Managerial Finance

MB 664 UVG-TAMU May 2009 1

ManagerialManagerial Finance

MB-664MB-664

Economic Concept OverviewEconomic Concept Overview


Today’s Decision ClimateToday’s Decision Climate• Global economy

• Little or no information lags

• Sources of risk in making decisions

• Decisions at the enterprise level

• Decisions related to expansion

• Importance of quality information in making decisions


Market ForcesMarket Forces


Expected Commodity PriceExpected Commodity Price

D = SD = S

D

S

$4

10

$1

$7

D = f(Po, PYD, Px, W, …)D = f(Po, PYD, Px, W, …)

S = f(Po, MIC, …)S = f(Po, MIC, …)


Implications for the FirmImplications for the Firm

Price

Quantity

D S

PE

QE

Price

OMAX

ATC MC

The MarketThe Market The FirmThe Firm


Implications for the FirmImplications for the Firm

Price

Quantity

D S

PE

QE

Price

OMAX

ATC MC

The MarketThe Market The FirmThe Firm

Profit


Knowing Your ElasticitiesKnowing Your Elasticities

• Market demand related elasticities

• Market supply related elasticities

• Concept of price flexibility

• Application and implications


Price Price

Quantity

∆P

∆P

Inelastic Market DemandInelastic Market DemandInelastic Market DemandInelastic Market Demand Elastic Market DemandElastic Market DemandElastic Market DemandElastic Market Demand

∆Q ∆Q

%∆P>%∆Q %∆P<%∆Q

Identical shiftin the supply curve

Identical shiftin the supply curve


Concept of Price FlexibilityConcept of Price FlexibilityPrice

Quantity

EP = - .25If the own price elasticity of demand is equal to .25, then

PF = 1/-.25 = -4.0

This means that if the This means that if the supply coming onto the supply coming onto the market is expected to market is expected to increaseincrease by one percent, by one percent, the price you can expect to the price you can expect to receive for your products receive for your products will will fallfall by 4 percent. by 4 percent.

-4%

+1%


Short Run Input DecisionsShort Run Input Decisions


5

B

C

D

E

FG

HI

J

Input Decision for Variable InputsInput Decision for Variable InputsInput Decision for Variable InputsInput Decision for Variable Inputs


Least Cost Decision RuleLeast Cost Decision Rule

The least cost combination of labor and capital in out example also occurs where:

MPPLABOR ÷ wage rate = MPPCAPITAL ÷ rental rate

MPP per dollar spent on labor

MPP per dollar spent on labor

MPP per dollar spent on capitalMPP per dollar spent on capital=

This decision rule holds for a larger number of inputs as well…


Least Cost Input Choice for 100 UnitsLeast Cost Input Choice for 100 UnitsLeast Cost Input Choice for 100 UnitsLeast Cost Input Choice for 100 Units

7

60


What Happens if Wage Rate Declines?What Happens if Wage Rate Declines?What Happens if Wage Rate Declines?What Happens if Wage Rate Declines?

As a consequence,the firm woulddesire to use morelabor and less capital…

As a consequence,the firm woulddesire to use morelabor and less capital…

MB 664 UVG-TAMU May 2009 15Page 141

What Inputs to Use for a Specific Budget?What Inputs to Use for a Specific Budget?


Short Run Enterprise DecisionsShort Run Enterprise Decisions


Combination of ProductsCombination of ProductsThe profit maximizing combination of two products isfound where the slope of the production possibilitiesfrontier (PPF) is equal to the slope of the iso-revenue curve, or where:

Canned fruit Price of vegetables Canned vegetables Price of fruit= –

Slope of an PPF curve

Slope of an PPF curve

Slope of iso- revenue line

Slope of iso- revenue line


Output combinations lying beyond the PPF exceed the firm’s existing capacity. The firm would have to expand its capacity and labor force to achieve this output.

Output combinations lying beyond the PPF exceed the firm’s existing capacity. The firm would have to expand its capacity and labor force to achieve this output.

Profit Maximization Product ChoiceProfit Maximization Product ChoiceProfit Maximization Product ChoiceProfit Maximization Product Choice


Canned fruit Price of vegetables

Canned vegetables Price of fruit

Canned fruit Price of vegetables

Canned vegetables Price of fruit= –

Shifting line AB out in a parallel fashion holds both prices constant at their current level

Shifting line AB out in a parallel fashion holds both prices constant at their current level



The firm would shift from point M on the PPF to point N as a result of the decline in the price of fruit. That is, to maximize profit, the firm would cut back its production of canned fruit and produce more canned vegetables.

The firm would shift from point M on the PPF to point N as a result of the decline in the price of fruit. That is, to maximize profit, the firm would cut back its production of canned fruit and produce more canned vegetables.



Long Run Capacity DecisionsLong Run Capacity Decisions


Growth of the firm…How much should we expand?Growth of the firm…How much should we expand?Growth of the firm…How much should we expand?Growth of the firm…How much should we expand?

Is this firm size earning a profit?Is this firm size earning a profit?

Page 17 in booklet

Page 17 in booklet



No. Its average cost exceeds its average revenue at price P. The firm therefore must either expand or cease operation. How much should it expand?

No. Its average cost exceeds its average revenue at price P. The firm therefore must either expand or cease operation. How much should it expand?


Q3

Firm size 2, 3 and 4would earn a profitat price P….

Firm size 2, 3 and 4would earn a profitat price P….



Q3

At size #2, the firm’s profit would be the green area shown above…

At size #2, the firm’s profit would be the green area shown above…



Q3 At size #3, the firm’s profit would be the area shown above…

At size #3, the firm’s profit would be the area shown above…



Q3





If price were to fall to PLR, only size 3 wouldnot lose money; it would break-even.

If price were to fall to PLR, only size 3 wouldnot lose money; it would break-even.



Expansion to size #4 runs the risk of having to downsize or idle part of its existing capacity if the industry settled at price PLR

Expansion to size #4 runs the risk of having to downsize or idle part of its existing capacity if the industry settled at price PLR



Optimal inputcombinationfor output=10

Optimal inputcombinationfor output=10

Expanding the Firm’s CapacityExpanding the Firm’s CapacityExpanding the Firm’s CapacityExpanding the Firm’s Capacity

Page 19 in booklet

Page 19 in booklet


Two options if doubling output: 1. Point B ?2. Point C?

Two options if doubling output: 1. Point B ?2. Point C?



Optimal inputcombinationfor output=10with budget DE

Optimal inputcombinationfor output=10with budget DE

Optimal inputcombination for output=20with budget FG

Optimal inputcombination for output=20with budget FG



This combinationcosts more toproduce 20 units of output sincebudget HI exceedsbudget FG

This combinationcosts more toproduce 20 units of output sincebudget HI exceedsbudget FG



Growth expansion pathGrowth expansion path



Capacity ConceptsCapacity Concepts


DefinitionsDefinitions Engineering capacityEngineering capacity – maximum output for which

enterprise was designed Economic capacityEconomic capacity – output given economic objectives

and normal operating policy Capacity utilization rateCapacity utilization rate – ratio of actual output to

engineering capacity Capacity efficiency rateCapacity efficiency rate – ratio of actual output to

economic capacity Desired utilization rateDesired utilization rate – ratio of economic to

engineering capacity BottleneckBottleneck – constraint on economic capacity


S1

Engineeringcapacity

Price

Concept of Capacity Utilization at Market LevelConcept of Capacity Utilization at Market LevelConcept of Capacity Utilization at Market LevelConcept of Capacity Utilization at Market Level


S1

Economiccapacity

Engineeringcapacity

D1

Price

P1



S1

Economiccapacity

Actualoutput

Engineeringcapacity

D1

Price

P1

S2



S1

Economiccapacity

Actualoutput

Engineeringcapacity

D1

Price

P1

P2

S2



S1

Economiccapacity

Actualoutput

Engineeringcapacity

BottleneckBottleneck

D1

Price

P1

P2

S2



Market Price/Quantity Market Price/Quantity RelationshipsRelationships


Stochastic Relationship Between Output and PriceStochastic Relationship Between Output and Price

An example of potential market outcomes

An example of potential market outcomes


An interpretation of potential price variability

An interpretation of potential price variability


Pro Forma Analysis of Future TrendsPro Forma Analysis of Future Trends

A necessary element to evaluating A necessary element to evaluating potential investment alternatives.potential investment alternatives.

A necessary element to evaluating A necessary element to evaluating potential investment alternatives.potential investment alternatives.

Weekly Closing Price Volitility

$3.50$3.75$4.00$4.25$4.50$4.75$5.00$5.25$5.50$5.75$6.00$6.25

6-Ju

l13

-Ju

l20

-Ju

l27

-Ju

l3-

Au

g10

-Au

g17

-Au

g24

-Au

g31

-Au

g6-

Sep

16-S

ep23

-Sep

30-S

ep5-

Oct

12-O

ct19

-Oct

26-O

ct2-

No

v9-

No

v16

-No

v23

-No

v30

-No

v7-

Dec

14-D

ec21

-Dec

28-D

ec4-

Jan

11-J

an18

-Jan

25-J

an1-

Feb

8-F

eb15

-Feb

22-F

eb29

-Feb

7-M

ar14

-Mar

20-M

ar30

-Mar

4-A

pr

11-A

pr

18-A

pr

25-A

pr

May 2008 Contract July 2008 Contract


Evaluation MethodsEvaluation MethodsStochastic analysis of commodity

prices and unit input costsRisk and required rates of returnRisk adjusted capital budgetingPro forma financial statement analysis

Managerial Finance

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