11

Where Positive Net Present

Values Come From
ANSWERS TO EXERCISES

Fill-in Questions

3. Marginal producer
1. Comparative advantage 4. Economic rent
2. Competitive advantage

Problems

1.

a. True e. False
b. False f. False
c. True g. False
d. True
2.
3.
a. For each ounce of gold mined per year, the present value of the
gross revenue stream is:

280 x (annuity factor: t = 5, r = 1.1/1.05 = 4.76%; 4.358) = $1,220

PV of costs = $220 x (annuity factor: t = 5, r = 10%; 3.791) = $834
NPV = -15,000,000 + 30,000 [1,220 - 834] = -$3,420,000
b. NPV = -15,000,000 + 30,000 [(5 x 400) - ($834)] = $19,980,000

4.
a. Universal will gain net revenues of $2.5 million on each of its 500
new units a year, and it will lose $500,000 on each of its existing
2,000 units of output. This gives an incremental cash flow of:

(500 x $2,500,000) - (2,000 x $500,000) = $250,000,000

At a 10 percent discount rate, the present value is $250 million, and

this is the maximum price Universal should be prepared to pay.
 b. Another company would not stand to lose revenues on the existing
plant. The new plant would be worth $1.25 billion to such a
company.

5.
a. The extra capacity will drive the price down to $12.50 [$24 (0.5 x
23)], but it is best to scrap C's old plant at any price below $13 [$10
+ ($30 x 0.1)]. The existing plant is therefore worth only its salvage
value of $120 million (4 x $30).
b. 4 million units, because at a price of $13 the unit will have to be
scrapped. A total capacity of 22 million units will cause the price to
fall to $13 = $24 (0.5 x 22).

c. Assuming the equilibrium price is $13, the NPV of firm C's project is
given as

NPV = [5,000,000 x ($6/0.1 - $70)] [$4,000,000 x

($5/0.1 - $30)]
-------= -$50,000,000 - $80,000,000
-------= -$130,000,000

If firm C scraps all its old plant and the price goes to $14.50, the
NPV is still negative (-$55 million).

d. It is not possible. When the price is $15, each unit of investment

has a NPV of -$70 +$8/0.1 = $10, but unless the old investment
has been scrapped, we also reduce the present value of the old
plant by 4 x $0.5/0.1 = $20

6. The incremental cash flows from Bay Corp. decision to maintain

production are as follows:

YEAR 0 YEAR 1
Net revenues after tax 0.5 x (P - 6) x 0.1
Proceeds on disposal -0.75 0.75
7. Where P is the unit price in dollars and the cash flows are expressed in
millions of dollars. These cash flows will have a positive NPV if the price is
greater than $7.50.

8. Similarly, the incremental cash flows from company Z's decision to

maintain production are:

YEAR 0 YEAR 1
Net revenues after tax 0.5 x (P - 6) x 0.l
Depreciation tax shield 0.25
Proceeds on disposal -1.25 1.00
9.
10. These cash flows will have a positive NPV if the price is greater than
$8.50.

11.
a. We can figure out from the structure of operating costs that the total
costs of transporting crude are minimized when the demands of
each route are satisfied as follows:

Route 1: 300 VLCC

Route 2: 200 VLCC, 300 MLCC
Route 3: 100 MLCC, 150 other

b. Since 150 "other" tankers are in use and the remaining 150 are
idle, this category of tanker represents a marginal producer, and its
rent must equal the opportunity cost of salvage. Since the cost of
capital is 10 percent and the salvage value is $150 per ton, the
rental must be $15 per ton.

MLCCs and "other" tankers are both used on route 3, but the
MLCCs are cheaper to operate by $2 per ton. They can therefore
command a $2-higher rental of $17 per ton.

VLCCs and MLCCs are both used on route 2, with a $3 cost

advantage to the VLCCs. This gives them a $3 rental advantage,
and the VLCC rental is $20 per ton.

c. Capitalizing the rentals of $20, $17, and $15, we find that the
market prices of the VLCC, MLCC, and "other" tankers are $200,
$170, and $150.
d. Route 2: 400 VLCC, 100 MLCC; route 3: 250 MLCC. All "other"
would be scrapped, MLCC would drop to salvage value of $150 per
ton, and VLCC to $180 per ton.

e. Compared with (a), 150 route 1 VLCCs would switch with 150 route
2 MLCCs. There is no change in tanker prices. Price for shipping oil
on route 1 increases by $5 per ton.