there are no taxes.) If the cost of carrying cargo by sailing ship were $70,000 per year, what would be the present value of a steamship? A. $114,091 B. $152,814 C. $215,000 D. None of the above Value of the steamship = salvage value

Type: Medium

24. NPVs can be thought of as the present value of: A. economic rents B. profits C. revenues D. none of the above

Type: Easy

25. A positive NPV for a new project is reliable only if it is based on: A. forecast of cash flows B. Michael Porter's theories C. identifiable sources of economic rents D. none of the above

Type: Difficult

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Chapter 11 - Investment, Strategy, and Economic Rents

26. You have inherited a run-down house in Chicago. There is an active market in properties of this type, and similar properties are selling for $100,000. If rented out, the cash returns are expected to be $12,000 per year forever. If the appropriate discount rate is 15%, how much is the house worth? A. $80,000 B. $100,000 C. $180,000 D. None of the above

Type: Medium

27. You have inherited 100 acres of Iowa farmland. There is an active market in this type of land and other similar properties are selling for $10,000 per acre. If planted with corn, the net cash flows are expected to be $800 per acre forever. If the discount rate is 10%, how much is the land worth per acre? A. $10,000 B. $8,000 C. $18,000 D. None of the above PV = 800/0.1 = 8,000; Market value = 10,000; Land Value = Market value

Type: Medium

28. When the markets become competitive, economic rents: A. Increase B. Decrease C. Remain the same D. Tend to be zero

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

29. In order to better understand a proposed positive net present value project, managers should: A. Recheck all calculations. B. Assume there are no forecast errors. C. Identify sources of economic rent. D. Evaluate other similar projects the company has undertaken in the past.

Type: Medium

30. The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.50. Assuming that the competition will never catch up and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. Zero B. +$500,000 C. +$250,000 D. +$50,000 Old plant: -500,000 + (100,000 (P-2))/ (0.2) = 0; P-2 = 1; P = $3; New plant: -500,000 + (100,000(3 - 1.50))/0.2 = $250,000

Type: Difficult

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Chapter 11 - Investment, Strategy, and Economic Rents

31. The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in three years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. $500,000 B. $210,648 C. +$250,000 D. None of the above Old plant: 500,000 + (100,000 (P-2))/(0.2) = 0; P-2 = 1; P = $3; New plant: -500,000 + [(100,000(3.0 - 1.0)) /1.2] + [(100,000(3.0 - 1.0)) /(1.2^2)] + [(100,000(3.0 - 1.0)) /1.2^3] + [500,000/(1.2^3)] = $210,648

Type: Difficult

32. The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000 gallon capacity plant costs $500,000 to build and have an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in five years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. $500,000 B. $210,648 C. $299,061 D. None of the above Old plant: - 500,000 + (100,000 (P-2))/(0.2) = 0; P-2 = 1; P = $3/ per gallon; New plant: -500,000 + [(100,000(3 - 1)/1.2)] + [(100,000(3 - 1)/(1.2^2))] + [(100,000(3 1)/1.2^3)] + [(100,000(3 - 1)/(1.2)^4)] + [(100,000(3 - 1)/(1.2^5)] + (500,000/1.2^5) = $299,061

Type: Difficult

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Chapter 11 - Investment, Strategy, and Economic Rents

33. The annual demand (in millions) for baseballs is given by the equation: Demand = 10 * (4-price). If the price of baseballs is $1.50, what is the demand for baseballs? A. 10 million B. 15 million C. 25 million D. None of the above Demand = 10 * (4 - 1.50) = 25 million

Type: Medium

34. The annual demand (in millions) for golf balls is given by the equation: Demand = 6 * (5price). If the price of a golf ball is $3, what is the demand for golf balls? A. 8 million B. 12 million C. 18 million D. None of the above Demand = 6 * (5 - 3) = 12 million

Type: Medium

35. Allen Technology Company is currently valued at $400 million. It is proposing a new plant with a net present value of $200 million. But the new plant will reduce the value of the existing plant by $50 million. What is the value of the company if it takes up the new plant? A. $600 million. B. $200 million. C. $550 million. D. None of the above. New value: 400 + 200 - 50 = 550

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

36. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the discount rate is 20%, what is the value of the plant at the end of year-1? A. $76,569 B. -23,400 C. 48,600 D. None of the above New value: 43,300/1.2 + 58,300/1.2^2 = $76,569

Type: Medium

37. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year-1 is $80,000, would you scrap the plant at the end of year-1? A. Yes B. No C. Need more information D. Don't know

Type: Medium

38. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year is $66,700, would you scrap the plant at the end of year one? A. Yes B. No C. Depends on the net present value D. Need more information value of the plant > salvage value; No

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

39. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the discount rate is 20%, what is the value of the plant at the end of year-2? A. $48,600 B. $-51,600 C. Zero D. None of the above Value of the plant at the end of year-2 = 58,300/1.2 = 48,600

Type: Difficult

40. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value at the end of year-2 is $60,000, would you scrap the plant at the end of year-2? A. Yes B. No C. Don't know D. Need more information

Type: Difficult

41. The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: Year-1: +43,300, Year-2: $43,300 and Year-3 = 58,300. (Assume there is no tax.) If the salvage value at the end of year-2 is $40,000, would you scrap the plant at the end of year-2? A. Yes B. No C. Don't know D. Need more information

Type: Difficult

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Chapter 11 - Investment, Strategy, and Economic Rents

42. The strategy of deliberately slowing down the rate at which new products are introduced by well established and technologically advanced firms is: A. a good strategy that maximizes economic rents B. a dangerous strategy as it provides opportunities for other firms to introduce new products C. a good strategy because firms only have a limited number of good projects D. all of the above

Type: Medium

43. In a highly competitive market, how will a firm most likely produce positive economic rents? A. A new marketing plan that will gain market share from competitors B. Renegotiation of financing terms with the firm's funding sources C. The introduction of new technology that creates manufacturing efficiencies D. All of the above

Type: Medium

44. What is the NPV of a project in a perfectly competitive environment? A. Positive B. Negative C. Zero D. Cannot be determined

Type: Medium

True / False Questions

45. If an asset is worth more to others than it is to you, you should always attempt to buy it from them. FALSE

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

46. Frequently the financial manager can observe market values for real assets e.g. real estate values, values of precious metals etc. However, they have no place in the capital budgeting analysis. For that purpose discounted cash flow is the only proper tool. FALSE

Type: Medium

47. Since gold is held as an investment but pays no cash dividends, today's price equals the present value of its forecasted future price. TRUE

Type: Medium

48. The expected rise in the price of a mineral less extraction costs should equal the cost of capital. TRUE

Type: Difficult

49. For a stock that pays no dividends, today's price is the present value of next year's price. TRUE

Type: Easy

50. The NPV of an investment is the discounted value of the economic rents that it is expected to produce. TRUE

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

51. In order to generate a positive NPV project, a firm must have competitive advantage. TRUE

Type: Medium

52. The cash forecasts for positive NPV projects are more reliable, if the managers of the firm are able to identify the economic rents associated with the projects. TRUE

Type: Difficult

53. According to Michael Porter, managers can secure a competitive advantage for their firm within its industry in three ways. They are: by cost leadership, by product differentiation, and by focusing on a particular market niche. TRUE

Type: Medium

54. In evaluating a project, it is necessary to consider its effect upon the sales of the firm's existing products. TRUE

Type: Easy

55. If a firm expects long-run economic rents from a particular project, the company is considering the effects of competition. FALSE

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

56. Sometimes the losses on existing plants may completely offset the gains from new technology. TRUE

Type: Easy

57. The total NPV of a new plant is equal to the NPV of the new plant plus the change in the present value of the existing plant. TRUE

Type: Medium

58. In a competitive market, a firm can earn high economic rents. FALSE

Type: Medium

59. Stealing market share is the best way to create economic rents in a competitive market. FALSE

Type: Medium

60. Price cutting in a competitive market will never lead to the creation of economic rents.

TRUE

Type: Medium

Short Answer Questions

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Chapter 11 - Investment, Strategy, and Economic Rents

61. Briefly explain how investing in gold is like investing in a stock that pays no dividends? The current price of a stock is given by: P0 = (D1 + P1)/(1 + r). But for gold D1 = 0. Hence, P0 = (P1)/(1 + r). But P1 = (P2)/(1 + r) and so on. Therefore, P0 = (Pt)/(1 + r)^t. In other words, Current price is the present value of future price. This holds good for any asset which pays no dividends, is traded in a competitive market, and costs nothing to store.

Type: Medium

62. Briefly explain the concept of "economic rent." Profits that are in excess of the opportunity cost of capital are called economic rents. These rents may be either temporary or persistent. The NPV of a project is the discounted value of the economic rents that it will produce. In order to generate economic rents, a firm should have some degree of competitive advantage or monopoly power. In a purely competitive world, there are no economic rents.

Type: Medium

63. Briefly explain the two ways in which PVs of cash flows can be estimated. There two ways in which firms can estimate the present value of cash flows. First, estimate the expected cash flows and discount these cash flows at a rate that is appropriate for the risk of the cash flows. Second, estimate the certainty-equivalent cash flows and discount these cash flows using the risk-free interest rate.

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

64. Why are economic rents important to a manager? All positive NPV projects should be analyzed for sources of economic rents. Otherwise, the forecast or positive NPV for the project may be spurious or erroneous. Only when the manager is convinced of the sources of economic rents should he/she accept the positive NPV project.

Type: Difficult

65. Briefly explain the main difference between the capital budgeting process and the strategic planning process. The capital budgeting process is a bottom-up process. That ideas bubble up from the departments to the top management through project proposals. The strategic planning process is a top-down process through which the top management provides its vision of the future. These two processes should match with each other for optimal performance.

Type: Difficult

66. Discuss how you would react if you were presented with a project that had a high positive NPV. The basic question to ask is, why is the net present value positive? Is it because of some forecast error or because of the company's competitive advantage? One should proceed with the project only if there are sources of economic rents that satisfactorily explain the high NPV of the project.

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

67. Briefly explain the effect of building new manufacturing plants on the existing plants. Generally, building new plants reduces the value of existing plants. This factor should be incorporated into the calculation of the NPV of the new plant. [NPVtotal = NPVnew plant + ∆PVexisting plant]

Type: Medium

68. What is the total net present value (NPV) of an expansion plan? The total NPV of an expansion plan is the sum of the NPV of new plant and the change in the PV of existing plan. [NPVtotal = NPVnew plant + ∆PVexisting plant]

Type: Difficult

69. Briefly explain the effect of competition on economic rents Competition drives down the value of economic rents to zero. In a purely competitive industry economic rents are zero. Therefore firms have to be always on the lookout for opportunities that offer economic rents.

Type: Medium

70. Briefly explain the advantage and the disadvantage of a high salvage value for a project. A high salvage value provides a firm with an option to abandon the project if the outcome from the project poor. On the other hand, if the competitors know that they can bail out easily, they are more likely to enter the market and thereby making it more competitive. This will reduce economic rent and hence the NPV off the project.

Type: Medium

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Chapter 11 - Investment, Strategy, and Economic Rents

71. State the difference between capital budgeting and strategic planning. Generally capital budgeting is a bottom-up process, that is, ideas and proposals start at the lower levels of the firm and move upwards for approval. Strategic planning is a top-down process where ideas and proposals start at the highest level of management and filter down to the lowest levels. A firm's capital investment choices should reflect both for successful implementation.

Type: Easy

72. Explain the economic concept that prevents economic rents from occurring. Economic rents are generated from the creation of value. These value added creations earn profits in excess of the firm's opportunity cost of capital. Under a perfectly competitive market, all products clear the market at the market price. In such situations, firms can sell all the product they wish at the market price cannot produce profits since the markets are competitively perfect. Prices will be bid down so as to eliminate any profits.

Type: Difficult

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