Chapter 1 Answers to Questions and Problems

By Brenda Ruiz,2014-07-09 10:09
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Chapter 1 Answers to Questions and Problems ...

Chapter 1: Answers to Questions and Problems

1. Consumer-consumer rivalry best illustrates this situation. Here, Levi Strauss & Co. is

    a buyer competing against other bidders for the right to obtain the antique blue jeans.

2. The maximum you would be willing to pay for this asset is the present value, which is

    150,000150,000150,000150,000150,000PV?????234510.09??? 10.0910.0910.0910.09????????????



    2??NQ?50?20Q?5Q.a. Net benefits are

    ??b. Net benefits when are N1?50?20?5?65 and when they are Q?1Q?5


    ??MNBQ?20?10Qc. Marginal net benefits are .

    ????d. Marginal net benefits when are MNB1?20?101?10and when Q?1Q?5

    ????MNB5?20?105??30they are .

    ??MNBQ?20?10Q?0e. Setting and solving for Q, we see that net benefits are

    maximized when Q?2.

    Q?2f. When net benefits are maximized at , marginal net benefits are zero. That is,



    a. The value of the firm before it pays out current dividends is

    10.08???$550,000PV???firm0.080.05. ???

    $19.8 million?

    b. The value of the firm immediately after paying the dividend is

    Ex?Dividend1?0.05??PVfirm?$550,000??. 0.08?0.05??

     ?$19.25 million

5. The present value of the perpetual stream of cash flows. This is given by

    CF$75PV???1,875. Perpetuityi.04

Managerial Economics and Business Strategy, 4e Page 1

    6. The completed table looks like this:


    Control Total Total Net Marginal Marginal Net

    Variable Benefits Cost Benefits Benefit Cost Benefit













a. Net benefits are maximized at Q?108.

    ??MC?120,MB?130b. Marginal cost is slightly smaller than marginal benefit .

    This is due to the discrete nature of the control variable.


    a. The net present value of attending school is the present value of the benefits

    derived from attending school (including the stream of higher earnings and the

    value to you of the work environment and prestige that your education provides),

    minus the opportunity cost of attending school. As noted in the text, the

    opportunity cost of attending school is generally greater than the cost of books

    and tuition.

    b. Since this increases the opportunity cost of getting an M.B.A., one would expect

    fewer students to apply for admission into M.B.A. Programs.


    a. Her accounting profits are $180,000. These are computed as the difference

    between revenues ($200,000) and explicit costs ($20,000).

    b. By working as a painter, Jaynet gives up the $100,000 she could have earned

    under her next best alternative. This implicit cost of $100,000 is in addition to the

    $20,000 in explicit costs. Since her economic costs are $120,000, her economic

    profits are $200,000 - $120,000 = $80,000.

    Page 2 Michael R. Baye

    ??1?i9. First, recall the equation for the value of a firm: . Next, solve this ???PV?firm0??i?g??

    ??1??i0equation for to obtain . Substituting in the known values implies a ??ggiPVfirm

    ??1?0.1010,000g?0.10??0.06growth rate of , or 6 percent. This would seem to 275,000

    ??be a reasonable rate of growth: 0.06?0.10g?i.

    10. Effectively, this question boils down to the question of whether it is a good

    investment to spend an extra $100 on a refrigerator that will save you $25 at the end

    of each year for five years. The net present value of this investment is




You should buy the energy efficient model, since doing so saves you $8.24 in present

    value terms.

    11. Under a flat hourly wage, employees have little incentive to work hard as working

    hard will not directly benefit them. This adversely affects the firm, since its profits

    will be lower than the $40,000 per store that is obtainable each day when employees

    perform at their peak. Under the proposed pay structure, employees have a strong

    incentive to increase effort, and this will benefit the firm. In particular, under the

    fixed hourly wage, an employee receives $144 per day whether he or she works hard

    or not. Under the new pay structure, an employee receives $264 per day if the store

    achieves its maximum possible daily profit and only $64 if the store’s daily profit is

    zero. This provides employees an incentive to work hard and to exert peer pressure on

    employees who might otherwise goof off. By providing employees an incentive to

    earn extra money by working hard, both the firm and the employees will benefit.


    a. Accounting costs equal $3,160,000 per year in overhead and operating expenses.

    Her implicit cost is the $56,000 salary that must be given up to start the new

    business. Her opportunity cost includes both implicit and explicit costs:

    $3,160,000 + $56,000 = $3,216,000.

    b. To earn positive accounting profits, the revenues per year should greater than

    $3,160,000. To earn positive economic profits, the revenues per year must be

    greater than $3,216,000.

    Managerial Economics and Business Strategy, 4e Page 3

    13. First, note that the $170 million spent to date is irrelevant, as it will be lost regardless

    of the decision. The relevant question is whether the incremental benefits (the present

    value of the profits generated from the drug) exceed the incremental costs (the $30

    million needed to keep the project alive). Since these costs and benefits span time, it

    is appropriate to compute the net present value. Here, the net present value of DAS’s

    R&D initiative is

    15,000,00016,500,00018,150,00019,965,00021,961,500 NPV??????30,000,00056789(10.07)(10.07)(10.07)(10.07)(10.07)?????


Since this is positive, DAS should spend the $30 million. Doing so adds about $26.6

    million to the firm’s value.

    14. Disagree. In particular, the optimal strategy is the high advertising strategy. To see

    this, note that the present value of the profits from each advertising strategy are as


    $15,000,000$90,000,000$270,000,000; PV????$290,871,525.17High2310.10???10.1010.10??????

    $30,000,000$75,000,000$150,000,000; $201,953,418.48PV????Moderate2310.10???10.1010.10??????

    $70,000,000$105,000,000$126,000,000PV????$245,078,888.10. low23??1?0.10????1?0.101?0.10

Since the high advertising results in profit stream with the greatest present value, it is

    the best option.


    a. Since the profits grow faster than the interest rate, the value of the firm would be

    infinite. This illustrates a limitation of using these simple formulas to estimate the

    value of a firm when the assumed growth rate is greater than the interest rate.

    ??11.08?i??b. billion. PV???$2.5$54?firm????ig?0.05????

    ??11.08?i??c. billion. PV???$2.5$33.8?firm????ig?0.08????

    ??11.08?i??d. billion. PV???$2.5$24.5?firm????ig?0.11????

    Page 4 Michael R. Baye

    16. If she invests $1,500 in pre-tax money each year in a traditional IRA, at the end of 4

    years the taxable value of her traditional IRA will be


She gets to keep only 83 percent of this (her tax rate is 17 percent), so her spendable

    income when she withdraws her funds at the end of 4 years is

    ????0.83$7,299.90?$6,058.92. In contrast, if she has $1,500 in pre-tax income to

    devote to investing in an IRA, she can only invest $1,245 in a Roth IRA each year

    (the remaining $255 must be paid to Uncle Sam). Since she doesn’t have to pay taxes on her earnings, the value of her Roth IRA account at the end of 4 years represents

    her spendable income upon retirement if she uses a Roth IRA. This amount is


Notice that, ignoring set-up fees, the Roth and traditional IRAs result in exactly the

    same after-tax income at retirement. Therefore, she should adopt the plan with the

    lowest set-up fees. In this case, this means choosing the Roth IRA, thus avoiding the

    $25 set-up fee charged for the traditional IRA. In other words, the net present value of

    her after-tax retirement funds if she chooses a Roth IRA,

    $6,058.92NPV??$0?$4,453.49 Roth4??1.08

is $25 higher than under a traditional IRA.

    17. No. Note first that your direct and indirect costs are the same regardless of whether

    you adopt the project and therefore are irrelevant to your decision. In contrast, note

    that your revenues increase by $9,807,700 if you adopt the project. This change in

    revenues stemming from the adoption from the ad campaign represents your

    incremental revenues. To earn these additional revenues, however, you must spend an

    additional $2,945,700 in TV airtime and $1,179,100 for additional ad development

    labor. The sum of these costs $4,124,800 represents the explicit incremental cost of the new advertising campaign. In addition to these explicit costs, we must add

    $6,000,000 in implicit costs the profits lost from foreign operations. Thus, based on

    the economically correct measure of costs opportunity costs the incremental cost

    of the new campaign is $10,124,800. Since these incremental costs exceed the

    incremental revenues of $9,807,700, you should not proceed with the new advertising

    campaign. Going forward with the plan would reduce the firm’s bottom line by

    $317,100. Expressed differently, the extra accounting profits earned in the U. S.

    would not offset the accounting profits lost from foreign operations.

    Managerial Economics and Business Strategy, 4e Page 5

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