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Solution Manual for Managerial Economics Applications Strategy and Tactics 11th Edition by

McGuigan

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Instructor’s Manual
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Chapter 1

Introduction and Goals of the Firm

Solutions to Exercises

1. If allowed to pursue their own self-interest, managers will tend to smooth earnings, avoid taking
risks that could lead to their dismissal, and divert company resources to pay for perks. Long-term
incentive pay involving restricted stock or stock options will be more effective in aligning
stockholder and manager interests. Nevertheless, risk-averse managers unable to diversify their
enormously focused human capital investment in one company will seek minimum cash salary
guarantees as a form of compensation insurance.

2. Bonus pay should be tied to the performance of other comparable companies and should be
deferred to remove any incentive to boost short-term cash flows at the expense of long-term
profitability. So, pay bonuses for exceeding the industry averages over the last several years and
channel this bonus pay through deferred stock options or restricted stock.

3. The temporary disequilibrium theory of profit suggests that at any time an individual firm or
industry may earn a return above or below the long-run "normal" rate of profit for that industry,
because of temporary dislocations (shocks) in the economy. The profits earned by oil companies in
the wake of the Iraq war fit this definition. Proposals to tax away these profits would eliminate the
symmetry in these shocks by making the oil companies give up periods of high profits but bear the
cost of periods of below normal profits. These periods of high profits might also be justified in the
context of the risk-bearing theory of profit.

4. High profits in the drug industry can be explained by the risk-bearing theory of profit, the
innovation theory of profit, and the monopoly theory of profit. Patents granted for the development
of drugs, which are the product of a firm's innovative efforts (and perhaps its managerial
efficiency), provide the developing firm with a monopoly position in the production and marketing
of that drug.

5. a. Prices may move to a more competitive (lower) level, reducing the firm's expected cash flow
stream and, hence, its value.

b. If these requirements are imposed equally on all firms, some of the cost burden will be borne by
the firm and some by consumers, depending on the nature of the demand function. If the impact of
the requirements is substantially different from one firm to another in an industry, the value of
some firms may be enhanced relative to those at a competitive disadvantage because of the
standards.

c. Labor costs may or may not increase. To the extent they increase without an offsetting increase
in productivity, the value of the firm would be reduced.

d. The impact is indeterminate depending on the ability of the firm to pass along higher costs to
consumers and on the specific impact of inflation on a firm's costs.

e. Cash flows and firm value should increase, at least until competitors adopt this new technology.

6. The first option (raising airfares) must be evaluated in the context of the responsiveness of the
market to accept these increases. Important considerations include the likely response of
competitor airlines and the price responsiveness of demand. If competitors do not follow the price
increases initiated by USAir, they will suffer substantial and costly losses of customers. Even if
competitors do follow USAir's lead, it is possible that the revenue increases will be insufficient to
offset the cost increases.
The decision to reduce the number of flights per day in some markets again depends heavily on
the response of competitors. To the extent that increased fuel costs raise the breakeven point for
individual flights, the firm may want to adjust its schedule to those markets where flights
persistently operate under the breakeven point of capacity. However, U.S. Air must concern itself
with the longer term impacts of withdrawing from some of its markets because of a short-term
change in costs, that is unlikely to be permanent.
Some airlines have, in the past, made long-term commitments to buy fuel. However, in the
highly competitive airline industry, this is a dangerous strategy. If future costs of fuel decline
below the contract prices, USAir will be at a cost disadvantage relative to its competitors.
Competitors would likely set their fares at a level consistent with these lower costs, and USAir
would be forced to follow. Such a long-run cost control strategy is very risky and would increase
the perceived risk of the cash flow stream of the airline.

7. a. If the proceeds received from the sale of Del Monte were greater than the expected present
value of cash flows that RJR-Nabisco expected to generate by retaining ownership, the sale would
increase shareholder wealth. In this particular case, the sale of Del Monte was an essential part of
the asset redeployment following the leveraged buyout of the firm. It was necessary if RJR was to
pay off the large amount of debt it had accepted.

b. The acquisition of Jaguar would increase shareholder wealth if the expected present value of
cash flows that could be generated from the Jaguar investment exceeded the cost. Many in and out

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of the industry felt that Ford overpaid for Jaguar (Toyota created its Lexus division for less than $1
billion). To date, Ford has experienced large losses on this acquisition.

c. There is no relationship between this action and shareholder wealth. It could stimulate sales to
the point that the firm's cash flows would increase and shareholder value would be enhanced. The
impact depends on the nature of the demand function for GM's products and the response of
competitors.

d. Ceteris paribus, an increase in interest rates should cause shareholder wealth to decline,
because projected future cash flows would be discounted at a higher rate.

e. In the near term, import restrictions should help Chrysler, because the price on the available
Japanese vehicles would be bid up (reflecting their short supply). This would give domestic firms
an opportunity to increase prices and market share. The long-term impacts of import restrictions
are less clear, since they may discourage the firm from aggressively pursuing actions that will
increase its long-term cost and quality competitiveness.

f. A drop in expected inflation, ceteris paribus, should result in lower capital costs and hence a
greater present value of future cash flows.

g. The impact of this new machine on shareholder wealth should be positive in the near-term.
However, to the extent that competitors also follow this action, there will be pressure to reduce
prices to reflect the lower costs. The more competitive the industry is, the less likely it is that any
one firm can sustain cost advantages for a long time.

Solution to Case Exercise: Designing a Managerial Incentive Contract

1. The expected gain from eliciting High work effort is then (0.3 x $200 million) + (0.4 x $300
million) = $240 million. So, ex ante, the shareholders would be willing to pay up to 1% of $240
million or $2.4 million to elicit High Effort in all three states.

2. The difficulty, of course, in all principal-agent models of moral hazard comes in distinguishing
the role of effort from the role of “Luck.” In this case, only at $1 billion could the shareholders be
sure that the manager had expended High Effort. Therefore, a $2.4 million cash bonus would be
paid only if the company realized $1 billion in profit.

3. Of course, the shareholders would also like to elicit High Effort with Medium and Bad Luck
since those behaviors would also increase company profit.
6 Chapter 1/Introduction and Goals of the Firm

4. Again, Good Luck and Low Effort cannot be distinguished from Moderate Effort and Bad
Luck, and furthermore, there is no incentive for High Effort.
5. $240 Million is the expected value with perfect information and $120 million is the maximum
expected value with incomplete information and optimal decision-making at $800 million for
bonuses. Therefore, the value of the perfect auditor information is the difference ($240 – $120 =
$120 million).

6. An exercise price of $70 can elicit High Effort in the “Good” and “Medium” states. These
outcomes will provide ($200 – $30) million × 0.3 plus ($300 – $10) × .4 = $167 million.
Comparing the $120 million outcome when bonuses are paid at $800 million value, the stock
option plan can increase shareholder value $47 million net.

Solution to Case Exercise: Reducing Greenhouses Gases

1. Regulatory directives, whether mandated minimums or quotas, seldom achieve efficient


pollution abatement. The reasons are threefold: First, regulatory directives seldom require the
correct magnitude of pollution abatement where external and private marginal benefits sum to
equal the marginal costs. Second, regulation tends to require the pollution abatement from all
sources, even though tradable pollution permits would quickly reveal that some abatement is much
less expensive (and should therefore be more extensive) than other abatement. Finally, regulatory
directives are typically less adaptive to new technologies than a market-based abatement system
like tradable pollution permits. Such permits elicit more abatement at a lower total cost than a
regulatory directive by triggering exchanges between high-cost point sources (the buyers) and low-
cost point sources (the sellers).