Brealey, Myers. Principles of Corporate Finance. 7th edition
Подождите немного. Документ загружается.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
278 PART III Practical Problems in Capital Budgeting
Most simulation models incorporate a business-as-usual strategy, which is fine
as long as there are no major surprises. The greater the divergence from expected
levels of market growth, market share, cost, etc., the less realistic is the simulation.
Therefore the extreme high and low simulated values—the “tails” of the simulated
distributions—should be treated with extreme caution. Don’t take the area under
the tails as realistic probabilities of disaster or bonanza.
SUMMARY
Visit us at www.mhhe.com/bm7e
There is more to capital budgeting than grinding out calculations of net present
value. If you can identify the major uncertainties, you may find that it is worth un-
dertaking some additional preliminary research that will confirm whether the proj-
ect is worthwhile. And even if you decide that you have done all you can to resolve
the uncertainties, you still want to be aware of the potential problems. You do not
want to be caught by surprise if things go wrong: You want to be ready to take cor-
rective action.
There are three ways in which companies try to identify the principal threats to
a project’s success. The simplest is sensitivity analysis. In this case the manager con-
siders in turn each of the determinants of the project’s success and recalculates
NPV at very optimistic and very pessimistic levels of that variable. This establishes
a range of possible values. The project is “sensitive to” the variable if the range is
wide, especially on the pessimistic side.
Sensitivity analysis of this kind is easy, but it is not always helpful. Variables do
not usually change one at a time. If costs are higher than you expect, it is a good
bet that prices will be higher also. And if prices are higher, it is a good bet that sales
volume will be lower. If you don’t allow for the dependencies between the swings
and the merry-go-rounds, you may get a false idea of the hazards of the fairground
business. Many companies try to cope with this problem by examining the effect
on the project of alternative plausible combinations of variables. In other words,
they will estimate the net present value of the project under different scenarios and
compare these estimates with the base case.
In a sensitivity analysis you change variables one at a time: When you analyze
scenarios, you look at a limited number of alternative combinations of variables. If
you want to go whole hog and look at all possible combinations of variables, then
you will probably use Monte Carlo simulation to cope with the complexity. In that
case you must construct a complete model of the project and specify the probabil-
ity distribution of each of the determinants of cash flow. You can then ask the com-
puter to select a random number for each of these determinants and work out the
cash flows that would result. After the computer has repeated this process a few
thousand times, you should have a fair idea of the expected cash flow in each year
and the spread of possible cash flows.
Simulation can be a very useful tool. The discipline of building a model of the
project can in itself lead you to a deeper understanding of the project. And once
you have constructed your model, it is a simple matter to see how the outcomes
would be affected by altering the scope of the project or the distribution of any of
the variables.
Elementary treatises on capital budgeting sometimes create the impression that,
once the manager has made an investment decision, there is nothing to do but sit
back and watch the cash flows unfold. In practice, companies are constantly mod-
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
CHAPTER 10 A Project Is Not a Black Box 279
ifying their operations. If cash flows are better than anticipated, the project may be
expanded; if they are worse, it may be contracted or abandoned altogether. Op-
tions to modify projects are known as real options. In this chapter we introduced the
main categories of real options: expansion options, abandonment options, timing op-
tions, and options providing flexibility in production.
Good managers take account of real options when they value a project. One con-
venient way to summarize real options and their cash flow consequences is to cre-
ate a decision tree. You identify the things that could happen to the project and the
main counteractions that you might take. Then, working back from the future to
the present, you can consider which action you should take in each case.
Decision trees can help the financial manager to identify real options and their
impacts on project risks and cash flows. The options may increase or decrease proj-
ect risk. Because risk changes, standard discounted-cash-flow techniques can only
approximate the present value of real options. We will cover option-valuation
methods in Chapter 21 and revisit real options in Chapter 22.
FURTHER
READING
Visit us at www.mhhe.com/bm7e
For an excellent case study of break-even analysis, see:
U. E. Reinhardt: “Break-Even Analysis for Lockheed’s TriStar: An Application of Financial
Theory,” Journal of Finance, 28:821–838 (September 1973).
Hax and Wiig discuss how Monte Carlo simulation and decision trees were used in an actual capital
budgeting decision:
A. C. Hax and K. M. Wiig: “The Use of Decision Analysis in Capital Investment Problems,”
Sloan Management Review, 17:19–48 (Winter 1976).
Merck’s use of Monte Carlo simulation is discussed in:
N. A. Nichols: “Scientific Management at Merck: An Interview with Judy Lewent,” Harvard
Business Review, 72:89–99 (January–February 1994).
Three not-too-technical references on real options are listed below. Additional references follow
Chapter 22.
M. Amram and N. Kulatilaka: Real Options: Managing Strategic Investments in an Uncertain
World, Harvard Business School Press, Boston, 1999.
A. Dixit and R. Pindyck: “The Options Approach to Capital Investment,” Harvard Business
Review, 73:105–115 (May–June 1995).
W. C. Kester: “Today’s Options for Tomorrow’s Growth,” Harvard Business Review,
62:153–160 (March–April 1984).
QUIZ
1. Define and briefly explain each of the following terms or procedures:
a. Sensitivity analysis
b. Scenario analysis
c. Break-even analysis
d. Monte Carlo simulation
e. Decision tree
f. Real option
g. Abandonment value
h. Expansion value
2. True or false?
a. Sensitivity analysis is unnecessary for projects with asset betas that are equal
to zero.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
280 PART III Practical Problems in Capital Budgeting
b. Sensitivity analysis can be used to identify the variables most crucial to a project’s
success.
c. If only one variable is uncertain, sensitivity analysis gives “optimistic” and
“pessimistic” values for project cash flow and NPV.
d. The break-even sales level of a project is higher when break even is defined in terms
of NPV rather than accounting income.
e. Monte Carlo simulation can be used to help forecast cash flows.
f. Monte Carlo simulation eliminates the need to estimate a project’s opportunity
cost of capital.
3. What are the advantages of scenario analysis compared to sensitivity analysis?
4. How should Monte Carlo simulation be used to help determine a project’s NPV?
5. Suppose a manager has already estimated a project’s cash flows, calculated its NPV,
and done a sensitivity analysis like the one shown in Table 10.2. List the additional steps
required to carry out a Monte Carlo simulation of project cash flows.
6. What are the four chief categories of real options?
7. True or false?
a. Decision trees can help identify and describe real options.
b. The option to expand increases NPV
c. High abandonment value decreases NPV.
d. If a project has positive NPV, the firm should always invest immediately.
8. Give an example of why flexible production facilities are valuable.
PRACTICE
QUESTIONS
Visit us at www.mhhe.com/bm7e
1. What is the NPV of the electric scooter project under the following scenario?
Pessimistic Expected Optimistic
Market size .8 million 1.0 million 1.2 million
Market share .04 .1 .16
Unit price ¥300,000 ¥375,000 ¥400,000
Unit variable cost ¥350,000 ¥300,000 ¥275,000
Fixed cost ¥5 billion ¥3 billion ¥1 billion
Conduct a sensitivity analysis. What are the principal uncertainties in the project?
3. Otobai is considering still another production method for its electric scooter. It would
require an additional investment of ¥15 billion but would reduce variable costs by
¥40,000 per unit. Other assumptions follow Table 10.1.
a. What is the NPV of this alternative scheme?
b. Draw break-even charts for this alternative scheme along the lines of Figure 10.1.
c. Explain how you would interpret the break-even figure.
Now suppose Otobai’s management would like to know the figure for variable cost per
unit at which the electric scooter project in Section 10.1 would break even. Calculate the
Market size 1.1 million
Market share .1
Unit price ¥400,000
Unit variable cost ¥360,000
Fixed cost ¥2 billion
2. Otobai’s staff has come up with the following revised estimates for the electric scooter
project:
EXCEL
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
CHAPTER 10 A Project Is Not a Black Box 281
level of costs at which the project would earn zero profit and at which it would have
zero NPV.
4. The Rustic Welt Company is proposing to replace its old welt-making machinery with
more modern equipment. The new equipment costs $10 million and the company ex-
pects to sell its old equipment for $1 million. The attraction of the new machinery is that
it is expected to cut manufacturing costs from their current level of $8 a welt to $4. How-
ever, as the following table shows, there is some uncertainty both about future sales and
about the performance of the new machinery:
Visit us at www.mhhe.com/bm7e
Pessimistic Expected Optimistic
Sales, millions of welts .4 .5 .7
Manufacturing cost with new
machinery, dollars per welt 6 4 3
Economic life of new
machinery, years 7 10 13
Conduct a sensitivity analysis of the replacement decision, assuming a discount rate of
12 percent. Rustic Welt does not pay taxes.
5. Rustic Welt could commission engineering tests to determine the actual improvement
in manufacturing costs generated by the proposed new welt machines. (See problem 4
above.) The study would cost $450,000. Would you advise the company to go ahead
with the study?
6. Summarize the problems that a manager would encounter in interpreting a standard
sensitivity analysis, such as the one shown in Table 10.2. Which of these problems are
alleviated by examining the project under alternative scenarios?
7. Operating leverage is often measured as the percentage increase in profits after depre-
ciation for a 1 percent increase in sales.
a. Calculate the operating leverage for the electric scooter project assuming unit sales
are 100,000 (see Section 10.1).
b. Now show that this figure is equal to 1 (fixed costs/profits) including
depreciation, divided by profits.
c. Would operating leverage be higher or lower if sales were 200,000 scooters?
8. For what kinds of capital investment projects do you think Monte Carlo simulation
would be most useful? For example, can you think of some industries in which this
technique would be particularly attractive? Would it be more useful for large-scale in-
vestments than small ones? Discuss.
9. Look back at the Vegetron electric mop project in Section 9.6. Assume that if tests fail
and Vegetron continues to go ahead with the project, the $1 million investment would
generate only $75,000 a year. Display Vegetron’s problem as a decision tree.
10. Describe the real option in each of the following cases:
a. Deutsche Metall postpones a major plant expansion. The expansion has positive
NPV on a discounted-cash-flow basis but top management wants to get a better fix
on product demand before proceeding.
b. Western Telecom commits to production of digital switching equipment specially
designed for the European market. The project has a negative NPV, but it is
justified on strategic grounds by the need for a strong market position in the
rapidly growing, and potentially very profitable, market.
c. Western Telecom vetoes a fully integrated, automated production line for the new
digital switches. It relies on standard, less-expensive equipment. The automated
EXCEL
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
282 PART III Practical Problems in Capital Budgeting
production line is more efficient overall, according to a discounted-cash-flow
calculation.
d. Mount Fuji Airways buys a jumbo jet with special equipment that allows the plane
to be switched quickly from freight to passenger use or vice versa.
e. The British–French treaty giving a concession to build a railroad link under the
English Channel also required the concessionaire to propose by the year 2000 to
build a “drive-through link” if “technical and economic conditions permit . . . and
the decrease in traffic shall justify it without undermining the expected return
on the first [rail] link.” Other companies will not be permitted to build a link before
the year 2020.
11. An auto plant that costs $100 million to build can produce a new line of cars that will
generate cash flows with a present value of $140 million if the line is successful, but only
$50 million if it is unsuccessful. You believe that the probability of success is only about
50 percent.
a. Would you build the plant?
b. Suppose that the plant can be sold for $90 million to another automaker if the line
is not successful. Now would you build the plant?
c. Illustrate this option to abandon using a decision tree.
12. Agnes Magna has found some errors in her data (see Section 10.3). The corrected fig-
ures are as follows:
CHALLENGE
QUESTIONS
1. You own an unused gold mine that will cost $100,000 to reopen. If you open the mine,
you expect to be able to extract 1,000 ounces of gold a year for each of three years. Af-
ter that, the deposit will be exhausted. The gold price is currently $500 an ounce, and
each year the price is equally likely to rise or fall by $50 from its level at the start of the
year. The extraction cost is $460 an ounce and the discount rate is 10 percent.
a. Should you open the mine now or delay one year in the hope of a rise in the gold
price?
b. What difference would it make to your decision if you could costlessly (but
irreversibly) shut down the mine at any stage?
Visit us at www.mhhe.com/bm7e
Price of turbo, year 0 $350,000
Price of piston, year 0 $180,000
Discount rate 8 percent
Redraw the decision tree with the changed data. Calculate the value of the option to ex-
pand. Which plane should Ms. Magna buy?
13. Ms. Magna has thought of another possibility. She could abandon the venture entirely
by selling the plane at the end of the first year. Suppose that the piston-engine plane can
be sold for $150,000 and the turboprop can be sold for $500,000.
a. In what circumstances would it pay for Ms. Magna to sell either plane?
b. Redraw the decision tree in Figure 10.8 to recognize that there will be
circumstances in which Ms. Magna will choose to take the money and bail out.
c. Recalculate the value of the project recognizing the abandonment option.
d. How much does the option to abandon add to the value of the piston-engine
project? How much does it add to the value of the turboprop project?
14. How can decision trees help the financial manager to “open up the black box” and un-
derstand a capital investment project better? Why are decision trees not complete solu-
tions to the valuation of real options?
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
CHAPTER 10 A Project Is Not a Black Box 283
2. You are considering starting a company to provide a new Internet access service. There
is a 60 percent chance the demand will be high in the first year. If it is high, there is an
80 percent chance that it will continue high indefinitely. If demand is low in the first
year, there is a 60 percent chance that it will continue low indefinitely.
If demand is high, forecasted revenue is $900,000 a year; if demand is low, fore-
casted revenue is $700,000 a year. You can cease to offer the service at any point, in
which case, revenues are zero. Costs other than computing and telecommunications are
forecasted at $500,000 a year regardless of demand. These costs also can be terminated
at any point.
You have a choice on computing and telecommunications. One possibility is to buy
your own computers and software and to set up your own network and systems. This
involves an initial outlay of $2,000,000 and no subsequent expenditure. The resulting
system would have an economic life of 10 years and no salvage value. The alternative
is to rent computer and telecommunications services as you need them from AT&T or
one of the other major telecommunications companies. They propose to charge you
40 percent of your revenues.
Assume that a decision to buy your own system cannot be reversed (i.e., if you buy
a computer, you cannot resell it; if you do not buy it today, you cannot do so later). There
are no taxes, and the opportunity cost of capital is 10 percent.
Draw a decision tree showing your choices. Is it better to construct your own sys-
tem or to rent it? State clearly any additional assumptions that you need to make.
3. Explain why real options are most valuable when forecasts of future cash flows are
most uncertain.
MINI-CASE
Visit us at www.mhhe.com/bm7e
Waldo County
Waldo County, the well-known real estate developer, worked long hours, and he expected
his staff to do the same. So George Probit was not surprised to receive a call from the boss
just as George was about to leave for a long summer’s weekend.
Mr. County’s success had been built on a remarkable instinct for a good site. He would
exclaim “Location! Location! Location!” at some point in every planning meeting. Yet fi-
nance was not his strong suit. On this occasion he wanted George to go over the figures for
a new $90 million outlet mall designed to intercept tourists heading downeast toward
Maine. “First thing Monday will do just fine,” he said as he handed George the file. “I’ll be
in my house in Bar Harbor if you need me.”
George’s first task was to draw up a summary of the projected revenues and costs. The
results are shown in Table 10.7. Note that the mall’s revenues would come from two sources:
The company would charge retailers an annual rent for the space they occupied and in ad-
dition it would receive 5 percent of each store’s gross sales.
Construction of the mall was likely to take three years. The construction costs could be
depreciated straight-line over 15 years starting in year 3. As in the case of the company’s
other developments, the mall would be built to the highest specifications and would not
need to be rebuilt until year 17. The land was expected to retain its value, but could not be
depreciated for tax purposes.
Construction costs, revenues, operating and maintenance costs, and real estate taxes
were all likely to rise in line with inflation, which was forecasted at 2 percent a year. The
company’s tax rate was 35 percent and the cost of capital was 9 percent in nominal terms.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
10. A Project is Not a Black
Box
© The McGraw−Hill
Companies, 2003
Visit us at www.mhhe.com/bm7e
284 PART III Practical Problems in Capital Budgeting
George decided first to check that the project made financial sense. He then proposed
to look at some of the things that might go wrong. His boss certainly had a nose for a good
retail project, but he was not infallible. The Salome project had been a disaster because
store sales had turned out to be 40 percent below forecast. What if that happened here?
George wondered just how far sales could fall short of forecast before the project would
be underwater.
Inflation was another source of uncertainty. Some people were talking about a zero long-
term inflation rate, but George also wondered what would happen if inflation jumped to,
say, 10 percent.
A third concern was possible construction cost overruns and delays due to required zon-
ing changes and environmental approvals. George had seen cases of 25 percent construction
cost overruns and delays up to 12 months between purchase of the land and the start of con-
struction. He decided that he should examine the effect that this scenario would have on the
project’s profitability.
“Hey, this might be fun,” George exclaimed to Mr. Waldo’s secretary, Fifi, who was head-
ing for Old Orchard Beach for the weekend. “I might even try Monte Carlo.”
“Waldo went to Monte Carlo once,” Fifi replied. “Lost a bundle at the roulette table. I
wouldn’t remind him. Just show him the bottom line. Will it make money or lose money?
That’s the bottom line.”
“OK, no Monte Carlo,” George agreed. But he realized that building a spreadsheet and
running scenarios was not enough. He had to figure out how to summarize and present his
results to Mr. County.
Questions
1. What is the project’s NPV, given the projections in Table 10.7?
2. Conduct a sensitivity and a scenario analysis of the project. What do these analyses re-
veal about the project’s risks and potential value?
Year
0 1 2 3 4 5–17
Investment:
Land 30
Construction 20 30 10
Operations:
Rentals 12 12 12
Share of retail sales 24 24 24
Operating and maintenance costs 2 4 4 10 10 10
Real estate taxes 2 2 3 4 4 4
TABLE 10.7
Projected revenues and costs in real terms for the Downeast Tourist Mall (figures in $ millions).
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
11. Where Positive Net
Present Values Come From
© The McGraw−Hill
Companies, 2003
CHAPTER ELEVEN
286
WHERE POSITIVE
NET PRESENT
VALUES
COME F R O M
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
11. Where Positive Net
Present Values Come From
© The McGraw−Hill
Companies, 2003
WHY IS AN M.B.A. student who has learned about DCF like a baby with a hammer? Answer: Because
to a baby with a hammer, everything looks like a nail.
Our point is that you should not focus on the arithmetic of DCF and thereby ignore the forecasts
that are the basis of every investment decision. Senior managers are continuously bombarded with
requests for funds for capital expenditures. All these requests are supported with detailed DCF
analyses showing that the projects have positive NPVs.
1
How, then, can managers distinguish the
NPVs that are truly positive from those that are merely the result of forecasting errors? We suggest
that they should ask some probing questions about the possible sources of economic gain.
The first section in this chapter reviews certain common pitfalls in capital budgeting, notably the
tendency to apply DCF when market values are already available and no DCF calculations are needed.
The second section covers the economic rents that underlie all positive-NPV investments. The third
section presents a case study describing how Marvin Enterprises, the gargle blaster company, ana-
lyzed the introduction of a radically new product.
287
Let us suppose that you have persuaded all your project sponsors to give honest fore-
casts. Although those forecasts are unbiased, they are still likely to contain errors,
some positive and others negative. The average error will be zero, but that is little con-
solation because you want to accept only projects with truly superior profitability.
Think, for example, of what would happen if you were to jot down your esti-
mates of the cash flows from operating various lines of business. You would prob-
ably find that about half appeared to have positive NPVs. This may not be because
you personally possess any superior skill in operating jumbo jets or running a
chain of laundromats but because you have inadvertently introduced large errors
into your estimates of the cash flows. The more projects you contemplate, the more
likely you are to uncover projects that appear to be extremely worthwhile. Indeed,
if you were to extend your activities to making cash-flow estimates for various
companies, you would also find a number of apparently attractive takeover candi-
dates. In some of these cases you might have genuine information and the pro-
posed investment really might have a positive NPV. But in many other cases the
investment would look good only because you made a forecasting error.
What can you do to prevent forecast errors from swamping genuine informa-
tion? We suggest that you begin by looking at market values.
The Cadillac and the Movie Star
The following parable should help to illustrate what we mean. Your local Cadillac
dealer is announcing a special offer. For $45,001 you get not only a brand new
Cadillac but also the chance to shake hands with your favorite movie star. You
wonder how much you are paying for that handshake.
There are two possible approaches to the problem. You could evaluate the worth
of the Cadillac’s power steering, disappearing windshield wipers, and other fea-
tures and conclude that the Cadillac is worth $46,000. This would seem to suggest
that the dealership is willing to pay $999 to have a movie star shake hands with
11.1 LOOK FIRST TO MARKET VALUES
1
Here is another riddle. Are projects proposed because they have positive NPVs, or do they have posi-
tive NPVs because they are proposed? No prizes for the correct answer.
Brealey−Meyers:
Principles of Corporate
Finance, Seventh Edition
III. Practical Problems in
Capital Budgeting
11. Where Positive Net
Present Values Come From
© The McGraw−Hill
Companies, 2003
you. Alternatively, you might note that the market price for Cadillacs is $45,000, so
that you are paying $1 for the handshake. As long as there is a competitive market
for Cadillacs, the latter approach is more appropriate.
Security analysts face a similar problem whenever they value a company’s
stock. They must consider the information that is already known to the market
about a company, and they must evaluate the information that is known only to
them. The information that is known to the market is the Cadillac; the private in-
formation is the handshake with the movie star. Investors have already evaluated
the information that is generally known. Security analysts do not need to evaluate
this information again. They can start with the market price of the stock and con-
centrate on valuing their private information.
While lesser mortals would instinctively accept the Cadillac’s market value of
$45,000, the financial manager is trained to enumerate and value all the costs and
benefits from an investment and is therefore tempted to substitute his or her own
opinion for the market’s. Unfortunately this approach increases the chance of er-
ror. Many capital assets are traded in a competitive market, so it makes sense to
start with the market price and then ask why these assets should earn more in your
hands than in your rivals’.
Example: Investing in a New Department Store
We encountered a department store chain that estimated the present value of the
expected cash flows from each proposed store, including the price at which it could
eventually sell the store. Although the firm took considerable care with these esti-
mates, it was disturbed to find that its conclusions were heavily influenced by the
forecasted selling price of each store. Management disclaimed any particular real
estate expertise, but it discovered that its investment decisions were unintention-
ally dominated by its assumptions about future real estate prices.
Once the financial managers realized this, they always checked the decision to
open a new store by asking the following question: “Let us assume that the prop-
erty is fairly priced. What is the evidence that it is best suited to one of our depart-
ment stores rather than to some other use? In other words, if an asset is worth more
to others than it is to you, then beware of bidding for the asset against them.
Let us take the department store problem a little further. Suppose that the new
store costs $100 million.
2
You forecast that it will generate after-tax cash flow of $8
million a year for 10 years. Real estate prices are estimated to grow by 3 percent a
year, so the expected value of the real estate at the end of 10 years is 100 ⫻ (1.03)
10
⫽ $134 million. At a discount rate of 10 percent, your proposed department store
has an NPV of $1 million:
Notice how sensitive this NPV is to the ending value of the real estate. For exam-
ple, an ending value of $120 million implies an NPV of ⫺$5 million.
It is helpful to imagine such a business as divided into two parts—a real estate
subsidiary which buys the building and a retailing subsidiary which rents and op-
erates it. Then figure out how much rent the real estate subsidiary would have to
charge, and ask whether the retailing subsidiary could afford to pay the rent.
NPV ⫽⫺100 ⫹
8
1.10
⫹
8
11.102
2
⫹
…
⫹
8 ⫹ 134
11.102
10
⫽ $1 million
288 PART III Practical Problems in Capital Budgeting
2
For simplicity we assume the $100 million goes entirely to real estate. In real life there would also be
substantial investments in fixtures, information systems, training, and start-up costs.