SIMDEF

MANUAL DEL PROFESOR

PREFACESIMDEF is designed for use in finance, managerial economics, and executive trainingprograms. It is a comprehensive, multiperiod finance case designed to provide anenvironment where skills are developed in both finance and general decision making.

A multiperiod decision-making setting that is not duplicated with standard cases orproblems is provided. Feedback on the results of previous decisions is received witheach iteration of play; thereby providing repeated reinforcement in learning financialdefinitions, analytical tools, and solution techniques. Furthermore, an iterativedecision-making environment forces the participants to recognize the importance ofmaintaining flexibility by maintaining a large set of feasible future options for theircompany. With single-stage problems, the consequences of the future restrictionsimposed by a given solution are often never realized.

Notes to the Instructor

The game was intentionally designed to be used by instructors having little or noknowledge of computers and computer programming. Thus, the instructor need nothave any computer knowledge to use any of the game versions that are now described.

The instructor has many options controlling the demands the game places on theparticipants. The set of decisions required from each company manager playing thegame is easily changed. This enhances the ability to use the game from introductory toadvanced courses.

In its simplest version of use, all the decisions will be made either by the instructor orautomatically by the simulation program. The game can be used in testing skills inpreparing pro forma statements while the students gain both a knowledge of the newgame environment and build the skills necessary to control given decision areas. Atthis level of use, the game can be appropriately used in an introductory course.

Control of one decision variable at a time will enable the participants to view theramifications of their decision on the entire set of statements. This version of use alsoprovides additional experience in solving single decision area problems.

At a more advanced level, the new company managers will sequentially addcontrollable decisions. The new manager just immersed in the game environmentoften finds it very difficult to intelligibly control the large number of requireddecisions of a fully operating company. Utilization of this version allows theparticipant to gain the necessary skills in each of the areas and become more familiarwith the rules and conditions governing the game.

The new manager is immediately given complete control of all the major decisions ofa company with the most popular version of use. Previous background in finance ormanagerial economics problem solving and decision making is usually necessary forthis full immersion approach to be successful. This version has been used with a greatdeal of success in case courses at both the undergraduate and MBA level. It hasproved to be an excellent complement to standard case texts.

At the most advanced level of use, the manager is given the complete control of a new

company initially having only cash and common stock equity. The manager mustbuild his company into a fully operating firm.

Simple changes in the first data card in the program are only required when changesare made in the participants' set of controlled decision variables. Otherwise, theadministrator does not need to enter any additional decisions once game play isstarted. If he so desires, there are many variables on the same first data card that canbe easily changed during game play. Thus the tax rate, product price, and most of thecosts that affect earnings and cash flow can be readily changed by the administratoron any iteration. making changes of this type, the game can, more closely simulate anactual environment. An expansion in the difficulty of the manager's decision situationresults.

The major student complaint with simulation games occurs when they have operatedfor several iterations and find themselves applying previously learned techniques tothe selection of decision inputs, i.e., they have programmed their response. This gameis constructed to enable the inclusion of rather specialized decision situations later inthe game when enthusiasm starts to wain. For example, at the instructor's discretion, apossible labor strike offer can be initiated requiring decisions on wage increases.Alternatively, a large extraordinary loss requiring cash outflows can be generatedrequiring immediate planning by the student to avoid technical insolvency. This gamesupplement limits complaints and maintains the learning experience through thecourse. Again, the special options just mentioned are generated by a simple change onthe first data deck card.

Additionally, a set of index numbers easily controlled by the game administratorestablishes the growth and stability of the industry in which the companies operate.Set before game play commences, the administrator can change the nature of theindustry so that each semester a uniquely different environment and set of operatingconditions are encountered by the game participants.

CHAPTER 1. INTRODUCTION

The simulation and this manual are designed to minimize the technical requirementsof administering the game. The specific procedures are not especially complex andcan be mastered quickly. A great deal of flexibility is available in using the game.Modifications can be easily made by the instructor to fit his particular classroomneeds. Knowledge of computers and computer programming are not needed for mostof the adjustments and changes.

This manual and the SIMDEF text both should be used by the administrator in gaininga full understanding of the nature of the game. The many game rules affecting thesimulation company are covered in the text, while the procedures for bothadministering the game and changing many of the game rules are included in thismanual. An instructor should have a thorough understanding of the game and itsoperation before play commences. Likewise, the students should be directed to coverall of the material in the text as early as possible. At a minimum, they shouldunderstand the material presented in Chapters 1 and 2 of the SIMDEF text.

SIMDEF can be appropriately used by students having different degrees ofcompetence in accounting, finance, or managerial economics. Generally, the studentshould have some general knowledge of finance and previous exposure to interpretingfinancial statements. In the past, the game has been successfully used in introductoryand advanced undergraduate finance courses, MBA courses, and executive seminars.The multiple "versions of use" that are available enable its use at different levels ofcomplexity. The available "versions of use" will be described in detail later in thischapter.

SIMDEF is a comprehensive multiperiod finance case requiring the participant toenter up to 18 decision items each period. The administrator can allow the gameplayer to exercise 'control over each of the major financial decision areas of acompany. Thus, the participant can control from zero to 18 decision inputs. When thedecisions are made on many of the variables there will be approximately the sameamount of control of financial decisions as one would find in a real company. Controlwill exist over the internal production and finance functions; the manager will alsodetermine the external acquisition of assets and funds.

Student's Operating Procedures

The participants make sequential decisions through several periods of play. Thedetailed tasks that should be performed and the specific rules and conditions thataffect the companies are given in the SIMDEF text. The basic procedures that theywill use follows:

1.. The companies are each provided with a set of statements about their company.This includes (a) the first quarter POSITION STATEMENT, (b) the QUARTERLYPERFORMANCE REPORT, and (c) the SUMMARY SHEET. The SUMMARYSHEET presents additional historical, current, and both estimated and actual futureinformation not given on the standard set of financial reports, (a) and (b).

2. The administrator states which variables the students control. The next subsectionprovides further information on this item.

3. The information from the set of statements, 1 above, and the conditions and rulesfor operating the firms are used by the student in formulating decisions on his set ofmanager-controlled variables. The environment and internal conditions and rulesunder which the firm operates are given in detail in Chapter 2 of the text.

4. Each company playing the game submits a set of decisions to the instructor on aDECISION INPUT FORM, shown in Exhibit 2.4 of the text. The information on thisform is used in the computer simulation.

5. Output of the results of the student's decisions is in the form of a new set offinancial statements and summary information for each participating company. TheSIMDEF managers use this information to evaluate their performance. Thisinformation is the same as in item 1 above.

This process is continual, with students receiving feedback on their previous decisionsand reformulating new sets of decisions based on both their past performance andforecasted information.

The Instructor's Operating Procedure

A summary of the decisions and operating procedures required by the instructor aregiven in this section. The procedure employed would vary slightly depending on howthe game were to be, used.

Versions of use. There are five major types of use. The approach or approaches usedwould be a function of the student's background, the time available for operating thegame, and the instructor's particular aims. The five versions of use are now brieflypresented.

1. With the first version, the student or manager does not have control of any of thevariables. This approach is often employed if the instructor wants the students to firstbecome familiar with the conditions and rules of the game without immediateimmersion into decision making. The students are provided with the company's initialset of financial statements and the set of decision inputs made by the administrator, orinternally generated in the game. With this information, the student is required toprepare pro forma financial statements.

2. With the second version, the student controls only one decision variable at a time.This approach is successfully used in an introductory finance or managerialeconomics course. The game serves as a supplemental problems workbook while alsointroducing the student to a gaming situation.

3. The next version sequentially adds variables controlled by the manager. Game playstarts with one decision variable controlled by the student. As time progresses, and thestudents add additional skills, the control is expanded to include additional variables.

4. The students start with the management of most of the major financial and

production area of a going concern with the fourth version of use. With this mostpopular version, the student is given immediate control over a set of decisions thatenable the complete operation of the firm. Some previous knowledge of finance isprobably required for this full immersion into a complex decision-making situation tobe successful.

5. In the final version, greater management ability is required. The manager has toorganize a new company. Starting only with equity and cash, the manager mustconstruct an operating firm.

More-information on each approach and its advantages and disadvantages are givenlater in this chapter. The detailed procedures on implementing a specific version aregiven in Chapter 3 of this manual.

The initial setup procedure.

No computer expertise is required by the instructor in setting up and operating thegame. Once the initial decisions are made by the instructor on the version to be used,the setup and operation of the game is quite mechanical. The coordination andoperation of the game is then often assigned to a teaching assistant.

The game is based on a central computer program that is used with all possibleversions of use, indicated earlier. The program and supportive data are on punchedcards that are supplied with the Instructor's Manual. It is recommended- that aduplicate deck of cards be immediately made on a duplicating machine to serve as abackup in case of; loss or ruin of the original deck.

The original deck includes (1) the source computer program of cards and (2) twoseparate sets er,data cards with 32 cards per deck. The source deck and each data deckare separated by blank Lab cards. Each data deck has a specific use.

The first data deck' is for use of versions 1 through 4 presented previously.Environmental and company information for a going concern is included in this datadeck. The second data deck is for use only when the manager has to organize a newcompany; item 5 under the previous section on "versions of use."

Each data deck is made up of two component parts called (1) the environmentalpacket, and (2) the company packet. The first 9 cars of each data deck make up theenvironmental packet, the remaining 23 make up the company packet. Theenvironmental packet includes the parameter value for the environment, such as theunderlying production demand, interest rates, and product prices for each period ofplay.

The first card of the environmental packet is the instructor's environment decisioncard. The first 18 columns are used to indicate whether the student will or will notenter decisions 1 through 18 listed under the "Participant's possible decisions"subsection of Chapter 1 of the SIMDEF text. A one, "1," indicates student control anda zero, "0," indicates that the decision will either be made by the administrator or willbe internally generated in the program. If a zero is entered for decision control and theadministrator wishes to enter the company's decision, then the decision is entered on

the second card. The specific details and examples are presented in Chapter 3. Therest of the first card and the other eight cards of the environmental packet are used forother required information and instructor controllable options. This is also covered inChapter 3. Through the first 18 -columns of the decision card, the instructor canoperate with any of the different versions of use indicated earlier. No further decisionsare required.

The company packet includes all the historical, current, and future information neededto operate the company in the simulation. All the firms will start the the samecompany that is represented in this packet. There is a i erent packet and thus adifferent starting company for the two data decks. If each firm will be submittingdifferent decisions, then each must have their own company packet. One companypacket is automatically machine generated in quarter 1 for each firm that will beplaying the game. This is accomplished by punching the number of firms that will beplaying the game on a given location of the instructor's decision card, alreadydescribed above. The (1) source program, (2) appropriate environment packet with theprepared instructor s ecis on card, and (3) company packet are run on the computer togenerate the required number of company packets. The printed and punched outputthat is obtained is the same as is described in the next section. All the materialnecessary for the period-to-period operation of the game is now available.

Period-to-period operating procedure. The punched card deck is set up in the sameway for every period of play. The ordering of the decks is almost identical to theinitial setup procedure. The deck is organized in the following manner:

1. The source computer program of 909 cards is first.2. The environmental packet is next.

a. The instructor decision card is first. This card is modified to reflect variablesthat are being deleted or added to the list of student-controlled variables. Otherinstructor options that are described in Chapter 3 can be initiated.b. The eight remaining environment packet cards follow the instructor decisioncard. Possible instructor modification of these cards are also covered in Chapter 3.

3. The company packets are last. There is one for each company playing the game.a. The company decision card is first. This includes each company's set ofdecisions for the coming period. The decisions come from the student'sDECISION INPUT FORM.b. The 22 following cards comprise the required historical, current, and futureinformation for the simulation.

The deck is then run on the computer. Both printed statements and punched cards arereceived as output from the run for each firm in each quarter.

1. Printed output includes:a.b.c.

the new end of quarter POSITION STATEMENT,the current quarter's QUARTERLY PERFORMANCE REPORT,the new SUMMARY SHEET.

Punched output includes:a. One new environmental packet of cards. The instructor's decision card for thecoming quarter is first and the eight new environmental packet cards follow.

b. A new 23-card company packet is generated for each firm playing the game. This isused in the coming period's input.

The punched card output minimizes the period-to-period card-punching requirements.The cards that will possibly need punching each period are now described.

1. The instructor's new decision card may need to be keypunched. This only needs tobe repunched if there are changes in either the student-controlled decisionvariables or other instructor's options. If no changes are to be made, the newoutput cards replace the last period's environmental packet for the next quarter'scomputer run.

2. The decision card for each firm playing the game needs to be keypunched. Thiscard replaces a card that contains the number of the company in columns 4 and 5.This is the first card of each company's new packet.

Thus, the maximum number of cards requiring keypunching is equal to the number offirms playing the game plus up to two instructor cards, if instructor changes are made.The source deck, environmental packet, and new company packets are then run for thenext period. The process is reiterated for each period of play of the game. Morespecific details on card format, available options, deck setup, and examples are givenin Chapter 3.

Classroom Procedures

The discussion on classroom procedures is intended to give general suggestions andguidelines. The instructor can select the particular approach that best meets his needs.

The course and the game. The relationship between the course and the game should beestablished. The simulation is most often used to complement a managerial finance orcase course. The game can be either highly integrated with other course material oroperated independently. In the first case, the students are immediately exposed toapplying their newly acquired tools and decision techniques to an operating situationthat closely resembles the real world. When the game is operated independently, theconnection between other course material and an application of that material to thesimulation is not as obvious. Past experiences indicate that the students achieve ahigher degree of satisfaction when they recognize the transferability of the new skillsto an operating problem on their own, rather than when they are directed to make thetransfer by the instructor. There is the possible concomitant cost that many of thestudents may not recognize that'the skills are transferable to the simulation, and thusthey establish a faulty evaluation procedure that is more difficult to discover andeliminate.

The choice between the highly integrated or independent approach will depend on theinstructor's approach to teaching as well as the ability and past training of thestudents. Thus, with an introductory course, the highly integrated approach willprobably be more appropriate while the independent approach might be employedwith greater success in higher level courses.

As an alternative to the preceding approaches, the central focus of the course can bedirected toward the simulation. With this approach, course lectures, classroom

discussions, and supplementary readings are used to improve decision making in thesimulation. The course is used to present new, and improve earlier, techniques. Theinstructor institutes and controls discussions on the formulation and revision ofpossible operating strategies. Time is spent reviewing differences in both pastdecisions and results and in formulating and revising forecasting procedures. This ap-proach can also be used in a less intensive form when the simulation complementsanother text.

Group or individual decisions. The simulation firms can be operated by individualclass members or groups. The need for group activity increases as either thecomplexity of the decision situation in the game increases or the time required tomake decisions is decreased.

The group approach has several different dimensions that make it a desirableclassroom procedure: it provides many types of experience not normally obtained inlecture courses.

1. The students participate in setting up and operating an organization where eachhas specific work responsibility and authority. This might be referred to as theformal organization.

2. Interpersonal relationships are formed and change over time as the membersinteract both with each other and their decision situation. This is the informalorganization structure where compromises are required, dominance positionsestablished, and task assignments made even though they are usually not apparentor explicit. Decision making in this type of an interactive situation provides anexperience quite similar to the type of decision-making situations the students willoperate in after graduation.

3. Less time is used in the mechanical phases of the game since the requirements canbe split between the members of the group. Proportionally more of each student'stime can be devoted to planning, analyzing, making decisions, and controlling thefirm.

4. There are more checks to control against computational, transpositional, andnonfinance-related errors. Errors of this nature affect the performance measuresand detract from the major purpose of the game.

The instructor determines the emphasis within and between the items just covered byspecifying both the tasks the groups will perform and the degree of authority that agroup will have in forming its own structural form. For example, by requiring sets ofpro forma statements and evidence as to how decisions are reached, the instructor canforce the group to place a good deal of emphasis on formal organization. By imposinga specific structural form--for example, by having a receivables manager, productionmanager, capital budgeting manager, and a treasurer--the instructor can even assignresponsibility on area performance. If no structure is imposed, more student effort willbe directed toward organizational decision making for both the formal and informalorganization. There will be an expected decrease in emphasis on financial decisionmaking. The instructor's desired emphasis can be maintained by the choices he makesin introducing and operating the game.

A secondary benefit to the group form comes from a decrease in the number of firmsimulations that need to be processed for any given course. Savings in both setup and

computer times are achieved.

With the individual game operator, the time utilized in establishing and maintaining afunctioning organization is avoided, and the emphasis is on financial decision making.The individual form is probably the best approach to use where problem solving is notvery complex. The major purpose of the group form is to provide a setting conduciveto the effective solution of complex problems. One could rightfully question thepurpose of utilizing a great deal of effort in establishing groups for the simpleproblem-solving situation. Further, it is obviously easy to affix responsibility for thefirm's performance when it is operated by a single student.

Periods of play. The length of the course, proportion of course effort devoted to thesimulation, and level of complexity of the operation of the game, are the mainvariables that affect both the total material and time interval between iterations.

The performance measure's reliability is directly correlated to the number of iterationsplayed. Items that have short-term effects decrease the reliability of the performancemeasure; however, their effects decrease as the number of iterations increase. Thus,for the purpose of obtaining a good performance measure, one would desire to have asmany iterations as possible. Ten or more periods of play insure fairly reliablemeasures that can be used to compare the relative performance of all the firms. Theten-period minimum is easily obtained in a quarter-based school by averaging a littlemore than one iteration per week. This provides ample time for the students to makeforecasts, prepare pro forma statements, update their records, and determine thedecision inputs for the next period. Slower turnover is needed in a semester-basedsystem to accomplish the same minimum ten iterations. In fact, fifteen iterations canbe easily obtained. With increased emphasis on the game, iterations could average ashigh as two per week. It is not recommended that the speed of turnover of iterationsoccur too rapidly since there is a tendency for students to deemphasize analysis infavor of the application of rote or programmed responses.

Information disclosures. One of the instructor's functions is to provide information oneach firm's published performance measure to the entire class. Students can thencompare their performance with the other firms. A copy of each of the firms financialstatements for each past period should also be retained by the instructor for possibleevaluation or error correction. The instructor may allow students to review all the paststatements. This makes the game situation more realistic. It also allows students tosecure enough information to compare their problem approach and performance withother groups' strategies and performances. The firm can use this information tomodify their own procedures and improve future performance. At the instructor'sdiscretion, a description of the underlying financial models and environmentalconditions incorporated in the game can be provided to students. This information isgiven in Chapter 2. Most instructors require that their students seek out thisinformation through game play rather than directly disclosing it to them. To aid thestudents' search for the information, discussion can be used to both direct attention toand obtain concensus on the underlying models and conditions.

Evaluation of performance. Many possible approaches to evaluating studentperformance in the game are available. Student performance can be evaluated usingthe: (1) per-share "Accumulated Wealth" given on their SUMMARY SHEET, (2) sets

of student-prepared pro forma statements and supporting schedules from eachiteration, (3) descriptions of how the firm arrived at each of its decisions in eachiteration, (4) the administrator's assessment of the relative performance of the com-panies, (5) quizzes given to test the individual student's knowledge of the rules,conditions, and proper evaluation procedures, or (6) some combination of the above.Historically, students have performed best when either per-share accumulated wealthor item 4 is used with items 2 and 3. Item 4 is very appropriate. An explanation ispresented in Chapter 4 of the SIMDEF text explaining why some subjectiveevaluation by the instructor is necessary in assessing performance. The disadvantageof using single measures of performance reinforces the use of subjective measures.Item 5 is especially useful when the group format is used since the instructor obtainsinformation on the knowledge of the individual group members.

The accumulated wealth measure indicates the students' overall performance over theseveral problem areas covered in the course. It is difficult, if not impossible, to affixthe change in performance in a given period to specific decisions. For example, thefull consequences of a capital budgeting decision will not be observed until the usefullife of the project is over. This may be eight or twelve iterations from the decisionpoint. In this respect, the game is much like the real-world decision-making situationwhere feedback on the decisions is both lagged and often not obvious. Quizzes,problems, and questions may be assigned if the instructor desires information onperformance in specific decision areas. In the game, also similar to the real world, theconsequences of decisions in some areas are greater than in other areas. It would bevery difficult to avoid this situation. As a partial control, the game is purposelyconstructed so that no single decision area dominates the performance measure.The class procedure used with the simulation can be structured to fulfill theinstructor's particular set of objectives. Several possible dimensions controlled by theinstructor have just been reviewed. The instructor's objectives, and thus the classprocedures used, should be highly related to the particular course that is utilizing thesimulation.

Suggestions for Use in Different Courses

The simulation is constructed to allow a great deal of flexibility in its use. Thus, itmay be used in many different types of courses and at many different levels ofcomplexity. Due to the ability to make the game more complex by the addition ofdecision variables, student interest can be maintained at a higher level for a largernumber of iterations of play. Some further possible uses of the game are nowreviewed. The procedures for organizing the computer program for the differentversions of use are presented in Chapter 3.

Pro forma statement preparation. At an elementary level, the game is used to test thestudents' skills in preparing pro forma statements while, at the same time, introducingthem to the simulation game. Chapter 3 of the SIMDEF text instructs the students onthe preparation and usefulness of the pro forma financial statement. Chapter 3 of thismanual provides the instructor with the procedure for implementation. The studentsare given the two financial statements and SUMMARY SHEET. The decision inputsthat will be made by the instructor or internally generated by the simulation, are alsogiven. With this information, and the rules and conditions of Chapter 2 of the

SIMDEF text, the students will construct the set of pro forma statements. Copies ofthe new statements that are generated by the instructor's decision inputs will be madeavailable to the students. Comparisons between the pro forma and actual statementswould be made to detect the source of variance. As a supplement, the instructor canrequire that students prepare variance reports explaining the differences between theirpro forma and actual statements. Instructions will be given in Chapter 3l of thismanual indicating how the students can be provided with perfect forecastinginformation. Other than slight rounding errors, variances between their pro formastatements and the actual statements occurring in this situation will be due solely tostudent error.

Pro forma statement preparation is usually required near the beginning of mostintroductory finance courses in order to provide a tool to be used later in both theplanning and forecasting function of financial analysis. The statement preparationsrefamiliarize the students with material generally covered in a preparatory accountingcourse. An interfacing, using the game as a vehicle, can be made between thepreparatory accounting course and the introductory finance course. This will beespecially possible with business degree programs where both courses are a requiredpart of the core curriculum and are generally sequenced one after the other. The proforma preparation and variance analysis material can then be covered in theaccounting course. The finance course will start the game with the immediateintroduction of finance decisions controlled by the students. The students more readilysee the connections between the accounting material they are learning and itsusefulness in an operating system. An important corollary benefit comes from thetime savings obtained by avoiding duplicate presentations of the same type of materialin the two courses.

Student control of one decision variable. At a second level of operation, the studenthas control over one decision variable at a time. He sees how the differences in hissingle decision affect the changes in both the firm's overall performance and inspecific financial statement accounts. Information of this nature is not obtained withmany problem-solving approaches.

The single decision input approach is especially appropriate in an introductoryfinancial management or managerial economics course. In this situation, the text andsimulation serve as a supplementary problems text or workbook. To enable the use ofthe game as a workbook, a key is provided in Appendix A of the SIMDEF text. Itgives cross references between major introductory texts and the decisionsincorporated into the game and SIMDEF text. The student is given control of the de-cision variable related to the material being covered in the major text. When thesubject area changes, for example, from inventories to capital budgeting, the student'scontrol of the decisions affecting the earlier subject, inventory, ceases and control ofthe new item, capital budgeting decisions, is initiated. The student has bothinsufficient tools and knowledge to operate the entire game successfully at thebeginning of the course. Forcing him to make all the decisions could prove to be bothvery frustrating and reinforce the use of faulty or poor decision-making techniques.

The sequential addition of student-controlled decision variables. An increase incomplexity is achieved by sequentially adding further student-controlled decisionvariables as the course progresses. Thus, when capital budgeting decisions are added,

the decisions affecting inventory are still retained. By the end of the introductorycourse, the student is in full control of all the decision variables of the model. Yet theproblems associated with initially giving the student control of a variable where hehas insufficient tools and knowledge is also avoided. This approach providescontinuous reinforcement for retaining subject material previously introduced in thecourse.

Student operation of an' established concern. The students can immediately be givencontrol of all the decision variables available to the firm. This is most successfullyused where students have previously acquired a background in managerial finance,either through experience or previous course work. This full immersion approach ismost often used in a course that follows the introductory course. It is probably moreefficiently used where the simulation has already been employed in a lower levelcourse, using the single or sequential decision approach. When there has been someprevious experience, setup time is minimized both with respect to introducing thestudents to the gaming situation and in refamiliarizing them with the techniques andconcepts of financial management.

The full immersion approach is probably most appropriately used in a nonintroductoryfinance course. It is a good complement to a case course for reasons previously stated.Alternatively, a course can be centered around the game and the SIMDEF text;supplementary readings are used to initiate discussion and improve analysis anddecision making in the game. The full immersion approach would only be used in thefirst phase of this course. Further possible phases to be included in the course aredescribed in the next two subsections.

Student organization of a new firm. One of the game options requires the student toorganize and build the firm. Starting with only cash, common equity, and a limitedamount of information about the firm and the environment, the student must constructa firm. At the first level, this requires them to formulate a strategy for seekinginformation that will be needed in determining financial policies. Next, polities haveto be implemented. Feedback information on performance, relative to otherparticipating firms, will enable constant remodification of strategy and financialpolicies. An appropriate decision-making structure in the new firm situation must bequite different from the structure in the tested and more full information environmentof an established concern. Planning must be very careful and deliberate both to secureadditional and currently unknown information and to protect the firm's flexibility.

The instructor can provide as much or as little information about the underlyingenvironment and firm as he desires. Both the method for operationalizing the newfirm option and information concerning the environment and firm are given inChapter 3. Suggestions as to what information should be made available to thestudents are also presented.

Testing and the game. At an advanced level, the students can test and possibly modifythe simulation. The simulation, rather than the firm, becomes the center of attention.The student's objective is to determine how the game works; they must developprocedures that will enable them to determine and specify the underlying models.Direct access to the underlying program should not be given; instead, the studentsshould be allowed to enter multiple sets of decisions. For example, by varying one

decision while holding all others constant, the students can determine how changes inthat one decision affect changes in the financial statements, performance, and otheradditional information. More complicated situations where there are multipledependent variables could also be tested and underlying models approximated.Through retesting, discussion, and analysis of the data, they should be able to specifysome of the functional relationships between the different variables. Both time seriesand cross-sectional analysis could be made. In effect, the students are able to applypreviously learned empirical research techniques to a situation not too unlike the realworld. The successful completion of the testing phase would result in a specificationof some of the underlying models that are explained in Chapter 2.

The students could next be directed to determine and specify how this environmentvaried from their views of the real world. This requires them to either explicitly orimplicitly structure the real world into a consistent set of underlying models and rulesbefore comparisons can be made. Some empirical testing of real-world informationmight be desired to verify some of the students' assertions. The students could theninvestigate the possibility of incorporating changes into the game that would enable itto more closely simulate the real-world situation.

They can be told that this same procedure can be used by an actual firm inestablishing a computer simulation6of its own operations. Useful Information on thepossible range and likelihood of outcomes the actual firm will face can be generatedeven though the, simulation firm and its environment cannot be constructed to fullyduplicate an actual firm and environment. For example, an actual firm can simulate itssurrogate firm at different production and demand levels to determine the re-t sultantshort-term funding requirements for inventories and receivables. Through time seriesanalysis, both the duration and the dollar amount of the requirements can beestimated. This technique for forecasting can provide invaluable' predictiveinformation. For example, this will enable the managers to prearrange lines of creditwith the firm's banks that protect it throughout the range of possible outcomes.The game testing approach is well suited for use in a seminar finance, managerialeconomics, or research methodology course. Material covered in these courses wouldbe needed in performing the testing outlined above.

Nonrepeating options. The game is constructed to enable the instructor's inclusion ofrather specialized decision situations. Major student complaints with simulationgames arise when they have operated for several iterations and find themselvesapplying previously learned rules to the selection of decision inputs, i.e., they haveprogrammed their responses. When this condition starts to occur, the instructor caninitiate new "one-shot" student decision situations. There are three nonrep?atingoptions.1. A labor-bargaining situation is initiated with the first option. The students have to

make a decision on the appropriate trade-off between labor cost increases and theprobability of a oneperiod strike.

2. The second option initiates a large extraordinary loss (or gain) that also results in acash outflow (or inflow). For example, a large loss would require immediateplanning by the student if his firm is to avoid technical insolvency.

3. figg is generated with this option. The fire eliminates all inventories and aninstructor's specified percentage of machine capacity. This has both an immediateeffect on fund inflows and a longer range effect by decreasing the following

period's production capacity. Extra planning in the production sector and fundacquisition sector are required.

Inclusion of nonrepeating options limits complaints and maintains the learningexperience through the course. The instructor also has direct control over many of theenvironmental variables. Changes in any of these items also affects changes in thestudents' decision making. Implementation of each of these nonrepeating options andchanges in environmental parameters are covered in Chapter 3.

Conclusions

A preview of the entire game was followed by suggestions on how the game could beused with different degrees of complexity in different course situations. Care must beexercised in avoiding a level of usage that requires skills that exceed or fall short ofthe students' abilities. To avoid this problem, the game, and thus the environment andfirm, is constructed to enable use at many levels. The level of use and classroomprocedures have to be carefully selected in light of both the amount of attention theinstructor desires to have directed toward the game and the students' background. Theclassroom procedure must be closely tied to the complexity of the game. For example,at higher levels of complexity, the group rather than the individual form is moresuccessfully employed. Utilizing both the appropriate level of complexity and amatching classroom procedure, the students are exposed to a dynamic decision-making situation that induces higher motivation, reinforces the learning of bothfinance and managerial economics, and increases decision-makingabilities.

CHAPTER 2. UNDERLYING FINANCIAL MODELS AND CONDITIONS

The game is structured to include many commonly accepted financial models fordetermining revenues, costs, and valuation. The information contained in this chapterprovides more detailed information, concerning the specific underlying models andenvironmental conditions, than is given in the SIMDEF text. The text often presents achoice of possible explanatory models to further increase the analysis required by thestudents. This section describes the actual explanatory models employed in the game.Students must seek information from the game to verify which models are beingemployed.

Information on the underlying models and conditions should not be directly revealedto the students. It detracts from the aims of the gaming situation. Information on theunderlying models is presented in this chapter primarily to facilitate the instructor'sunderstanding of the game. False notions that students often form in their moreinformation-constrained situation can then be easily disspelled.

Some of the instructor's options are mentioned in this chapter; their implementationwill be covered in Chapter 3. Many of the more mechanical details and rules that arenot directly connected with an understanding of the major underlying financial modelsand environmental conditions are given in Chapter 2 of the SIMDEF text.

Economic Indicator

The economic indicator is a variable representing the general business condition. Asthe indicator increases, the general market conditions the firm faces improve. Thebase index has a norm value of 100 and can take on values between zero and 200without material distortion to any of the variables. The items affected by the indicatorand the nature of the effect are now described. The actual values of the dependentvariables for different index numbers are presented in Chapter 3.

Unit sales demand. The actual demand, Da, is derived from the given quarter'seconomic indicator, II, and a randomly generated number, M. We have

(2-1) Da = 970.75I1 + 616M.

The random number varies from zero to one. This last factor is added to increase, thestudents' difficulty in determining the exact multiplier. If it could be derived, theycould perfectly forecast the economic indicator. The undesired result would be that agood deal of uncertainty in the game would be removed. Further, the analysis anddecision on purchasing forecasts would not have to be made, thus decreasing thescope of the decision-making requirements of the game. By the end of the game, thestudents should be able to estimate demand quite accurately without knowing theexact nature of the intrinsic equation.

The unit demand is not affected by past decisions of the firm or the actions of otherfirms. There is also, no interaction in the determination of the price of the product.

Sales price of product. The product has a norm price of $100. A constant multiplier isapplied to the economic indicator in deriving an addition to or subtraction from thenorm price of the product. The price, Pr, is positively correlated to the economicindicator. We have

(2-2) Pr = $100 + $.33(I1 - 100).

The instructor has the option of suppressing the price derived from the economicindicator and substituting his own price. For example, by giving the students a priceeither below variable out-ofpocket costs or between full absorption and out-of-pocketcosts, the students' knowledge of marginal costing can be tested.

Cost of machinery and plant. Both per unit machinery and plant cost, Pt and Me, arepositively related to the next quarter's economic indicator. We have

(2-3) Mc = I2(.402 + 2.10R0)

(2-4) Pt = I2 (2.803 + 9.20R0)

where R0 is an interest rate that will be derived in the next subsection. One wouldnormally expect heavy capital goods demand, and thus prices, to expand or contract inadvance of the increase in demand for ultimate finished goods. This condition isincorporated into thg game by using the following period's economic indicator, I2, indetermination of the price of plant and machinery. Students who either know this, orcan determine it, can gain a competitive advantage by using a longer time horizon inmaking decisions on machinery and plant. They will possibly purchase one period ormore before the actual necessary purchase period. They would need to analyze theoffsetting costs of greater initial unused capacity and lower initial costs.

Plant has a fixed order cost of $100,000 in addition to the variable'cost per unit. Thiscondition requires additional preplanning in determining the frequency and size ofplant purchases.

Interest rates. Interest rates are also partially determined from the next period'seconomic indicator. The base interest rate, R0, on an annual basis can be between 2and 8 percent depending on the economic indicator. The function is

(2-5) R0 = .05 + .03(I2 - 100).

The base rate, positively related to the conomic indicator, is used both in thedetermination of many other interest rates and as the return rate for marketablesecurities. The other rates affected by the base rate include costs of short-term loans,intermediate debt, long-term debt, preferred stock and common stock. Moreinformation on the costs of these items is given in the subsection on "Costs of Fundsand Valuation."

Purchase of Demand and Price Forecasts

The student can purchase forecasts of demand and price. The least accurate forecasthas no cost. More accurate forecasts cost $30,000 or $75,000. With each forecast anestimate is generated for each of the next four quarters. With the environmental cardssupplied with the game, the accuracy of the estimates decreases the further away theestimate. The reliability of the estimates is also directly related to the price paid forthe forecast. The estimates are .uniform random variables that are within a specificpercentage distance, plus or minus, from the actual demand. Table 2.1 indicates thepercentage ranges.

TABLE 2.1

Maximum Percentage Variation of Estimates of Demand from ActualReliabilityFuture

quarter Low Medium High1 5 3 22 10 6 43 15 10 64 20 12 8

The price percentage range variations are one fourth of the ranges indicated in Table2.1. The method for changing the above percentage ranges is described in Chapter 3.A warning is given that the ranges should not be substantially increased. Theadvantages that come from additional planning and forecasting decrease as therelative uncertainty of demand and price increase.

Student Specification of Product Price

Normally, the price of the product is determined within the game. An extra dimensionis added to the game by allowing the student specification of price. When price isspecified, the unit market demand for the product is variable, and inversely related tothe student's stated price. The function determining the demand, Dm, induced by amanagement-specified price, Pm, is

(2-6) Dm = Da($200 - Pm)/($200 - Pr),

where Da and Pr are the actual demand and price that would exist if the pricing optionwere not controlled.

It is recommended that the student price option should not be used at the beginning ofthe game. This is even recommended when using the game with advanced levelstudents. Successful decision making with respect to variable price requiressubstantial production, contribution margin, and price-demand elasticity analysis. Theeffort and time required in these areas will be substantialand will detract from the more central financial decision-making areas. Aftercompetence is demonstrated in the major financial decision-making areas, the studentprice option can be added. This will maintain interest and increase student knowledgein analytical areas that are more closely related to the areas of production and pricing.

Capital Budgeting Decisions

The capital budgeting alternatives are generated from two underlying projects.Uniformly distributed random numbers are used to generate both differences in initialcost, overhead costs, and the unit labor savings for each of the periods of life of theproject. The underlying projects were constructed so that some of the generatedprojects will not provide an adequate return. The percentage of acceptable projects is,inversely related to the firm's cost of funds.

Labor and Materials Costs

Unit labor costs are related to the volume of production. The computer environmentdecks provided with the game have step decreases in marginal costs per unit up to avolume of 120,000 units. The SUMMARY SHEET, Exhibit 2.2 of the SIMDEF text,provides the schedule of labor costs at the different levels of production that comeswith the game. There is a sharp increase in marginal cost per unit for any itemsproduced in excess of 120,000. These conditions require production planning tominimize the cost of output when there are variations in demand through time. Thus,the production planning decision can have an effect on the performance of the firm.The given structure of costs can easily be changed by the instructor. If, for instance,the instructor did not want a volume production strategy to directly affect theperformance of the firm, the labor costs per unit could be kept the same for all levelsof production. The procedure for changing the labor costs are described in Chapter 3.

Material costs are constant, they are not functionally related to any environmental orfirm variables. The instructor has direct control of the per unit material costs; they canbe changed each quarter.

The Labor Strike

The labor strike is a special option initiated by the instructor. When the option isinitiated, a statement about the strike appears on every student's next set of financialstatements and summary data. The statement indicates that bargaining with the laborunion is continuing and that in two periods the firm will possibly have a strike if theydo not fully meet the union's demand of a permanent $2 increase in labor cost perunit. A compromise offer of a $1 increase in labor costs can be entered by the studentwith a 30 percent probability of a one-period strike. T.he third student option is torefuse all union demands and accept a 60 percent chance of a one-period strike. Theproblem is a complex one requiring students to examine the possible trade-offsbetween opportunity losses with missed production and increases in costs throughoutthe game due to fulfillment of the union demands; it would also affect theirpresettlement production strategy.

Inventory Carrying Costs

Additional out-of-pocket costs are charged for inventory balances. There are threecost-perunit rates.

TABLE 2.2

Inventory Carrying Costs

Cost per unit Inventory increment

$ 1 1 - 2,0003 2,001 - 7,0008 7,001 +

The three costs supplied with the game were constructed to make the holding ofinventory greater than 7,000 units uneconomical in most circumstances. The studentscan easily miss this conclusion if they fail to consider additional costs of the fundsinvested in the inventory when making their decisions. The instructor has the optionof entering his desired set of carrying costs. For example, if the carrying costs forgreater than 7,000 units were set approximately equal to the marginal cost per unit,the affect would be similar to having a perishable product.

Accounts Receivables Discounts

The student choice of discount terms is a special option. A financial model needs tobe constructed by the game managers if they are to maximize the position of theirfirm. The discount policy only affects receivables collections. There are no effects onthe sales demand of the product. The student's alternatives are to have no discount, a 1percent discount, or a 2 percent discount.

1. With no discount, 33 percent of the quarterly sales are collected in the currentperiod. This implies accounts receivable terms of net 60.

2. With a 1 percent'discount rate, 80 percent of the quarterly sales are discounted andcollected in the same quarter. Twenty percent of the receivables do not take thediscount. As in the nodiscount case, 33 percent of this 20 percent is collected inthe current period and 67 percent in the next quarter.

3. The amount discounted is 90 percent with the 2 percent discount. Cash inflows areon the 90 percent discounted and 33 percent of the remaining 10 percent.

One would expect part of the discounted receivables to be collected in the followingperiod. For simplicity, it is assumed that all discounted receivables are collected in thecurrent period. The students are notified of this condition in the text. Otherinformation on the percentage of collections with the 1 or 2 percent discount is notprovided to the students in the text. In lower level courses, the information on thepercentages of collection should be provided by the instructor. At higher levels, thestudents should be told that by testing they can determine the information necessaryfor determining the optimal policy. They will have to derive both the differences incollections and the amount of sales discounted. The trade-off between decreased salesrevenue and the decrease in carrying costs of the receivables will have to beconsidered in deriving the optimal discount policy. In the game, the only receivablescarrying costs is the cost for the funds invested for the receivables.

Short-Term Liquidity Management

Cash, marketable securities, and a penalty cost loan are used to maintain a positivecash balance. If management has failed to obtain a positive ending cash bjilance, thenthe game will automatically make adjustments in marketable securities and thepenalty loan to assure the maintenance of liquidity. Additional rules governingliquidity maintenance are provided in Chapter 2 of the SIMDEF text.

Marketable securities. Marketable securities earn an annual rate of return equal to thecurrent base rate, R0, presented in the economic indicator section of this chapter.Additional marketable securities can be either purchased or sold each period. Planningfor cash flows and adjusting securities balances to accommodate the needs must beperformed each quarter. Because of oversights, errors in statement preparations, orforecasting errors, a liquidity problem can arise where there is insufficient cash. If apositive marketable securities balance exists, the cash shortage will automatically becovered by liquidating a sufficient amount of marketable securities to cover the short-age. The marketable securities liquidated will be discounted by 3 percent to cover"transaction" costs. Thus, if c is the cash shortage, the marketable securities retired,Sm, would be

(2-7) Sm = 1.03c.

The 3 percent discount serves as a penalty for faulty cash flow planning. The discountis a current period interest expense included in the section, "Short-Term Loan Interest:Shark Loans, Inc.," of the QUARTERLY PERFORMANCE STATEMENT. Thenegative cash balance can exceed the discounted marketable securities. If this occurs,all the marketable securities are retired at a discount, and a short-term high-costpenalty loan is issued to cover the remaining negative cash balance.

Short-term penalty loan. Shark Loans, Inc. advances short-term funds on a quarterlybasis to cover insufficient cash balances. The rate charged on the loans can bespecified by the instructor. Thus, if no penalty is desired, a low rate equal to or near toa short-term loan rate can be used. The environment cards supplied with the game usea 5 percent quarterly interest charge. This imposes a healthy penalty formismanagement of liquidity in the form of a 20 percent annual charge before taxes.The penalty loans are automatically retired in the next quarter provided that there aresufficient ending cash and marketable securities balances. The penalty loan continuesto be replaced if cash deficits occur.

Selling and Administrative Expenses

Selling and administrative expenses include a fixed cost component of $1,000,000 anda variable cost component equivalent to 5 percent of total dollar sales. The expense isa current quarter cash outflow. Costs of purchased demand and price forecasts alsoenter this account.

Accounts Payable Balances

Ten percent of the total of quarterly materials, labor, and other overhead chargesenters the account, "Accounts Payable." The balance in the account is paid in the nextquarter.

Cost of Funds and Valuation

Debt and equity costs are affected by both the economic indicator and risk. Businessand financial risk are incorporated into the risk measure; additionally, debt costs areaffected by the life of the debt issued.

Debt maturity and cost. A multiplier that is an inverse function of the life of the debtissue is used. The multiplier is applied to the base interest rate, defined earlier, indetermining one of the components of the cost of a debt issue. The multipliers of thebase rate are as follows:Short-term loans 1.5Two-year intermediate term loan . 1.3Three-year intermediate term loan 1.1Long-term debt 9

This declining schedule makes shorter term funding relatively more expensive. This isdone to partially reward the students for the additional planning required with longerterm debt. The students should also obtain some extra return for accepting, throughlonger term commitments, a decrease in the flexibility of their firm's capital structure.

The debt cost component just covered contains an effect from the economic indicatorthrough the base rate, R0; a further effect comes from the maturity of a debtobligation, through the multiplier. A risk rate is used as a second debt component.

Debt risk and cost. The probability of not obtaining a ratio of operating income beforefinancial expenses to financial expenses equal to one is used in determining theinterperiod risk component of debt costs. A second risk factor adjusts for intraperioddebt changes. This is used to constrain massive single-period debt offerings until theinterperiod risk premium can be adjusted for the new higher level of debt.

First, with the interperiod risk component, the times interest earned figure iscalculated for the current period. The ratios for the last seven quarters are in eachfirm's historical data (maintained on punched cards). The average, E, and the standarddeviation, a, of the times interest earned ratio for the eight periods are calculated. Anassumption is made that the ratios are normally distributed around E with a standarddeviation of a. With this information, the probability that the firm will not obtain aone times interest earned figure can be calculated.1 In Figure 2.1 a below, this is 16percent,

FIGURE 2.1

Times Interest Earned Examples

while in 2.1b the probability is 80 percent. An annual risk premium between zero and23 percent is generated depending on the probability obtained above.

The probability of default in a real-world situation is closely tied to the ability ofmaintaining, through time, an interest earned ratio greater than one. The inability to'maintain this position will eventually lead to insolvency. Using an eight-quarter ortwo-year average, the firm's position can deteriorate for some time before insolvencyoccurs. Again, this is similar to a real-world situation where a firm has severalmethods of acquiring emergency funds to temporarily avoid interest default.

The continued profitability of the firm is more important to longer term debt than toshorter term debt. Short-term liquidity, and thus the ability to repay short-term debt, isoften not dependent on the profitability of the firm. Yet, long-term liquidity is onlyobtained through maintenance of profitability. Therefore, factor multipliers on the riskcomponent are positively correlated to the life of the obligation. They are:

Short-term loans 467Two-year intermediate term loan . . . 538Three-year intermediate term loan. . 637Long-term debt 778

Thus, the risk component of debt cost is derived by multiplying the risk premiumtimes the appropriate factor multiplier.

Business risk is implicitly included in the calculated costs of debt. The expectedoperating income and its variance determine the level of the business risk. Operatingincome is in the numerator of times interest earned ratio. Thus, for example, anincrease in the variance of operation income, with financial charges held constant,will result in an increase in the variance of the times interest earned ratio. Thisincreases the probability of not obtaining a one times interest earned and results in ahigher interest premium for risk. Likewise, financial risk increases the dispersion ofexpected returns and usually results in an increase in the risk of insolvency. Financialrisk is also incorporated into the risk premium since the denominator of the timesinterest earned ratio includes total fixed financial charges. For example, if all othervariables are held constant, as fixed financial charges increase, the probability of onenot obtaining an interest earned ratio of one increases with a resultant higher riskpremium.

The second risk factor is for intraperiod adjustment and is derived directly from thesize of a new debt offering. This cost increases by .125 percent per million dollars ofnew debt for the shortor intermediate term loans. Thus, if the underlying quarterly rateof an offering were 2 percent and an offering of $6.5 million were made, the yield on

the entire issue of new debt would be 2.75 percent (2 + 6 x .125). The bonds use anincremental cost of .25 percent for every increrhental $2 million of debt. The size ofthe offering risk premium is applied to each specific type of debt; the aggregate debtoffered in a given quarter is not used in determining the premium. The students arenot provided with specific information on the risk premium functions and must factorout both the rates of increase (.125 of .25 percent) and the size of debt increments ($1or $2 million) before they can accurately estimate future debt rates. Until the studentsgain more knowledge of the expected consequences of their decision, they should bewarned against major changes in debt policy.

The total debt cost is the sum of the maturity adjusted economic component and therisk component. Even though the debt cost model may seem quite complex, the basicrules underlying it are easily understood by most students. The text material helpssubstantially in explaining the basic principles to the students without disclosing theexact nature of the underlying model.

Preferred stock cost. Preferred stock cost is derived in much the same manner as debtcost. A multiplier of 1.6 times the base rate gives the economic component. The riskcomponent is calculated like the debt risk component except the times interest earnedis defined differently. With preferred stock, the times interest earned ratio is obtainedby dividing the before-interest cost operating income by the expenses and a before-taxdollar cost of preferred dividends. The investors' required rate of return on preferredstock includes both the economic and risk component.

Common stock cost. A risk-adjusted cost that is affected by the economicenvironment is used in the pricing of common stock. A risk-return valuation model isused where expected percent returns of a security and a measure of the reliability ofexpected returns are used to represent the return and risk component.2 An equilibriummarket condition is assumed where all equities are valued according to a single capitalmarket line, r*r', of Figure 2.2, in risk-return space. In the game the total dollar netearnings after taxes to common shareholders for the current and last seven quarters areused as input into the common stock valuation model. The equilibrium value of allcommon stockholders' equity is derived using a capital market line equivalent to r*r'of Figure 2.2.

The actual valuation procedure employs two future earnings estimates and a hybridrisk measure. The first earnings estimate, El, is the average earnings derived from thecurrent and last seven quarters' earnings. The second earnings estimate, E2, is derivedfrom a regression line. A best fit least squares linear regression line is derived usingtime as the independent variable and the eight historical quarterly earnings figures asthe dependent variable observations. Figure 2.3 provides a graphical example of thederivation of El and E2. In the example, the historical input data for quarters 1through. 8 are used in deriving the two estimates for quarter 9. The final earningsestimate, E, is derived from the two estimates, E1 and E2, and the coefficient ofdetermination, S, of the least square regression line,

(2-8) E = E1(1 - S) + E2S.

The earnings estimate, E, is directly used in the final valuation model. The aboveprocedure places greater weight on the regressed earnings estimates as the reliability

of the regressed line increases. Alternatively stated, as the reliability of the regressedestimate decreases, increasing weight is placed on the average historical earnings,little reliability can be placed in estimates varying from the historical norm.

A dispersion of expected returns measure is used as the measure of risk in thevaluation model. The coefficient of determination, S, represents the percentage ofvariance in earnings that is related to time. It is a measure of the reliability of theregression line. Therefore, (1 - S) is used in the valuation model as the measure ofrisk.

The derived return estimate, E, and the dispersion measure, S, of the eight total dollarearnings figures are used in obtaining the total value of the common equity of thefirm, V. The value is found by capitalizing by the base rate, r*, the total of the derivedearnings estimate, E, less the multiplier, b, times the dispersion, of estimates measure,(1 - S). In symbolic form

(2-9) V = (E - bE[l - S))/r*

where the value of an individual share is derived by dividing V by the total number ofshares outstanding.3 The multiplier b is equal to .1R0 in the-game. With a positiveslope to the capital market line,

The equation is equivalent to valuing according to the capital market line of Figure2.2. From the equation above,

(3)(2- 10) r* = E - bE(V- S)

V V

(2-11) E = r* + bE(1-S) V V

as indicated in Figure 2.2, increased. returns are required for increases in the varianceof common shareholders' returns. This condition is consistent with theory andempirical evidence. Business risk is included since variances in operating incomedirectly determine the dispersion in expected returns of residual equity holders.Financial risk;is also included since the dispersion in common shareholders' returnsare positively correlated to the level of fixed cost funding used by the firm.

The economic environment affects the valuation of common stock. The risk-adjusteddollar returns of the firm that are in the numerator of equation 2-9 are capitalized bythe base rate, r*, which is a function of the economic condition. Second, themultiplier, b, is positively related to the economic indicator. Both of these conditionshave the effect of increasing both the intercept and decreasing the slope with respectto the return axis of the capital market line as the economic indicator improves. InFigure 2.4, sequentially higher economic conditions would be represented by thecapital market lines that start at rl*, r2*, and r3*. The conditions incorporated into themodel allow it to approximate the potential real-wprld situation that is describedbelow.

FIGURE 2.4

Risk-Return Trade-Off Functions Risk

In this environment, the alternative opportunity for returns outside the firm increasewith prosperity; thus, there is an increase in the required rate of return for any givensecurity or investment. The increase required returns, through the shift to the right ofthe capital, market line, could also be caused by higher inflation that oftenaccompanies more prosperous times. Further, as prosperity increases, more firmsobtain successful and more stable earnings. Increased opportunities for higher returnsand stable growth decrease the market desire to hold firms still maintaining unstableearnings. This market movement away from firms still having high-risk stocks wouldalso be expected if higher levels of inflation were anticipated. Both of theseconditions would cause a decrease in the slope of the capital market line atsuccessively higher levels of prosperity.

The firm that maintains either more stable and/or higher earnings trends through timewill achieve a higher share value and performance measure. Items that affect eitheroperating income variations or financial leverage can affect share price. For example,a capital budgeting project may offer a rate of return equivalent to the firm's cost ofcapital and yet not high enough to warrant purchase. This could occur if the heavyfixed costs charges from depreciation and increases in overhead costs causes anincrease in the variance of shareholders' dollar income. This would cause a shift toboth a higher required percentage return rate and standard deviation rate. The cost ofcapital of the firm would increase and the capital budgeting project would not give anadequate return. Thus, decisions on applications of funds can affect the expectedoperating income and its variance with a resultant change in the risk and requiredreturn of equity holders. Similarily, decisions affecting the capital structure can affectthe expected common stock dollar earnings, and thus, the risk and required return.

The value of common stock is further modified through dividend payment andstability models. In the dividend payout model, the required payout is inverselyrelated to the growth rate of the company's earnings stream. The growth rate is theaverage earnings percentage growth rate over the current and last seven quarters. Thepayout ratio is calculated with the average of the current and last three quarters'dividends. The optimal payout rate for annual earnings growth rates between 20 andzero percent is between zero and 80 percent. The penalty for incorrect decisionsranges from zero to 25 percent of common stock price. If liquidating dividends arebeing made, the penalty can approach 100 percent of stock price. The penalty isdirectly related to the distance of the firm's payout policy from the calculated optimalpayout rate. An error of 7.5 percent above or below the optimal payout rate isallowed. For example, assume a 50 percent payout ratio is the optimal for the firm

Risk

Return

having an 8 percent annual growth rate in earnings. If the firm's actual payout ratio isbetween 42.5 percent and 57.5 percent, the payout rate would be acceptable and nopenalty would be imposed. If the actual payout is either above or below the 42.5percent to 57.5 percent payout ranges, a penalty decreasing the value of the stockwould be imposed. The further the percentage range from -the optimal, the greater thepenalty. The dividend stability model only considers a downward move in the currentdividends. Increases in dividends are not viewed as violating the stability policy. If thecurrent quarter's dividend divided by the average four-quarter earnings is more than20 percent below the optimal payout rate a penalty for loss of stability will beimposed. The penalty can be as great as 8 percent of the adjusted common stock price.The adjusted common stock price includes the previous dividend payout penalty. If afirm's payout is consistently more than 20 percent below its optimal, a specialcondition arises. In this situation, the dividends could be stable, i.e., not decreasing ingiven periods, and a penalty would still be imposed. In this situation, the penalty is ineffect an additional penalty for a poor payout decision.

Issuance, Retirement, and Repurchase of Debt and Equity

The underlying models and conditions for issuance, retirement, and the repurchase ofdebt and equity influence the attainment and maintenance of the desired capitalstructure. Shifts in the costs of different debt and equity securities can force a revisionin the desired capital structure. Therefore, the determination of the costs given in aprevious subsection should be considered in both establishing and modifying capitalstructure through issuance, retirement, and repurchase of debt and equity.

Short-term loans. Short-term loans are issued for four quarters and are repaid in equalinstallments. The loan is taken out at the beginning of the quarter with the first fourthrepaid at the end of the quarter. Retirement is automatically made by the program.There is no option to retire before maturity. A current interest rate that changes withboth the environment and times interest earned ratio is used to calculate interest costs.There is a new rate each period, not too unlike a prime rate. This new rate is appliedto all short-term loans outstanding, not just the new short-term loans.

Intermediate term loans. A two- or three-year intermediate term loan is available. Thenew loans are repayable in eight or twelve equal quarterly installments. The loan istaken out at the beginning of the quarter and repayment starts at the end of the quarter.Retirement is automatic. Retirement before maturity is also allowed without penaltyor extra cost. The most recent installments are retired first. The cost of newintermediate loans is at a current rate that includes both an economic environment andboth a times interest earned and size of offering risk component. An historicalweighted average cost is used on previous intermediate issues. The previous issues areaggregated and thus it is not possible to retire specific issues as one would be able todo in a real situation.

Long-term debt. Long-term debt has a life of ten years. A given bond at the beginningof the quarter is repayable in 40 equal quarterly installments starting at the end of theissuance quarter. Retirement is automatic. There is a $10,000 floatation cost everytime bonds are issued. This condition reduces the students' use of unrealistically smallissues.

The bonds are callable at a premium specified on the students' SUMMARYINFORMATION STATEMENT. This premium is constant throughout the gameunless changed by the instructor. The most distant installments are retired first. Theinterest rate on the new bonds is derived in a manner similar to intermediate debt, theprocedure outlined above. A weighted average percentage cost is used on all previousbond issues. Dollar amounts of various original issues coming due in a given quarterare aggregated; thus, there is no way to retire a particular issue. An "average" bond isretired.

Preferred stock. Preferred stock is perpetual, once issued it remains outstanding untilrepurchased. The market price of preferred, Vp, is determined by capitalizing theconstant dividend, Dp, by the current preferred stock's required rate of return, rp,

The company's receipts have to be adjusted for floatation costs of $5,000, an initial 5percent discount, and an add on 2 percent discount for every $1,000,000 of marketvalue worth of stock sold.

To minimize the costs of funding, the fixed and variable floatation costs for bonds,preferred and common stock require students to sequentially fund with different typesof issues rather than offer a small amount of each type every time they seek externalfunding. This condition is offset by the'size of offering risk premium. Therefore, anoffering that is either too small or large can increase the company's cost of capital.Further decisions should be made on the frequency of external funding, size offunding, and the maintenance of flexibility needed to react to specific conditions thatmight arise with changes either in the economic environment or firm's position.

Preferred stock is repurchased either at a call price or at current market price,whichever is lower. The call price per share is determined by multiplying thepreferred's average book value per share times one plus a call premium. The callpremium is constant throughout the game unless changed by the instructor. Stocktransactions take place at the beginning of the quarter and dividends are paid only onthe shares outstanding at the end of the period.(2-13) Vp = Dp/rp

Common stock. Common stock can either be issued or repurchased. The issuance isexplained to the students as coming from a primary offering through an investmentbanker. The students supply both the number of shares, Sn, they desire to offer andthe minimum receipts, M, per share that they will accept. The model is

(2-14) R = P - 5000 1.06 + .5Sn/S0 Sn

The actual receipts per share, R, that would be obtained is determined through twofactors. First there is a $5,000 fixed cost per common share offering, represented bythe last component of the equation. The first component discounts the currentcommon stock price, P, by 6 percent to adjust for floatation costs. This componentalso includes a function, .5Sn/ S0, that makes the receipts, R, inversely related to thesize of the offering. S0 is the total number of shares currently outstanding. If the

receipts per share, R, equal or exceed the minimum, M, the offering is made and thefirm receives R dollars per share. If M > R, the underwriter does not accept theoffering. There are no penalties for an offering that fails other than the obvious onethat no shares are issued. If no minimum, M, is entered by the student, the offering ismade at a per-share receipts to the firm of R. The three factors included in the modelare those thought to most influence the receipts on an offering. In summary, there is:(1) a fixed cost per offering, (2) a variable cost that is a fixed percentage of the totaldollar receipts, and (3) an adjustment for the size of the supply relative to theoutstanding shares of the company.

Common stock repurchase is made by a tender offer. Students enter the number ofshares, Sn, they wish to repurchase and the price, M, they will pay. Models within thegame determine the price, R, that the shares would be bid to if Sn shares weredemanded. As the demand shares, Sn, increase, the required price, R, increases. If thetender price, M, is greater than the demand adjusted market price, R, the tender isexercised and the shares repurchased at a price of M. If R is greater than M, the tenderoffer fails and a $1 per-share charge for the Sn shares tendered is paid by the firm.This would cover the advertising, legal, and other costs involved in initiating theunsuccessful tender. The fees and transaction costs of a successful tender are coveredby the per-share increase in the price they must pay over the current market price.

Conclusions

The major models underlying the game were presented. The set of models provides asimulation environment conducive to learning additional finance and generaldecision-making skills. Chapter 4 of the student text provides material on the realismof the game's rules, conditions, and models.

Less accurate information is provided in the SIMDEF text than in this chapter topurposely require the participants to determine actual underlying models. With thelack of knowledge of the actual models, the students face a more uncertain, complex,and realistic decision-making setting.

Many of the rules and conditions in Chapter 2 of the student's text were not reviewedin this chapter. They were fully described in Chapter 2 of the text and no benefitwould be gained by their restatement. The instructor should review Chapter 2 of thetext to gain a thorough understanding of how the underlying models just explainedinterface with the additional rules and conditions that affect game play.