Chapter1GoalsoftheFirm5

PARTIINTRODUCTION
Chapter1

IntroductionandGoalsoftheFirm

Managerialeconomicsisthatpartofeconomicsappliedtothedecisionsthatmanagersmust
make. Whenmanagersmakedecisionsthatmaximizefirmprofits,theysimultaneously
maximizeshareholderwealthandpromoteefficientallocationofresources.Managersdrift
awayfromthisobjectivewhentheyconcentrateontheirownsecurity.Toavoidnonprofit
maximizingbehavior,agrowingnumberoffirmsarestructuringcompensationplansfor
managersthatpromotelongtermprofitability.
ShareholderWealthMaximization
1. ToaligntheinterestsoftheshareholdersofSalomonSmithBarneywiththeinterests
ofitschairman,mostofthechairman'scompensationisbasedontheperformanceof
thecompanyrelativetoitsfivemajorcompetitors.
2. ExecutivecompensationisbasedonSalomon'returnonequityandreturnonequity
oftheircompetitors.Thebonuscanbeaslargeas$24million.
ManagerialEconomicsandEconomicTheory
1. ManagerialEconomicsdealswithapplicationsofmicroeconomics. Itisusefulfor
making business decisions concerning pricing, production, cost analysis, market
structure,andstrategy.
2. HondaandToyotabothexpandedcapacitytoproducecarsintheUS.Thedecisionis
either to expand (S1) or notexpand (S2). Bothfirms believe that the capacity
expansionwasprofitable.
3. Steps in decision making include: Establish and identify objectives, define the
problem,findpossiblealternativesolutions,selectthebestsolution,andimplement
thatchoice.
TheRoleofProfits

6ManagerialEconomicsStudyGuide
1. Economic profit is the difference between revenues and total economic cost
(includingtheeconomicoropportunitycostofownersuppliedresourcessuchastime
andcapital).
2. Economic cost (or opportunity cost) is the highest valued benefit that must be
sacrificedasaresultofchoosinganalternative,whichincludesbothexplicitand
implicitcomponents.
3. Theoriesofwhyprofitvariesacrossindustries:
a. RISKBEARINGTHEORYOFPROFIT .Higherprofitiscompensationforinvestingin
riskierendeavors.Example:investinginthestockofCircusCircus.
b. DYNAMIC EQUILIBRIUM(OR FRICTIONAL)THEORY OF PROFIT.Industriesearning
abovenormalprofits(economicprofits)willeventuallyfindmorecompetition.
Addedcompetitionwillbringprofitsbacktonormal(zeroeconomicprofits)over
time. Competition directs resources to industries with the greatest profit.
Example:petroleumindustryprofitsrisewhenthereareinternationalwarsinoil
producingcountries.
c. MONOPOLY THEORY OF PROFIT.Barriers,suchasgovernmentalregulations,are
thesourceofhigherthannormalprofits.
d. INNOVATION THEORY OF PROFIT. Thereisarewardfordevelopingnewideas,
newconstructiontechnologies,andforfindingnewmarkets.
e. MANAGERIAL EFFICIENCY THEORY OF PROFIT.Exceptionalmanagerialskillscan
producesuperiorprofits.
4. CircusCircus,aLasVegascasinoandhotel,earnedexceptionallyhighreturnsin
1994,butasimilarfirm,Bally's,earnedratherlowreturns.Highaveragereturnstend
tooccurinindustrieswithhighrisk.
ObjectiveoftheFirm
1. Profitmaximization asagoalimpliesthatdecisionsthatraiserevenuesmorethan
costsorlowercostsmorethanreducerevenuesshouldbeselected.Thisisashort
termobjective.
2. Shareholderwealthmaximization asagoalimpliesthatdecisionsthatincreasethe
presentvalueofexpected future profitsshouldbeselected. Evendecisions that
reduce today's profits, yet substantially raise future profits, may be appropriate
decisions.Thisisalongtermbusinessgoal.

Chapter1GoalsoftheFirm7
3. Thepriceofashareofstockcanbethoughtofasthepresentvalueofexpectedfuture
cashflowspershare.Cashflowsarediscountedattheshareholdersrequiredrateof
return,ke.

5. Thevalueofthefirm,VALUE,isthepricepershare,V 0,timesthenumberofshares
outstanding. VALUE=V0SharesOutstanding. Thepricepershare,V0,isthe
presentvalueoffutureprofitpershare,where t iscashflowpershareineach
periodandkeistheinvestorsrequiredrateofreturn.

VALUE=V0SharesOutstanding={t/(1+ke)t}SharesOutstanding
t=1
6. Profitistotalrevenueminustotalcost(TRTC).Totalrevenueforasingleproduct
firmispricetimesquantity,PQ. Totalcost (TC)istotalvariablecostplusfixed
cost,F.Totalvariablecostisthevariablecostperunit,V,timesthenumberofunits,
Q.Hence,=PQVQF.According,thevalueofthefirmcanalsobewrittenas
thepresentvalueofallfutureprofits:

VALUE==(PtQtVtQtFt)/(1+ke)t
t=1
7. Businessdecisionsaffecttheamountandtimingofrevenues,costs,andthediscount
rateusedbyinvestors. Forexample,selectingacapitalintensivetechnologymay
raisefixedcosts,F,butlowervariablecostsperunit,V.
8. Iffirmisperceivedaslessrisky,thenareductioninrequiredrateofreturn,k e,raises
thevalueofthefirm.
9. Expectedfutureprofitsarenotthesameasaccountingprofits.Accountingprofitsdo
notconsidertheopportunitycostofcapitalinvestedbyownersoractualcashflows
collectedorpaidbythecompany.Inpractice,managerswhobasetheirdecisionson
waystomaximizethepresentvalueofcashflows,willmakedecisionsthatmaximize
thewealthofshareholders.

10. Profit maximization is the primary goal of William Buffett, CEO of Berkshire
Hathaway,whohasproducedhigherprofitsandhighersharevaluesthanmarket
averagesovertime.
ManagerialActionstoInfluenceShareholderWealth

8ManagerialEconomicsStudyGuide
1. EconomicEnvironmentFactorsincludethelevelofeconomicactivity(recessionor
boom), tax rates, competition, governmental regulations, unionization, and
internationaleconomicexposure. Also ConditionsinFinancial Markets suchas
interestrates,investorsentiment,andanticipatedinflationaffectprofitability.These
arefactorconstrainprofits,butareoutsidethedirectcontrolofmanagers.
2. Major Policy Decisions include product mix, production technology, marketing
network, investment strategies, employment policies and compensation, form of
organization, capital structure (use of debt versus equity), working capital
management, and dividend policies. These decisions are under the managers
control.
SeparationofOwnershipandControl:TheProblemofAgency
1. Inmanycorporations,themanagersownveryfewshares.Shareholdersmaywant
profits,butmanagersmaywishtorelax.Theshareholdersareprincipals,whereas
the managers are agents. Divergent objectives between these groups are called
agencyproblems.
2. Solutionstoagencyproblemsinvolvecompensationthatisbasedontheperformance
ofagents.Somefirmshavecompensationplansthatextendstockoptions,bonuses,
andgrantsofstocktoworkers,sothatemployeeshaveaddedincentivestoincrease
theircompany'svalue.
3. RJRNabiscowasmismanaged.Anunfriendlytakeoverofthefirmwassuccessful,
andtheysoldthebadperformingbusinesses.Also,O.M.Scott,afertilizercompany,
waspartoftheITTconglomerate. OnceScottFertilizerwastakenprivateina
leveragebuyout,performanceimprovedininventorylevelsandotherareas.
ImplicationsofShareholderWealthMaximization
1. Criticsclaimthataligningcompensationwithshareholderinterestsleadstoshortrun
objectives.
2. PatentsforEliLillysprofitabledrugProzacwererunningout.Lillyhopedtofind
waystoextendthepatents. Whenafederaljudgeblockedtheextensionin2000,
competitorscameinwithgenericversionsofProzac. Lillyusedshortruncrisis
management.Longerrunthinking,suchasscenarioplanningwouldhaveledthem
tobringoutnewgenerationantidepressantsbeforethepatentterminated.
3. TheSaturnCorporationoffersanexampleofaninitiallysuccessfulnewcarcompany
thatfacedmeagerprofitsovertime. Itslowpriceprovidedlowprofitmarginsfor

Chapter1GoalsoftheFirm9
Saturn.Lowreturnsleadtolessreinvestmentintonewmodels.MiddleagedSaturn
buyerstradeduptolargerJapaneseimports.
4. Maximizationofthepresentvalueofexpectedcashflowsworkswellifthefollowing
conditionsaremet:
a. COMPLETEMARKETSthereareliquidmarketstobuyandsellthefirm'sinputs,
contaminants(includingpollutingbyproducts),andcommonpropertyresources.
b. NOSIGNIFICANTASYMMETRICINFORMATIONbuyersandsellersallknowthe
samethings.
c.

KNOWNRECONTRACTINGCOSTSfutureinputcostsarepartofthepresentvalue
ofexpectedcashflows.Theexistenceoffutureandforwardmarketsininputs
canhelplockinfutureinputcosts.

GoalsinthePublicSectorandtheNotForProfit(NFP)Enterprise
1. NFPorganizationssuchasperformingartsgroups,mosthospitals,universities,and
volunteerorganizationsreceiveasubstantialportionoftheirfinancialsupportfrom
contributions,andsomesupportfrom"clients"whousetheirservices.
2. NFPorganizationsseekgoalssuchasincreasedcontributions. Theymayachieve
theirgoalsbybeingefficientintheservicestheyofferorbyprovidingmeritorious
services.
3. Amanagerofafoodsheltermaydecidetomaximizetheutilityofcontributorsor
donorsbyselectingvery"healthyfoods"togivetoclients;ormaydecidethatthe
objectiveistogiveoutthegreatestvolumeoffoodpossible. Theymaybequite
efficientinachievingtheirgoals.
ManagingaGloballyCompetitiveEconomy
1. Managerialinnovations,suchas"justintime"inventorymethods,efficienttransfer
pricing, and total quality management concepts can be learned by observing
successfulcompetitorsintheU.S.orabroad.
2. Globalmanagersneedtobeuptodatewiththetoolsofmanagerialeconomicsto
competeandwinintheworldmarketplace.

TrueandFalseQuestions

10ManagerialEconomicsStudyGuide
10
Agreeordisagreewiththefollowingstatements,andcorrectthepartthatiserroneous.
1. The goal of shareholder wealth maximization implies that managerial decisions
maximizeonlythecurrentquarter'sexpectedprofitsofthefirm.
2. WhenAlanGreenspan(chairoftheFederalReserveBoard)cutsinterestrates,thistends
toreducetheinvestorsrequiredreturnandraisestockprices.
3. Anexampleofanagencyproblemisastoremanager,whoavoidstakingarisk,sothat
hecannotbeblamedformakingabaddecision.
4. Ifyouownedandworkedinyourowncardshop,andifyoudidnotpayyourselfawage,
thenyouhaveignoredaneconomiccostofrunningyourbusiness.
5. Decisionsthatdonotaffecttheamountofrevenuesandcosts,butchangethetimingof
receiptsanddisbursementwillnotaffectthevalueofthefirm.
6. Theamountofprofitsisentirelyunderthecontrolofthemanager.
7. Notforprofitorganizationscan'tearnprofits,sotheyhavenogoals.
8. Inthelongrun,allfirmsearnthesamerateofreturn.
Answers
1. Disagree.Expectedlongrunprofitsofthefirmaffectsfirmvalue.Alossinthecurrent
quarterthatleadstoprofitslatermaybeanappropriatestrategy.
2. Disagree.Macroeconomicsdealswithmarketaggregates,suchaswholecountries,the
marketforalllabor,inflation,businesscycles,andunemployment.
3. True.However,stockpricesareinfluencedbyexpectationsofthefutureandmanyother
factorsbesidestherequiredreturn.
4. True.
5. Disagree.Timingaffectsthepresentvalueofthefirm.Moniesreceivedsooneraremore
valuablethanthesameamountreceivedlater.
6. Disagree. EconomicEnvironmentFactors and Conditions inFinancialMarkets are
outsidethecontrolofmanagers,anddoaffectprofitability.
7. Disagree.ThegoalsofNFPmayvary,suchasmaximizingnumberofclientsservedor
maximizingthehappinessoftheorganization'smanagement.Buttheydohavegoals.
8. Disagree.Barrierstofreetrade,asinsomekindsofgovernmentalregulations,cancreate
monopoly.Theremaybedifferencesinrisk,degreesofinnovation,andtheremaybe
changesintechnologyandtastesthatcreateabovenormal,andbelownormal,profitrates
indifferentindustriesevenoverlongperiodsoftime.

Chapter1GoalsoftheFirm11

MultipleChoiceQuestions
1. The primary objective of a for-profit firm is to ___________.
a. minimize average cost
b. maximize shareholder value
c. maximize total revenue
d. find an output where total revenue equals total cost
2. Whichofthefollowingarelikelytoincreasethevalueofthefirm,basedonthe
shareholderswealthmaximizationmodelofthefirm?
a. Therateofinflationincreasessubstantially.
b. Apreviouslynonunionworkforcevotestounionize.
c. Atechnologicalbreakthroughallowsthefirmtoreduceitscostofproduction.
d. thegovernmentimplementsstrictpollutioncontrolrequirements.
3. TheRussianRepublichascontinueditssaleofformerlystaterunenterprises.When
asteelfactoryissold,thevalueshouldbebased:
a. mostlyonthepastoutputlevelsassigneditbycentralplanners.
b. primarilyonthefutureearningpotentialinacompetitiveeconomy.
c. onthecostofthebuildings,adjustedbyappropriatedepreciationmeasures.
d. incomparingthefacilitieswithequivalentfacilitiesintheUnitedStates.
4. TheAgencyProblemshowsupinmanydifferentsituationswithinafirm.Whichis
NOTagoodexampleofthisproblem?
a. Firmmanagerssometimewanttorelaxonthejob.
b. Diversifiedstockholdersaremoreeagertoacceptrisksthanarefirmmanagers.
c. Firmmanagersreceivecashbonusesbasedontheperformanceofthefirm.
d. Employeessometimetakeitemsfromthestoreinwhichtheywork.
5. Executivecompensationshould:
a. beanincreasingfunctionofthefirm'sexpenses.
b. beanincreasingfunctionofthesalesrevenuereceivedbythefirm.
c. createincentivessothatmanagersactlikeownersofthefirm.
d. avoidmakingtheexecutivesownsharesinthecompany.
6. Whichofthefollowingmaybeanexampleofanagencyproblem?
a. timenotspentonactualbusinessbyanemployeeonanoutofstatebusinesstrip.
b. outputofapiecerategarmentworker.
c. thejobperformanceofaparkinglotattendant.
d. workperformanceofamanagerofacardshop,whoalsoownsthecardshop.
7. Toreduceagencycosts,firmsincurcostsinalltheseareasEXCEPT:

12ManagerialEconomicsStudyGuide
12
a.
b.
c.
d.

compensationinducementstoexecutivestotakeactionsthatshareholderswant.
paymentofpayrolltaxes.
expenditurestomonitortheactionsofmanagers,includinginternalaudits.
bondingexpenditurestoprotecttheownersfrommanagerialdishonesty.

8. Economicsistraditionallydefinedasthesciencethat:
a. showspeoplehowtogetrichusingthestockmarket.
b. triestoprovehowhumansdifferfromotherspecies.
c. dealswiththeallocationofscarceresourcesamongcompetingends.
d. providesaguidetothesuccessfulmanagementofapersonalbusiness.
9. Intheshareholderwealthmaximizationmodel,thevalueofafirm'sstockisequalto
thepresentvalueofallexpectedfuture_____________discountedatthe
stockholders'requiredrateofreturn.
a. cashflows
b. revenues
c. outlays
d. costs
10. Thebranchofeconomicsthatdealswiththeanalysisofthewholeeconomyiscalled:
a.shareholderwealthmaximization.
b. macroeconomics.
c. gestalteconomics.
d. microeconomics.
11.

Whichofthefollowingwillimproveshareholderwealth,whichisimplicitinthe
formula:

VALUE= [PtQtVtQtFt]/(1+ke)t
t 1

a.
b.
c.
d.
12.

largerquantityofsales,Qt,assumingpriceisgreaterthanaveragevariablecost.
higherdiscountrateonequity,ke.
higherfixedcostsperperiod,Ft.
alloftheabove.

Agencyproblemsbetweenmanagersandshareholderscanbereducedby:
a. payingmanagersbasedontheprofitabilityofthefirm.
b. requiringmanagerstoownsharesofthecompany.
c. payingmanagersstockoptions,whichimproveinvalueasthestockpricerises.
d. alloftheabove.

Chapter1GoalsoftheFirm13
13.

Ifshareholdersdonotmindtheirfirmbeingtakenoverbymergeroracquisition
whenthepriceishigh,butmanagersprefertofighttakeovers,whatcanshareholders
do?
a. offeraChristmasbonusof$500everyyeartomanagement.
b. offerfreelifeinsurancepoliciestoallemployees.
c. offeragoldenparachutecontract(averylargeseverancepackage)ifmanagement
losestheirpositioninatakeover.
d. offeranextraweekofpaidvacationtoemployees whohaveworkedatthis
companyforoverfiveyears.

14.

Oneimportantdifferencebetweensocialistandmarketeconomiesis:
a. privateincentivesarerewardedhighlyinsocialistcountries.
b. allcitizensarealwayswealthierinmarketeconomiesthaninsocialisteconomies.
c.decisionmakingonwhattoproduceisdecentralizedinsocialisteconomies.
d. decisionmakingonwhattoproduceisdecentralizedinmarketeconomies.

15.

16.

c
d
e
f

a.
b.
c.
d.

Which of the following theories of profit best reflects the surprising success
General Electric has produced over the two decades while being run by the
phenomenal Chief Executive Officer (C.E.O.) Jack Welch?
a. innovation theory of profit
b. dynamic equilibrium (frictional) theory of profit.
c. risk-bearing theory of profit
d. managerial efficiency theory of profit
Which of the following "theories of profit" best reflects theupwardjumpinthe
profitsofmanufacturersofducktapebytheannouncementbytheSecretaryof
HomelandSecurity,TomRidgethatAmericansshouldstockuponsuppliesfor
preparedness?
innovationtheoryofprofit
dynamicequilibrium(frictional)theoryofprofit.
monopolyprofittheoryofprofit
managerialefficiencytheoryofprofit

17.

The drug industry earned 26.5% returns, whereas other Value Line firms earned
15%. What theory of profit best reflects the performance of the drug industry?
a. the risk-bearing theory of profit
b. the dynamic equilibrium (frictional) theory of profit
c. the over-investment hypothesis theory of profit
d. themanagerialefficiencytheoryofprofit

18.

O.M. Scott was a division of the conglomerate ITT. A group of managers at the
Scott division borrowed money and took O.M. Scott private in an LBO (a
leveraged buyout). The change in ownership is an example of:
a. a way to reduce the agency problems between stockholders and firm managers

14ManagerialEconomicsStudyGuide
14
b. increase the monopoly power of Scott fertilizer in the marketplace
c. finding that conglomerates make the best fertilizer
d. vertical integration of fertilizer manufactures and farmers working together
Answers
1. b
2. c
3. b
4. c
5. c
6. a
7. b

8. c
9. a
10. b
11. a
12. d
13. c
14.d

15. d
16.b
17.a
18.a
19.
20

ProblemsorShortEssays
1. Withapproximately100newsatelliteslaunchedeachyear,whoisresponsibleforthe
spacejunkthataccumulateseachyear?Howcanthespacejunkproblembesolved?
2. Managers ofpublicly ownedenterprises must face shareholders at annual meetings.
Theymustreportthequarterlyandannualearningsfortheyear.Iftheytakeonprojects
thatdonothaveaquickpayback,theyareafraidthatshareholderswillbecomeangry,
calltheirdirectors,andseeknewmanagement.Howcanshareholdersrewardmanagers
whotakealongrunviewtoprofitabilitytoavoidthisagencyproblem?
3. Thevalueofafirmcanberepresentedbythepresentvalueofthestreamofprofits:

VALUE=[PtQtVtQtFt]/(1+ke)t
t=1
a. Ifmanagerialdecisionsincreasetheperceived risk ofthefirm,whatvariables
aboveincrease?
b. Whatvariablesarechangedinthevaluefunctionaboveifmanagementattempts
toimprovetheperceived quality oftheirproductsthroughmoreprecisequality
control?
4. Whatisthevaluetodayofasingle$200cashflowintwoyears,ifone'sperceivedrateof
returnis15%?

Answers
1. Theproblemofspacejunkisduetocommonpropertyresources.Asnooneowns
orbitalspace,nooneseemsresponsibleforkeepingthespacefreeofcostlydebris.

Chapter1GoalsoftheFirm15
Thisisthesameproblemforairandwaterpollution.Thesolutiontypicallyrequires
thecreationofpropertyrights.Forexample,theUnitedNations,orotherinternational
groups,couldbegivenorbitalpathsrights.Theserightscouldbeauctionedoff,with
thewinnerhavinga99yearlease.Thisprivatizesorbitalspace.Firmswillbemore
carefulnottodamagetheirownspace.
2.

Tyingcurrentprofitabilityperformancetocurrentmanagementcompensationtendsto
emphasizetheshortrun.
Shareholdersmaywishtheirdirectorstodevisecompensationthatpaysbonusesinthe
futureforgoodlongtermperformance. Forexample,stockoptionsorwarrantsthat
expireinthedistantfuturebecomemorevaluableasthevalueofthefirmimproves.
Managersmaywishtoexplaintoshareholdersthattheyareinvestingforthelongrun,
andthatcurrentearningsarelowbecauseoftheinvestment.Ifthisisatrueexplanation
oflowercurrentearnings,mostshareholderswouldapprove.
Furthermore, when managers own shares directly, this creates incentives for
managementtoimproveshareholderwealth.

3a. Increasesintheperceivedriskwillnotchangeexpectedcashflowsbutitwillincrease
thediscountrate,ke.Forexample,ifinvestmentdecisionsincreasethecorrelationof
thefirm'sreturnswithreturnsinthemarketingeneral,theperceivedriskinessofthe
firmmayincrease.
3b. The price andquantity of the improved quality product may raise both P and Q.
However,thecostperunit(V)willlikelyriseduetomoreeffortatqualitycontrol.
Theremaybeadditionalfixedcost(F)aswell.
4. Itisthepresentvalueof$200intwoyears,whichis$200/(1.15)2=$151.23

WorkedProblems
1.

MenloBoulevardConstruction,Inc.expectstobuildseventeengaragesthisyearand
eighteengaragesnextyear. Eachgaragesellsfor$8,900thisyearand$9,100next
year.Expenses(materialsandlabor)areanticipatedtobe$3,600pergaragethisyear
and$3,750nextyear,withfixedcostsof$44,200peryearforthenoncancellablerental
contractontrucksandequipmentinbothyears.Assumethattaxesarezeroandthatall
revenuesandexpensesarereceivedorpaidattheendofeachrespectiveyear.Whatis
thepresentvalueofMenlo'sexpected profitsata10%requiredrateofreturnfor
discounting?

16ManagerialEconomicsStudyGuide
16
Answer:Expectedprofitsthisyearis:0=(8,900173,60017)44,200=$45,900.
Expectedprofitsnextyearis:1=(9,100183,75018)44,200=$52,100.Hence,
thepresentvalueofMenlo'sstreamofprofitsoverthetwoyearsis:
V= $45,900+
(1.10)

$52,100
(1.10)2

=$84,785.12.

2. AmericanAppraisal,Inc. sendsyoutotheRussianRepublictoevaluatetheselling
pricesforformerlystaterunenterprises. Youarriveatabuilding35kilometersfrom
Moscow,knowinglittleRussianlanguageandnoRussianorSovietaccountingmethods.
Throughtranslators,youfindthatthebuildinghadbeenusedtomakegreenglassbottles
formineralwater.Youcancountthenumberof1950vintagebottlemakingmachines
in the building, the inventory of completed glass bottles, but there exists little
informationastohowmanybottlescouldbemadeperday,howmanyworkershad
previouslyworkedthere,oranyotherrecord.Nootherbottlefirmshavebeenprivatized.
a. Therearethreeprimaryappraisaltechniques:(1)evaluatethesalepriceofequivalent
"businesses"orsocalled comparables; (2)evaluate thereplacement costofthe
machinery; or(3)thediscountedpresentvalueoftheexpectedfuturecashflows.
Whichofthesethreeappraisaltechniqueswouldyouuseinthissituation?
Answer:Wewouldlikelyselectnumber3.
Unlikerealestateappraisal,wheretherearemanysimilarpropertiesbeingsold,
theremaybefewequivalentbottlebusinessesthathavebeensoldinEastern
EuropeortheformerSovietUnion.Sotechnique(1)wouldbedifficult.
Itisalsohardtoimaginewhyonewouldwishto"replace"outdatedmachinery,
althoughonecouldfindouthowmanybottleseachmachinecouldprocessper
hour,anddeterminehowmanyoldmachinesareequivalenttoanewmachine.
Sotechnique(2)wouldhavelimitedusefulnessinthissituation.
Therefore, the only reasonably useful approach is to use a measure of the
discountedpresentvalueofexpectedfuturecashflows,asintechnique(3).We
couldfindoutthesellingpricesofnewbottles,thequantityofbottlesthatthis
factorywouldmake,andfindlocalwagerates. Thisassumesthatthefactory
continuestooperateasabottlemakingoperation. Thevalueoftheproperty
couldbegreaterorlower,ifthereareotherusesforthebuildingandland. In
addition,wewillneedtocheckforenvironmentalhazardsleftontheproperty,
andfindoutthecostforacleanup.
b. AFrenchfirmthatisconsideringsellingwineingreenglassbottleswillusethe
appraisal. TheFrenchfirmwouldinvestinthepurchase. Whatissuesdoesthis

Chapter1GoalsoftheFirm17
introduce when considering the appropriate discount rate to use when deciding
whethertobuythisbottlefactory.
Answer:Thediscountratereflectsthecostofborrowingandcompensatesforthe
riskinessoftheinvestment. SincetheRussianpoliticalsituationisnotstable,
thereisariskthatshouldtheFrenchfirmbuythefactory;somenewgovernment
that couldappear inafewyears maypossiblyconfiscate it. Foreignowned
propertieshavehistoricallybeenexpropriatedafterpoliticalrevolutions.Hence,
thediscountratewouldbehighertopurchasethisfactorythanasimilarfactoryin
FranceortheU.S.

NetSources
1.

Profitsvaryacrossindustrialgroups.Economictheorysuggestsreasonsfor
variationinprofitabilityincludedifferencesincompetitionandrisk.For
informationonprofitabilitybyindustrygroupslookat:
MarketGuideIndustries,aserviceofYahooFinance.Itpresentsfirmdata
groupedbyindustriesonprofitmargins,returnonassets,andotherfinancial
accountingdataat:biz.yahoo.com/p/industries.html
BureauofLaborStatistics(BLS)theprincipalfactfindingagencyforthe
FederalGovernmentinthebroadfieldoflaboreconomicsandstatisticsat:
stats.bls.gov/
StatisticalAbstractoftheUnitedStatesprovidesdatadividedbyindustriesas
wellasstates.Itisavailableinthereferencesectionoflibrariesormore
convenientlyat:www.census.gov/statab/www/

2.

StandardIndustrialClassifications(SIC)arenumbersassignedtoindustry
groups.Thesitegives2digitand4digitSICcodesforindustries.Examples
include:
31LEATHERANDLEATHERPRODUCTS
32STONE,CLAY,ANDGLASSPRODUCTS
33PRIMARYMETALINDUSTRIES
34FABRICATEDMETALPRODUCTS
Tofind4digitclassificationsofindustries,lookat:
www.wave.net/upg/immigration/sic_index.htmlOrforthenewersixdigitNorth
AmericanIndustryClassificationsystem,NAICS,lookat:http://www.naics.com/

3.

PROJECT

18ManagerialEconomicsStudyGuide
18
ComparetheaverageROE(returnonequity)oftwodistinctlydifferentindustries
from: biz.yahoo.com/p/industries.html. Select three firms from each industry to
findtheaverageROEfortheindustry.UseaverageROEsinbothindustries.Do
the differences appear consistent with differences in risk, friction, monopoly
power, innovation, or managerial efficiency (which are the five reasons for
differencesinprofitsacrossindustries)?