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returns on these projects should disappear very quickly.
An integral basis for the existence of a “good” project is the creation and
maintenance of barriers to new or existing competitors taking on equivalent or similar
projects. These barriers can take different forms, including
a. Economies of scale: Some projects might earn high returns only if they are done on a
“large” scale, thus restricting competition from smaller companies. In such cases, large
companies in this line of business may be able to continue to earn super-normal returns
on their projects because smaller competitors will not be able to replicate them.


b. Cost Advantages: A business might work at establishing a cost advantage over its
competitors, either by being more efficient or by taking advantage of arrangements that
its competitors cannot use. For example, in the late 1980s, Southwest Airlines was able to
establish a cost advantage over its larger competitors, such as American and United
Airlines by using non-union employees, the company exploited this cost advantage to
earn much higher returns.
c. Capital Requirements: Entry into some businesses might require such large
investments that it discourages competitors from entering, even though projects in those
businesses may earn above-market returns. For example, assume that Boeing is faced
with a large number of high-return projects in the aerospace business. While this scenario
would normally attract competitors, the huge initial investment needed to enter this
business would enable Boeing to continue to earn these high returns.
d. Product Differentiation: Some businesses continue to earn excess returns by
differentiating their products from those of their competitors, leading to either higher
profit margins or higher sales. This differentiation can be created in a number of ways -
through effective advertising and promotion (Coca Cola), technical expertise (Sony),
better service (Nordstrom) and responsiveness to customer needs.
e. Access to Distribution Channels: Those firms that have much better access to the
distribution channels for their products than their competitors are better able to earn
excess returns. In some cases, the restricted access to outsiders is due to tradition or
loyalty to existing competitors. In other cases, the firm may actually own the distribution
channel, and competitors may not be able to develop their own distribution channels
because the costs are prohibitive.
f. Legal and Government Barriers: In some cases, a firm may be able to exploit
investment opportunities without worrying about competition because of restrictions on
competitors from product patents the firm may own to government restrictions on
competitive entry. These arise, for instance, when companies are allowed to patent
products or services, and gain the exclusive right to provide them over the patent life.


Quality of Management and Project Quality
In the preceding section we examined some of the factors that determine the
attractiveness of the projects a firm will face. While some factors, such as government
restrictions on entry, may largely be out of the control of incumbent management, there
are other factors that can clearly be influenced by management.13 may largely be out of
the control of incumbent management, there are other factors that can clearly be
influenced by management. Considering each of the factors discussed above, for instance,
we would argue that a good management team can increase both the number of and the
returns on available projects by
taking projects that exploit any economies of scale that the firm may possess; in

addition, management can look for ways it can create economies of scale in the firm™s
existing operations.
establishing and nurturing cost advantages over its competitors; some cost advantages

may arise from labor negotiations, while others may result from long-term strategic
decisions made by the firm. For instance, by owning and developing SABRE, the
airline reservation system, American Airlines has been able to gain a cost advantage
over its competitors.
taking actions that increase the initial cost for new entrants into the business; one of

the primary reasons Microsoft™s was able to dominate the computer software market
in the early 1990s was its ability to increase the investment needed to develop and
market software programs.
increasing brand name recognition and value through advertising and by delivering

superior products to customers; a good example is the success that Snapple
experienced in the early 1990s in promoting and selling its iced tea beverages.
nurturing markets in which the company™s differential advantage is greatest, in terms

of either cost of delivery or brand name value. In some cases, this will involve
expanding into foreign markets, as both Levi Strauss and McDonalds did in the 1980s
in order to exploit their higher brand name recognition in those markets. In other

13 When government policy is influenced by lobbying by firms, it can be argued that even these factors
may be affected by the management of a firm.


cases, this may require concentrating on segments of an existing market as The Gap
did, when it opened its Banana Republic division, which sells upscale outdoor
improving the firm™s reputation for customer service and product delivery; this will

enable the firm to increase both profits and returns. One of the primary factors behind
Chrysler™s financial recovery in the 1980s was the company™s ability to establish a
reputation for producing quality cars and minivans.
developing distribution channels that are unique and cannot be easily accessed by

competitors. Avon, for instance, emplyed large sales force to go door-to-door to reach
consumers who could not be reached by other distribution channels.
getting patents on products or technologies that keep out the competition and earn

high returns; doing so may require large investments in research and development
over time. It can be argued that Intel™s success in the market for semiconductors can
be traced to the strength of its research and development efforts and the patents it
consequently obtained on advanced chips, such as the Pentium.14
While the quality of management is typically related to the quality of projects a
firm possesses, a good management team does not guarantee the existence of good
projects. In fact, there is a rather large element of chance involved in the process; even
the best laid plans of the management team to create project opportunities may come to
naught if circumstances conspire against them “ a recession may upend a retailer, or an
oil price shock may cause an airline to lose money.

The Role of Acquisitions
As firms mature and increase in size, they are often confronted with a quandary.
Instead of being cash poor and project rich, they find that their existing projects generate
far more in cash than they have available projects in which to invest. This can be
attributed partly to size and partly to competition. As they face up to their new status as
cash-rich companies, with limited investment opportunities, acquiring other firms with a
ready supply of high-return projects looks like an attractive option, but there is a catch. If
these firms are publicly traded, the market price already reflects the expected higher

14 It is estimated that Intel spent between $3 billion and $5 billion developing the Pentium chip.


returns not only on existing projects but also on expected future projects. In terms of
present value, the value of a firm can be written as
Value of Firm = Present Value of Cash Flows from Existing Projects
+ Net Present Value of Cash Flows from Expected Future Projects
Thus, firms that are earning super-normal returns on their existing projects and are
expected to maintain this status in the future will sell at prices that reflects these
expectations. Accordingly, even if the cash-rich firm pays a “fair” price to acquire one of
these firms, it has to earn more than the expected super normal returns to be able to claim
any premium from the acquisition. To put all this in perspective, assume that you are
considering the acquisition of a firm that is
Super Normal Returns: These are
earning 25% on its projects, when the hurdle rate
returns which are greater than the returns
on these projects is 12%, and that it is expected
that would normally be earned for an
to maintain these high returns for the foreseeable investment of equivalent risk.
future. A fair price attached to this acquisition
will reflect this expectation. All this implies that
an acquisition will earn super-normal returns for the acquirer if, and only if, one of the
following conditions holds:
The acquisition is done at a price below the fair price (i.e., the company is

significantly undervalued).
The acquisition is done at a price that reflects

Synergy: This is the increase in the
the expectation that the firm will earn 25% value that results from combining two
but the acquirer manages to earn an even firms.

higher return, say 30%, on future projects.
The acquisition enables the firm to take on projects that it would not have taken on as

an independent firm; the net present value of these additional projects will then be a
bonus that is earned by the acquiring firm. This is the essence of synergy.
The acquisition lowers the discount rate on projects, leading to an increase in net

present value, even though the returns may come in as expected.
Overall, it is clear that internally generated projects have better odds of success than do
acquisitions since no premium is paid for market expectations up front.


5.14. ˜: Firm Value and Overpayment on Acquisitions
Megatech Corporation, a large software firm with a market value for its equity of $ 100
million, announces that it will be acquiring FastMail Corporation, a smaller software
firm, for $ 15 million. On the announcement, Megatech™s stock price drops by 3%. Based
upon these facts, estimate the amount the market thinks Megatech should have paid for
FastMail Corporation.
a. $ 15 million
b. $ 3 million
c. $ 12 million
How does NPV additivity enter into your answer?

Corporate Strategy and Project Quality
At the lofty level of corporate strategy, there may be seem to be little use for the
mechanics of corporate finance. Consequently, corporate strategic decisions are often
made with little or no corporate financial analysis to back them up. One way in which
corporate strategy can be linked to corporate finance, however, is through investment
policy. An objective of any corporate strategy should be to enable the firm to develop a
long-term capacity to differentiate itself and earn higher returns than its competitors.
Alternatively, the efficacy of a corporate strategic choice can be measured through its
effect on the firm™s capacity to earn excess returns on its projects. Many of the concepts
that are popular in corporate strategy can be linked to the discussion in the previous

Investment analysis is arguably the most important part of corporate financial
analysis. In this chapter, we have defined the scope of investment analysis, and examined
a range of investment analysis techniques, ranging from accounting rate of return
measures, such as return of equity and return on assets, to discounted cash flow
techniques, such as net present value and internal rate of return. In general, it can be
argued that:


Any decision that requires the use of resources is an investment decision; thus,

investment decisions cover everything from broad strategic decisions at one extreme
to decisions on how much inventory to carry at the other.
There are two basic approaches to investment analysis; in the equity approach, the

returns to equity investors from a project are measured against the cost of equity to
decide on whether to take a project; in the firm approach, the returns to all investors
in the firm are measured against the cost of capital to arrive at the same judgment.
Accounting rate of return measures, such as return on equity or return on capital,

generally work better for projects that have large initial investments, earnings that are
roughly equal to the cash flows, and level earnings over time. For most projects,
accounting returns will increase over time, as the book value of the assets is
Payback, which looks at how quickly a project returns its initial investment in

nominal cash flow terms, is a useful secondary measure of project performance or a
measure of risk, but it is not a very effective primary technique because it does not
consider cash flows after the initial investment is recouped.
Discounted cash flow methods provide the best measures of true returns on projects

because they are based upon cashflows and consider the time value of money.
Among discounted cash flow methods, net present value provides an un-scaled

measure while internal rate of return provides a scaled measure of project
performance. Both methods require the same information, and, for the most part, they
agree when used to analyze independent projects. The internal rate of return does tend
to overstate the return on good projects because it assumes that intermediate cash
flows get reinvested at the internal rate of return. When analyzing mutually exclusive
projects, the internal rate of return is biased towards smaller projects and may be the
more appropriate decision rule for firms that have capital constraints.
Firms seem much more inclined to use internal rate of return than net present value as

a investment analysis tool; this can be partly attributed to fact that IRR is a scaled
measure of return, and partly to capital rationing constraints firms may face.


Live Case Study
Analyzing A Firm™s Existing Investments
Objective: To analyze a firm™s existing investments, and to identify differential
advantages that explain excess returns on existing investments.


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