Managerial Economics Chapter 2
Economic Value Added (EVA) formula:
(Return on total capital - Cost of capital) x Total capital
Two Major types of risk are:
- Financial risk - Business risk
Non-economic objectives
- Good work environment for employees - Quality products and services for customers - Good corporate citizenship and social responsibility
Examples of Transaction Costs
- Offshoring to source consumer products (e.g. retail stores) - Manufacturing components overseas (e.g. the automotive industry) - Logistics services (e.g. warehousing, delivery, etc.)
Signs of Reshoring
- Wages in developing countries have been rising. - The decrease in the value of the dollar has increased the cost of importing. - Increases in energy costs have made it more expensive to ship products - Manufacturing firms have significantly increased productivity making firms production more competitive.
Reasons for satisficing by companies
- larger firms are owned by thousands of shareholders - stockholders generally own only minute interests in the firm and hold diversified holdings in many other firms
Economic and Financial Growth Objectives
- market share, growth rate - profit margin - return on investment, return on - assets - technological advancement - customer satisfaction - shareholder value
Two forces leading to satisficing
- position and power of stockholders - position and power of management
Influences of Transaction Costs
- uncertainty - frequency of recurrence - asset specificity
Do firms maximize profits?
Argument against companies not maximizing profits but instead merely aim to satisfice, which means firms seek to achieve a satisfactory goal--one that may not require the firm to 'do its best'.
Risk Aversion
Investments involving lower returns with known risks rather than higher returns with unknown risks.
Reshoring
Operations returning to the country where the offshoring occurred
Profit Equation
Price x Unit sold = Revenue -Costs = Profit
False, Future cash flows (Di) must be 'discounted' to find their present equivalent value
T/F Future cash flows (Di) must be 'discounted' to find their future value
True
T/F High-level managers may own very little of the firm's stock
True
T/F Managers may be more interested in maximizing their own income and perks
True
T/F Market value includes value of both equity and debt
False, Stockholders are concerned with the performance of their entire portfolio, not an individual stock.
T/F Stockholders are concerned with individual stock performance
True
T/F Stockholders are much less informed about the firm than management
True
T/F While the market value of the company will always be positive, MVA may be positive or negative
Opportunity Cost related to TVM
There is an opportunity cost of getting a dollar in the future instead of today.
Firm
a collection of resources that is transformed into products demanded by consumers
Time Value of Money (TVM)
a dollar earned in the future is worth less than a dollar earned today.
Economic Value Added (EVA)
a measure of a company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.
Historical Costs
a measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company.
External Transactions
a transaction with an outside party, such as the purchase or sales of a good.
How accounting profits and economic profits differ
accountants measure explicit incurred costs, as allowed by GAAP accountants use historical cost economic costs include not only the historical costs and explicit costs recorded by the accountants, but also the replacement costs and implicit costs
Internal Transactions
an exchange from one department to another in the same company that changes something in the accounting equation.
Capital includes:
book value of equity and debt as well as certain adjustments
Financial Risk
concerns the variation in returns that is induced by 'leverage'
Market Value Added (MVA)
difference between the market value of the company and the capital that the investors have paid into the company
Outsource
goods or a service from an outside or foreign supplier, especially in place of an internal source.
Transaction costs
incurred when entering into a contract. Types of transaction costs: - investigation - negotiation - enforcing contracts
Business Risk
involves variation in returns due to the ups and downs of the economy, the industry, and the firm.
Leverage
is the proportion of a company financed by debt
Satisfice
means firms seek to achieve a satisfactory goal--one that may not require the firm to 'do its best'.
Principal Agent Problem
one party (agent) agrees to work in favor of another party (principle) in return for some incentives. Such an agreement may incur huge costs for the agent, thereby leading to the problems of moral hazard and conflict of interest.
What is the discount rate (k) affected by?
risk
Replacement Costs
the amount that an entity would have to pay to replace an asset at the present time, according to its current worth.
Economic Costs
the combination of gains and losses of any goods that have a value attached to them by any one individual. It is used mainly by economists as means to compare the prudence of one course of action with that of another.
Profit
the difference between revenue received and costs incurred
Normal Costs
the normal or regular costs which are incurred in the normal conditions during the normal operations of the organization. They are the sum of actual direct materials cost, actual labor cost and other direct expense. Example: repairs, maintenance, salaries paid to employees.
Optimal decision
the one that brings the firm closest to its goal
Implicit Costs
the opportunity cost equal to what a firm must give up in order to use a factor of production for which it already owns and thus does not pay rent.
Profit maximization hypothesis
the primary objective of the firm (to economists) is to maximize profits
Economic Profits
total revenue minus all the economic costs.