Quiz 1: Managers, Profits, and Markets

Business

Some managers are known for their reliance on "practical" decision-making rules and processes, and they can be quite skeptical of decision rules that seem too theoretical to be useful in practice. While it may be true that some theoretical methods in economics can be rather limited in their practical usefulness, there is an important corollary to keep in mind: "If it doesn't work in theory, then it won't work in practice." Explain the meaning of this corollary and give a real-world example ( Hint: see "Some Common Mistakes Managers Make").

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Q 2

Using a discount rate of 6.5 percent, calculate the present value of a $1,000 payment to be received at the end of a. One year b. Two years c. Three years

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Essay

Given information Compute Future value of $1,000 for three different time period at a discount rate of 6.5%. Where, r = discount rate and n = time period a. For a time period of one year, the present value of $1,000 would be: Thus, Present value is equal to $938.97. b. A payment of $1,000 which would be received at the end of two years would have a present value equal to: Thus, Present value is equal to $881.66. c. A payment of $1,000 which would be received at the end of three years would have a present value equal to: Thus, Present value is equal to $827.85.

Q 3

At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in order to start his own business, Sound Devices, Inc. The new company builds, installs, and maintains custom audio equipment for businesses that require high-quality audio systems. A partial income statement for the first year of operation for Sound Devices, Inc., is shown below: To get started, the owner of Sound Devices spent $100,000 of his personal savings to pay for some of the capital equipment used in the business. During the first year of operation, the owner of Sound Devices could have earned a 15 percent return by investing in stocks of other new businesses with risk levels similar to the risk level at Sound Devices. a. What are the total explicit, total implicit, and total economic costs for the year? b. What is accounting profit? c. What is economic profit? d. Given your answer in part c, evaluate the owner's decision to leave his job to start Sound Devices.

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Essay

An audio engineer started his own business leaving his job where he was earning a salary of $175,000 per year. And he spent his savings to start his business which could earn an interest of $15,000. a. The following point explains various cost and income during his business: Explicit cost refers to the cost of using outside resources. Examples of such costs are wage, salaries, rents and taxes. Therefore explicit cost would be: Thus, explicit for first year is $793,000. Implicit cost refers to the opportunity cost of choosing an option. In this case engineer left his job and put his personal saving of $100,000 that could have earned an interest of $15,000 a year. Thus, implicit cost is $190,000. Total economic cost is total of explicit and implicit costs. It can be calculate in following manner: Thus, economic cost is $983,000. b. Accounting profit is the difference between total revenue and explicit cost. Here opportunity cost is not considered. It can be calculate in following manner: Thus, accounting profit is $177,000. c. Economic profit is the difference between total revenue and total cost which includes both explicit and implicit costs. It can be calculate in following manner: Thus, first year this business earned an economic loss of $13,000. d. The economic profit for SD Inc. is in negative which means an economic loss in the first year. But there is an accounting profit in the first year. Therefore, there could be an expected growth and increase in profits in the further years as the cost reduces and income increases. A judgment cannot be passed on the basis of one year profit and loss result.

Q 4

What is the present value of a firm with a five-year life span that earns the following stream of expected profit? (Treat all profits as being received at year-end.) Use a risk-adjusted discount rate of 12 percent.

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Q 5

A doctor spent two weeks doing charity medical work in Mexico. In calculating her taxable income for the year, her accountant deducted as business expenses her roundtrip airline ticket, meals, and a hotel bill for the two-week stay. She was surprised to learn that the accountant, following IRS rules, could not deduct as a cost of the trip the $8,000 of income she lost by being absent from her medical practice for two weeks. She asked the accountant, "Since lost income is not deductible as an expense, should I ignore it when I make my decision next year to go to Mexico for charity work?" Can you give the doctor some advice on decision making?

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Q 6

Suppose that, in their divorce settlement, Ashton Kutcher offers Demi Moore $10 million spread evenly over 10 years, but she instead demands $5 million now. If the appropriate discount rate is 8 percent, which alternative is better for Ashton and which for Demi? What if the discount rate is 20 percent?

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Q 7

When Burton Cummings graduated with honors from the Canadian Trucking Academy, his father gave him a $350,000 tractor-trailer rig. Recently, Burton was boasting to some fellow truckers that his revenues were typically $25,000 per month, while his operating costs (fuel, maintenance, and depreciation) amounted to only $18,000 per month. Tractor-trailer rigs identical to Burton's rig rent for $15,000 per month. If Burton was driving trucks for one of the competing trucking firms, he would earn $5,000 per month. a. How much are Burton Cummings's explicit costs per month? How much are his implicit costs per month? b. What is the dollar amount of the opportunity cost of the resources used by Burton Cummings each month? c. Burton is proud of the fact that he is generating a net cash flow of $7,000 (5 $25,000 ? $18,000) per month, since he would be earning only $5,000 per month if he were working for a trucking firm. What advice would you give Burton Cummings?

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Q 8

You are considering the purchase of a piece of land that can be leased to the government for 100 years. The annual lease payment is $20,000 and the appropriate discount rate for your situation is 4 percent. What is the (approximate) present value of this stream of constant lease payments?

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Q 9

Explain why it would cost Rafael Nadal or Venus Williams more to leave the professional tennis tour and open a tennis shop than it would for the coach of a university tennis team to do so.

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Q 10

An article in The Wall Street Journal discusses a trend among some large U.S. corporations to base the compensation of outside members of their boards of directors partly on the performance of the corporation. "This growing practice more closely aligns the director to the company. [Some] companies link certain stock or stock-option grants for directors to improved financial performance, using a measure such as annual return on equity." How would such a linkage tend to reduce the agency problem between managers and shareholders as a whole? Why could directors be more efficient than shareholders at improving managerial performance and changing their incentives?

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Q 11

An article in The Wall Street Journal reported that large hotel chains, such as Marriott, are tending to reduce the number of hotels that they franchise to outside owners and increase the number the chain owns and manages itself. Some chains are requiring private owners or franchisees to make upgrades in their hotels, but they are having a difficult time enforcing the policy. Marriott says this upgrading is important because "we've built our name on quality." a. Explain the nature of the agency problem facing Marriott. b. Why would Marriott worry about the quality of the hotels it doesn't own but franchises? c. Why would a chain such as Marriott tend to own its hotels in resort areas, such as national parks, where there is little repeat business, and franchise hotels in downtown areas, where there is a lot of repeat business? Think of the reputation effect and the incentive of franchises to maintain quality.

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Q 12

Fortune magazine reported that SkyWest, an independent regional airline, negotiated a financial arrangement with Delta and United to provide regional jet service for the two major airlines. For its part of the deal, SkyWest agreed to paint its jets the colors of Delta Connection and United Express and to fly routes specified by the two airlines. In return, Delta and United agreed to pay SkyWest a predetermined profit margin and to cover most of the regional airline's costs. Fortune explained that while the deal limited the amount of profit SkyWest could earn, it also insulated the smaller airline from volatility in earnings since Delta and United covered SkyWest's fuel costs, increased its load factor (the percentage of seats occupied), and managed its ticket prices. Fortune suggested that Wall Street liked the deal because SkyWest's market valuation increased from $143 million to $1.1 billion after it began its service with the two major airlines. Explain carefully how this arrangement with Delta and United could have caused the value of SkyWest to increase dramatically even though it limited the amount of profit SkyWest could earn.

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