+ Managerial Economics & Business Strategy

Transcription

1 + Managerial Economics & Business Strategy Chapter 1 The Fundamentals of Managerial Economics McGraw-Hill/Irwin Michael R. Baye, Managerial Economics and Business Strategy Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

2 + Plan of the course The Fundamentals of Managerial Economics. Market Forces: Demand and Supply. Quantitative Demand Analysis The Theory of Individual Behavior The Production Process and Costs The Organisation of the Firm The Nature of Industry Managing in Competitive, Monopolistic and Monopolistically Competitive Markets Basic Oligopoly Models

3 + Case Study: Amcott loses $3.5 Million; Manager Fired On Tuesday software giant Amcott posted a year-end operating loss of $3.5 million. Reportedly, $1.7 million of the loss stemmed from its foreign language division. With short-term interest rates at 7 percent, Amcott decided to use $20 million of its retained earnings to purchase three-year rights to Magicword, a software package that converts generic word processor files saved as French text into English. First-year sales revenue from the software was $7 million, but thereafter sales were halted pending a Copyright infringement suit filed by Foreign, Inc. Amcott lost the suit and paid damages of $1.7 million. Industry insiders say that the copyright violation pertained to a very small component of Magicword. Ralph, the Amcott manager who was fired over the incident, was quoted as saying, I m a scapegoat for the attorneys [at Amcott] who didn t do their Homework before buying the rights to Magicword. I projected annual sales of $7 million per year for three years. My sales forecasts were right on target. Do you know why Ralph was fired?

4 + Managerial Economics 1-4 Manager A person who directs resources to achieve a stated goal. Economics The science of making decisions in the presence of scare resources. Managerial Economics The study of how to direct scarce resources in the way that most efficiently achieves a managerial goal.

5 + Six Principles of Effective Management Identify goals and constraints Recognize the nature and importance of profits Understand incentives Understand markets Recognize the time value of money Use marginal analysis

6 + Economic vs. Accounting Profits 1-6 Accounting Profits Total revenue (sales) minus dollar cost of producing goods or services. Reported on the firm s income statement. Economic Profits Total revenue minus total opportunity cost.

7 + Opportunity Cost 1-7 Accounting Costs The explicit costs of the resources needed to produce produce goods or services. Reported on the firm s income statement. Opportunity Cost The cost of the explicit and implicit resources that are foregone when a decision is made. Economic Profits Total revenue minus total opportunity cost.

8 + Profits as a Signal 1-8 Profits signal to resource holders where resources are most highly valued by society. Resources will flow into industries that are most highly valued by society.

9 + The Five Forces Framework and Industry Profitability

10 + Understanding Markets Three sources of rivalry that exists in economic transaction: Consumer-producer rivalry Consumer-consumer rivalry Producer-producer rivalry Government and the market

11 + Recognising the Time Value of Money A dollar today is worth more than a dollar tomorrow Present Value is the amount that would have to be invested today at the prevailing interest rate to generate the given future value. PV = FV 1 (1 + i) n where PV is present value FV is future value I is the rate of interest n is the number of years

12 + Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years? PV = = (1.08) $2,572

13 + The present value of a future payment reflects the difference between the FV and the opportunity cost of waiting (OCW): PV = FV OCW If the interest rate is zero, then PV=FV

14 + Present Value of a Stream Net Present Value PVs can be added together to evaluate multiple cash flows PV FV FV FV = nn (1 + i) (1 + i) (1 + i) Net Present Value of a project is the PV of the income stream generated by the project minus the current cost C0: NPV FV FV FV = nn -C (1 + i) (1 + i) (1 + i) If NPV of a project is positive, then the project is profitable; otherwise the project should be rejected

15 + Demonstration Problem 1-1 The manager of Automated Products is contemplating the purchase of a new machine that will cost $300,000 and has a useful life of five years. The machine will yield (year-end) cost reductions to Automated Products of $50,000 in year 1, $60,000 in year 2, $75,000 in year 3, and $90,000 in years 4 and 5. What is the present value of the cost savings of the machine if the interest rate is 8 percent? Should the manager purchase the machine?

16 + Present Value of Indefinitely Lived Assets Some decisions generate cash flows (CF) that continue indefinitely: CF0 today, CF1 one year from today, etc. The PV of such cash flows is PV = CF CF CF Asset 0 (1 + i) (1 + i) If CF0=0 and CF1=CF2=CF3=, then PV = = CF CF Perpetuity (1 + i) (1 + i) 1 2 CF i

17 + Example - Perpetuity In order to create an endowment, which pays $100,000 per year, forever, how much money must be set aside today if the rate of interest is 10%? 100, 000 PV = = $1, 000,

18 + Determining the Value of a Firm The value of a firm of the PV of the stream of profits (cash flows) generated by the firm s physical, human and intangible assets. If p0 is the firm s current level of profits, then p1 is the next year s profit, etc. p p PV Firm p 0 (1 + i) (1 + i) =

19 + Profit Maximization Maximizing profit means maximizing the value of the firm which is the present value of current and future profits Suppose a firm s current profits are p0, they have not been paid to stockholders as dividends. Imagine that these profits are expected to grow at a constant rate of g<i. In this case: PV 2 3 1(1 + g) p2 (1 + g) p g æ + i ö = p = p ç è i- gø p (1 ) Firm 0 (1 + i) (1 + i) (1 + i) 0 Maximizing the lifetime value of the firm is equivalent to maximizing its current profits p0

20 + What if current profits have already been paid as dividends? Then: PV = PV -p Ex-dividend Firm Firm 0 Or: PV - æ1+ gö = p 0ç è i- gø Ex dividend Firm

21 + Principle Maximizing Short-Term Profits May Maximize Long- Term Profits If the growth rate in profits is less than the interest rate and both are constant, maximizing long-term profits is the same as maximizing current (short-term) profits.

22 + Demonstration Problem 1-2 Suppose the interest rate is 10 percent and the firm is expected to grow at a rate of 5 percent for the foreseeable future. The firm s current profits are $100 million. (a) What is the value of the firm (the present value of its current and future earnings)? (b) What is the value of the firm immediately after it pays a dividend equal to its current profits?

23 + A Problem to Solve Recently, a major airline offered a one-year membership in its Air Club for $125. Alternatively, one could purchase a three-year membership for $300. Many managers and executives join air clubs because they offer a quiet place to work or relax while on the road; thus, productivity is enhanced. Let s assume you wish to join the club for three years. Should you pay the up-front $300 fee for a three-year membership or pay $125 per year for three years for total payments of $375? For simplicity, let s suppose the airline will not change the annual fee of $125 over the next three years.

24 Marginal (Incremental) Analysis 1-24 Control Variable Examples: Output Price Product Quality Advertising R&D Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

25 + Net Benefits 1-25 Let B(Q) be total benefits derived from Q units of some variable that is within manager s control N(Q) net benefits C(Q) total costs of the corresponding level of Q Objective: maximize the net benefits: N(Q)=B(Q)-C(Q)

26 + Determining the Optimal Value of a Control Variable: the discrete case

27 1-27 Marginal Benefit (MB) Change in total benefits arising from a change in the control variable, Q: DB MB= D Q Slope (calculus derivative) of the total benefit curve in continuous case.

28 1-28 Marginal Cost (MC) Change in total costs arising from a change in the control variable, Q: DC MC= D Q Slope (calculus derivative) of the total cost curve Marginal net benefit MNB (Q): MNB(Q) = MB(Q)-MC(Q)

29 + Marginal Principle 1-29 To maximize net benefits, the managerial control variable should be increased up to the point where MB = MC. MB > MC means the last unit of the control variable increased benefits more than it increased costs. MB < MC means the last unit of the control variable increased costs more than it increased benefits.

30 + Determining the optimal level of a control variable: the continuous case

31 + The Geometry of Optimization: Total 1-31 Benefit and Cost Total Benefits & Total Costs Slope =MB Costs Benefits B C Slope = MC Q* Q

32 + The Geometry of Optimization: Net Benefits 1-32 Net Benefits Maximum net benefits Slope = MNB Q* Q

33 + Demonstration Problem 1-3 An engineering firm recently conducted a study to determine its benefit and cost structure. The results of the study are as follows: B( Y) = 300Y - 6Y C( Y) = 4Y 2 2 so that MB =300 12Y and MC = 8Y. The manager has been asked to determine the maximum level of net benefits and the level of Y that will yield that result.

34 + What is the answer for the headline problem?