Chapter 12 Solutions

2. The key is to recognize that in a highly competitive industry, companies earn

zero NPV from their projects. Therefore, the question is simply asking for the PV-
based break-even price of the utility meter. If we set that equal to y, annual cash
flow is equal to 500,000×(y-5). Let’s then figure out the break-even annual cash
flow by setting NPV equal to zero.

NPV=C0 + C1/r = -50 million + C1/0.1 = 0
C1 = 5 million

Let’s then solve for y by setting up the following equation:

500,000×(y-5) = 5 million
y = 15.

10. The key is to find out what the selling price will be after the patent runs out in five
year

First, consider the sequence of events:

 At t = 0, the investment of $25,000,000 is made.
 At the end of the 1st year, i.e., t = 1, production begins, so the first revenue
and expenses is recorded at the end of the 2nd year, t = 2.
 At the end of the 5th year, t = 5, the patent expires and competition enters.
Since it takes one year to build the facility and start production, smart
competitors will begin construction of their facility at t=4 so that they can start
production as soon as the patent runs out at t=5.
 As a result, starting from t = 6, full competition will exist and thus any new
entrant into the market for BGs will earn the 9% cost of capital, i.e., a zero
NPV.
Next, calculate the cash flows:
 At t = 0: –$25,000,000
 At t = 1: $0
 At t = 2, 3, 4, 5: Sale of 200,000 units at $100 each, with costs of $65 each,
annual cash flow = $7,000,000.
 Starting from t = 6, the break-even price will be in effect since the NPV of new
investment must be zero. Hence, to find the selling price per unit (P) solve the
following for P:
CF CF
NPV = − 25,000,000 + 2
+L + = 0, where CF = 200,000 × (P − 65).
1.09 1.0912
It is more convenient to first solve for CF and then P.
To solve for CF,
CF CF
NPV = −25,000,000 + 2
+L +
1.09 1.09 12
1 CF CF
= −25,000,000 + ×( +L + )
1.09 1.09 1.09 11
1
= −25,000,000 + × PV (11 - year annuity)
1.09
1 1 1 1
= −25,000,000 + × CF × ( − × )
1.09 0.09 0.09 1.0911
=0
 CF = 4,000,000
Since CF=200,000×(P-65), P=85. So for years t = 6 through t = 12, the annual
cash flow will be: [200,000 × ($85 - $65)] = $4,000,000.
Finally, the net present value (in millions):
7 7 4 4
NPV = − 25 + 2
+ L + + 6
+ L +
1.09 1.09 5
1.09 1.0912
1
= −25 + × PV (4 - year annuity of 7 million per year)
1.09
1
+ × PV (7 - year annuity of 4 million per year)
1.095
1 1
= -25 + × 22.6780 + × 20.1318
1.09 1.095
= 8.89 million