Chapter 1: Fundamentals

Question 1

Compute the PV of a preferred stock that pays, in perpetuity, an annual cash flow of $200 at an annual interest rate of 5%.

Answer 1

$4,000

Question 2

As the interest rate increases, the opportunity cost of waiting to receive future amount:

Answer 2

Increases. The PV reflects the difference between the FV and OC of waiting. As i increases, the higher is the OCW and the lower the PV.

Question 3

Which of the following is an implicit cost to a firm that produces a good or service?

Answer 3

Foregone profits of producing a different good or service.

Question 4

The primary inducement for new firms to enter an industry is:

Answer 4

Presence of economic profits

Question 5

In order to maximize net benefits, firms should produce where:

Answer 5

Marginal benefits = marginal costs

Question 6

If i = 10%, CF are $1,000 at end of year one and $2,000 at end of year two, then the PV of these cash flows is:

Answer 6

$2562

Question 7

Scarce resources are ultimately allocated toward the production of goods most wanted by society because:

Answer 7

Firms attempt to maximize profits. Also, profits signal to resource holders where resources are most highly valued by society

Question 8

Economic profits are:

Answer 8

Total revenue minus total opportunity cost.

Question 9

What is difference between accounting costs and opportunity costs?

Answer 9

Accounting costs are the explicit costs of resources needed to produce goods or services; opportunity costs are the costs of the explicit and implicit resources that are foregone when a decision is made.

Question 10

Why do accounting profits overstate your economic profits?

Answer 10

The costs do not include the time you spent running the business (OC of time). You could have rented the bldg you did business in and earned income.

Question 11

What is Porter’s Five Forces Framework?

Answer 11

Many interrelated forces and decisions influence the level, growth, and sustainability of profits. These factors that impact industry profitability include 1. ease of entry, 2. power of input suppliers, 3. power of buyers, 4. industry rivalry and 5. substitutes and complements.

Question 12

Entry–barriers of entry affect the ease with which other firms can enter the industry. What are the economic factors that affect the ability of entrants to erode existing industry profits?

Answer 12

Entrants are less likely to capture market share quickly enough to justify the costs of entry in environments where there are 1. sizable sunk costs, 2. significant economies of scale, 3. significant network effects, or 4. where existing firms have invested in strong reputations for providing value to a sizable base of loyal customers or to aggressively fight entrants. Also govt plays role (patents, licenses) and environmental legislation, trade policies. Also strategies used to raise the costs to consumers of “switching”.

Question 13

Power of Input Suppliers

Answer 13

Industry profits tend to be lower when suppliers have the power to negotiate favorable terms for their inputs. Supplier power tends to be low when inputs are standardized and relationship-specific investments are minimal, input markets are not highly concentrated, or alternative inputs. Govt may constrain prices of inputs through price ceilings, limiting supplier profit.

Question 14

Power of Buyers

Answer 14

Industry profits lower when customers have power to negotiate. In most consumer mkts, buyers are fragmented and thus buyer concentration is low. Buyer power tends to be lower in industries where the cost to customers of switching to other products is high, or few close substitutes. Govt regulations such as price floors and ceilings can also impact ability of buyers to obtain more favorable terms.

Question 15

Industry Rivalry

Answer 15

The sustainability of industry profits also depends on the nature and intensity of rivalry among firms competing in the industry. Higher profits in concentrated industries–that is, those with relatively few firms. The level of product differentiation and the nature of the game being played–whether firms’ strategies involve prices, quantities, capacity, or quality/service attributes, also impact profitability.

Question 16

Substitutes and Complements

Answer 16

The level and sustainability of industry profits also depend on the price and value of interrelated products and services. The presence of subst erodes profits. Govt policy can also restrict avail of subst.

Question 17

A firm has the oppor to invest in a project that will pay $5M next year. If they can borrow at 5%, what is the PV of the project today? What would be the PV if it paid out in 3 years?

Answer 17

a. $4,761,905 b. $4,319,188

Question 18

Assuming i=8%, what is NPV of project that costs $2M today and will pay them $3M next year? Would you prefer a project that cost $5M and paid $3M in each of the next 3 years?

Answer 18

a. $777,778 b. $2,731,291

Question 19

Assuming i=10%, what is the NPV of a project which costs $10M today and will pay them $3M every year going forward?

Answer 19

$20,000,000

Question 20

Firm valuation

Answer 20

The value of a firm equals the PV of current and future profits (cash flows). A common assumption among economists is that it is the firm’s goal to maximize profits. This means the PV of current and future profits (cash flows), so the firm is maximizing its value.

Question 21

Marginal Analysis

Answer 21

Optimal managerial decisions involve comparing the marginal (or incremental) benefits of a decision with the marginal (or incremental) costs. i.e. the optimal amt of studying for this course is determined by comparing 1) the improvement in grade that will result from additional hour of studying and 2) the additional costs of studying an additional hour. If benefits greater than costs, then profitable. Once an additional hour of studying adds more to costs than it does to benefits, should stop studying.

Question 22

Control variable examples include:

Answer 22

1. output, 2. price, 3. product quality, 4. advertising, 5. R&D.

Question 23

How much of the control variable should be used to maximize net benefits?

Answer 23

For each of the control variables, at some point there will be diminishing returns, so do not want to use unlimited amounts. Continuous decision vs. discreet.

Question 24

Marginal benefit is:

Answer 24

Change in total benefits arising from a change in the control variable, Q. MB=∆B/∆Q. How the change in quantity affects the change in benefits.

Question 25

Marginal cost is:

Answer 25

Change in total costs arising from a change in the control variable, Q: MC=∆C/∆Q

Question 26

Marginal net benefit is:

Answer 26

Change in net benefits that arise from a one-unit change in Q. MNB can also be obtained as the difference between MB and MC. MNB(Q)=MB(Q)-MC(Q). Expressed differently, when MB exceed MC, the net benefits of increasing the use of Q are +; by using more Q, net benefits increase. There are costs associated with achieving more total benefits and stop producing when MNB=0. The goal of maximizing net benefits takes costs into account, while the goal of maximizing total benefits does not. In the context of a firm, maximizing TB is = to maximizing revenues without regard to cost. In context of studying for exam, maximizing TB requires studying until you maximize your grade, regardless of how much it costs you to study.

Question 27

Derivative

Answer 27

Marginal change of a given function. Way of talking about functional ∆. 3 rules: 1. Derivative of a constant = 0 (constant doesn’t ∆ as x ∆’s (horizontal line on graph). i.e. B=10,000; MB = 0. 2. Derivative of aQ=a (like the slope of a line–as Q increases, total increases by a). Slope=rise/run (upward slope). i.e. B=5Q ($5/piece); MB=5. 3. Derivative of a squared term, e.g. cQ²=2cQ. i.e. B=10Q²-3Q; MB=20Q-3 (10Q²=2x10xQ=20Q)

Question 28

Optimization. Determining the optimal level of a contorl variable. TB’s and TC’s

Benefit is linear , what does that mean?

Costs are quadratic, what does that mean?

Do we produce where Costs = Benefits?

Where MC=MB. Maximizes their differences. (Not MIN)

Graph depicts TB and TC using diff levels of Q under the assumption that Q is infinitely divisible.

Answer 28

Question 29

Net Benefits. B(Q)-C(Q) and represents the vertical difference between B and C in the above slide. Net benefits are maximized at the point where the difference between B(Q) and C(Q) is the greatest in the above slide. The slope of B(Q) is ∆B/∆Q, or marginal benefit, and the slope of C(Q) is ∆C/∆Q, or marginal cost. The slopes of the TB cureve and the TC curve are equal when NB are maximized. This is just another way of saying that when NB are maximized, MB=MC.

Answer 29