Managerial Economics Week 1

I need assistence with the attached homework in mangerial economics. I have also attached supporting slides. The book used is

Managerial Economic

: Economic Tools for Today’s Decision Makers, Sixth Edition

Paul G. Keat; Philip K.Y. Young

ISBN-13: 978-0-13-604004-0

Please assign asma. I need it my Wednesday March 27th 12 noon EST. Thank you

Managerial EconomicsManagerial Economic

BUSN6120

Homework 1

Answer the following questions:

1. Define scarcity and opportunity cost. How are these economic concepts related? What role do they play in the making of managerial decisions?

2. A company has two million shares outstanding. It paid a dividend of $2 during the past year, and expects that dividends will grow at 6 percent annually in the future. Stockholders require a rate of return of 13 percent. What would you expect the price of each share to be today, and what is the value of the company’s common stock?

3. Discuss the difference between the calculations of shareholder wealth and the concept of Market Value Added. Which of the two appear to be more meaningful from the viewpoint of a shareholder?

Chapter One
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Chapter 1

Introduction
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Chapter One
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Overview

Economics and managerial
decision making
Economics of a business

Review of economic terms

Chapter One
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Learning objectives

define managerial economics
cite important types of resource
allocation decisions

illustrate how economic changes affect a
firm’s ability to earn an acceptable return

apply to an individual firm the three basic
questions faced by a country
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter One
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Economics and managerial decision making

Economics

The study of the behavior of human
beings in producing, distributing and
consuming material goods and
services in a world of scarce
resources
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Chapter One
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Economics and managerial decision making

Management

The science of organizing and allocating a
firm’s scarce resources to achieve its
desired objectives
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Chapter One
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Economics and managerial decision making

Managerial economics

The use of economic analysis to make
business decisions involving the best use
(allocation) of an organization’s scarce
resources
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Chapter One
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Economics and managerial decision making
Relationship to other business disciplines

Marketing: demand, price elasticity
Finance: capital budgeting, breakeven
analysis, opportunity cost, value added
Management science: linear
programming, regression analysis,
forecasting
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Chapter One
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Economics and managerial decision making
Relationship to other business disciplines

Strategy: types of competition,
structure-conduct-performance
analysis
Managerial accounting: relevant
cost, breakeven analysis, incremental
cost analysis, opportunity cost
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter One
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Economics and managerial decision making
Questions that managers must answer:
What are the economic conditions in our particular market?
market structure?
supply and demand?
technology?

Chapter One
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Economics and managerial decision making
Questions that managers must answer:
Should our firm be in this business?
if so, at what price?
and at what output level?

Chapter One
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Economics and managerial decision making
Questions that managers must answer:
How can we maintain a competitive advantage over other firms?
cost-leader?
product differentiation?
market niche?
outsourcing, alliances, mergers?
international perspective?

Chapter One
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Economics and managerial decision making
Questions that managers must answer:
What are the risks involved?
shifts in demand/supply conditions?
technological changes?
the effect of competition?
changing interest rates and inflation rates?

Chapter One
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Economics and managerial decision making
Questions that managers must answer:

What are the risks involved?
exchange rates (for companies in international trade)?
political risk (for firms with foreign operations)?

Risk is the chance that actual future outcomes will differ from those expected
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter One
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Review of economic terms
Microeconomics is the study of individual consumers and producers in specific markets, especially:
supply and demand
pricing of output
production process
cost structure
distribution of income

Chapter One
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Review of economic terms
Macroeconomics is the study of the aggregate economy, especially:
national output (GDP)
unemployment
inflation
fiscal and monetary policies
trade and finance among nations

Chapter One
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Review of economic terms
Resources are inputs (factors) of production, notably:
land
labor
capital
entrepreneurship

Chapter One
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Review of economic terms
Scarcity is the condition in which resources are not available to satisfy all the needs and wants of a specified group of people
Opportunity cost is the amount (or subjective value) that must be sacrificed in choosing one activity over the next best alternative

Chapter One
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Review of economic terms
Allocation decisions must be made because of scarcity. Three choices:

What should be produced?
How should it be produced?
For whom should be produced?
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Chapter One
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Review of economic terms
Economic decisions of the Firm

What – begin or stop providing
goods/services (production)
How – hiring, staffing, capital budgeting
(resourcing)
For whom – target the customers most
likely to purchase (marketing)
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter One
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Review of economic terms

Entrepreneurship is the willingness to take certain risks in the pursuit of goals
Management is the ability to organize resources and administer tasks to achieve objectives

Chapter Two
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Chapter 2

The Firm and its Goals
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Chapter Two
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Overview
The firm
Economic goal of the firm
Goals other than profit
Do companies maximize profits?
Maximizing the wealth of stockholders
Economic profit

Chapter Two
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Learning objectives

understand the rationale for existence of firms
explain economic goals and optimal decision making
describe the ‘principal-agent’ problem

Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Learning objectives
distinguish between profit maximization and shareholder wealth maximization
apply Market Value Added and Economic Value Added

Chapter Two
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The Firm

A firm is a collection of resources that is transformed into products demanded by consumers
Profit is the difference between revenue received and costs incurred

Chapter Two
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The Firm

Transaction costs are incurred when entering into a contract
types of transaction costs
investigation
negotiation
enforcing contracts

Chapter Two
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The Firm

Transaction costs are incurred when entering into a contract

influences
uncertainty
frequency of recurrence
asset specificity

Chapter Two
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The Firm

Examples

Kodak – uses offshoring to source cameras
IBM – manufacturing computers overseas
Exult – third party services used in human resources

Chapter Two
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The Firm
Limits to firm size
tradeoff between external transactions and the cost of internal operations
company chooses to allocate resources so total cost is minimum
outsourcing of peripheral, non-core activities

Chapter Two
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Economic goal of the firm
Profit maximization hypothesis: the primary objective of the firm (to economists) is to maximize profits

Other goals include market share, revenue growth, and shareholder value

Optimal decision is the one that brings the firm closest to its goal

Chapter Two
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Economic goal of the firm
Short-run versus Long-run
nothing to do directly with calendar time
short-run: firm can vary amount of some resources but not others
long-run: firm can vary amount of all resources
at times short-run profitability will be sacrificed for long-run purposes

Chapter Two
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Goals other than profit
Economic goals
market share, growth rate
profit margin
return on investment, return on assets
technological advancement
customer satisfaction
shareholder value

Chapter Two
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Goals other than profit
Non-economic objectives
good work environment
quality products and services
corporate citizenship, social responsibility

Chapter Two
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Do companies maximize profit?
Criticism: companies do not maximize profits but instead merely aim to satisfice, which means to achieve a satisfactory goal, one that may not require the firm to ‘do its best’

two forces affect satisficing:
position and power of stockholders
position and power of management

Chapter Two
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Do companies maximize profit?

Position and power of stockholders
larger firms are owned by thousands of shareholders
shareholders own only minute interests in the firm … and hold diversified holdings in many other firms

Chapter Two
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Do companies maximize profit?
Position and power of stockholders
shareholders are concerned with performance of entire portfolio and not individual stocks
less informed about the firm than management

 stockholders not likely to take any action if earning a ‘satisfactory’ return
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Chapter Two
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Do companies maximize profit?
Position and power of management
high-level managers may own very little of the firm’s stock
managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular

Chapter Two
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*
Do companies maximize profit?
Position and power of management
managers may be more interested in maximizing own income and perks
management incentives may be misaligned (eg. revenue not profits)

 divergence of objectives is known as ‘principal-agent’ problem
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
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Do companies maximize profit?
Counter-arguments which support the profit maximization hypothesis
large stockholdings held by institutions (mutual funds, banks, etc.)  scrutiny by professional analysts
stockmarket discipline  if managers do not seek to maximize profits, firms face threat of takeover
incentive effect  the compensation of many executives is tied to stock price

Chapter Two
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Maximizing the wealth
of stockholders
Views the firm from the perspective of a stream of profits (cash flows) over time
 the value of the stream depends on when cash flows occur
Requires the concept of the time value of money: says a dollar earned in the future is worth less than a dollar earned today

Chapter Two
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Maximizing the wealth
of stockholders
Future cash flows (Di) must be ‘discounted’ to find their present equivalent value

The discount rate (k) is affected by risk

Two major types of risk:
business risk
financial risk
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Maximizing the wealth
of stockholders

Business risk involves variation in returns due to the ups and downs of the economy, the industry, and the firm

All firms face business risk to varying degrees
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Maximizing the wealth
of stockholders

Financial risk concerns the variation in returns that is induced by ‘leverage’

Leverage is the proportion of a company financed by debt
 the higher the leverage, the greater the potential fluctuations in stockholder earnings
 financial risk is directly related to the degree of leverage
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
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Maximizing the wealth
of stockholders
The present price of a firm’s stock should reflect the discounted value of the expected future cash flows to shareholders (dividends)

P = present price of the stock
D = dividends received per year
k = discount rate
n = life of firm in years
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Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Maximizing the wealth
of stockholders

If the firm is assumed to have an infinitely long life, the price of a unit of stock which earns a dividend D per year is given by the equation:

Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Maximizing the wealth
of stockholders
Given an infinitely lived firm whose dividends grow at a constant rate (g) each year, the equation for the stock price becomes:
P = D1/(k-g)
where D1 is the dividend to be paid during the coming year
Multiplying P by the number of shares outstanding gives total value of firm’s common equity (‘market capitalization’)
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
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Maximizing the wealth
of stockholders
Company tries to manage its business in such a way that the dividends over time paid from its earnings and the risk incurred to bring about the stream of dividends always create the highest price for the company’s stock

When stock options are substantial part of executive compensation, management objectives tend to be more aligned with stockholder objective
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
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*
Maximizing the wealth
of stockholders

Another measure of the wealth of stockholders is called Market Value Added (MVA)®

MVA = difference between the market value of the company and the capital that the investors have paid into the company
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
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*
Maximizing the wealth
of stockholders
Market value includes value of both equity and debt

‘Capital’ includes book value of equity and debt as well as certain adjustments
e.g. accumulated R&D and goodwill
While the market value of the company will always be positive, MVA may be positive or negative
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
Maximizing the wealth
of stockholders
Another measure of the wealth of stockholders is called Economic Value Added (EVA)®

EVA=(Return on total capital – Cost of capital) x Total capital

if EVA > 0 shareholder wealth rising
if EVA < 0 shareholder wealth falling Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Two Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Economic profits Economic profits and accounting profits are typically different accountants measure explicit incurred costs, as allowed by GAAP accountants use historical cost of machines Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. Chapter Two Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. * Economic profits Economists are concerned with implicit costs, called opportunity costs Accordingly, economists use replacement cost of machines  economic costs include historical and explicit (accounting) costs as well as replacement and implicit (economic) costs  economic profit is total revenue minus all economic costs Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. n n k D k D k D k D P ) 1 ( ) 1 ( ) 1 ( ) 1 ( 3 3 2 2 1 + + + + + + + + = L

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Managerial Economics Week 1