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Investment Strategy

Investment Strategy. April 11, 2007 (LA) or April 5, 2007 (OCC). 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. Sources of Present Values.

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Investment Strategy

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  1. Investment Strategy April 11, 2007 (LA) or April 5, 2007 (OCC)

  2. 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

  3. 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

  4. Sequencing of Decisions • Most investments can be developed in a sequence of stages where the investment strategy can be refined or the project abandoned • Decision trees useful Good result Good result Expand Test Market Bad result Close Down Bad result

  5. 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.

  6. Invest Decision Tree for Stewart Pharmaceutical Invest The firm has two decisions to make: To test or not to test. NPV = $3.4 b To invest or not to invest. Success Test Do not invest NPV = $0 Failure Do not test NPV = –$91.46 m

  7. 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: • The NPV evaluated at date 0 is: So we should test.

  8. 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

  9. Break-Even Analysis • Accounting break-even analysis • Present-value break-even analysis • Example

  10. 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

  11. Management options Abandon Contract Switch Wait Expand Growth Currently Invested: React to Bad News Not Currently Invested Currently Invested: React to Good News

  12. 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

  13. 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?

  14. 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

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