Managerial Finance

1. Managerial Finance MB-664 Economic Concept Overview MB 664 UVG-TAMU May 2009

2. Today’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 MB 664 UVG-TAMU May 2009

3. Market Forces MB 664 UVG-TAMU May 2009

4. Expected Commodity Price D $7 S D = f(Po, PYD, Px, W, …) D = S $4 S = f(Po, MIC, …) $1 10 MB 664 UVG-TAMU May 2009

5. Implications for the Firm The Firm The Market Price Price D S ATC MC PE QE OMAX Quantity MB 664 UVG-TAMU May 2009

6. Implications for the Firm The Firm The Market Price Price D S ATC MC PE Profit QE OMAX Quantity MB 664 UVG-TAMU May 2009

7. Knowing Your Elasticities • Market demand related elasticities • Market supply related elasticities • Concept of price flexibility • Application and implications MB 664 UVG-TAMU May 2009

8. Inelastic Market Demand Elastic Market Demand Price Price %∆P>%∆Q %∆P<%∆Q ∆P ∆P Identical shift in the supply curve ∆Q ∆Q Quantity MB 664 UVG-TAMU May 2009

9. Concept of Price Flexibility If the own price elasticity of demand is equal to .25, then PF = 1/-.25 = -4.0 This means that if the supply coming onto the market is expected to increase by one percent,the price you can expect to receive for your products will fall by 4 percent. Price EP = - .25 -4% +1% Quantity MB 664 UVG-TAMU May 2009

10. Short Run Input Decisions MB 664 UVG-TAMU May 2009

11. Input Decision for Variable Inputs D C E B F G 5 I H J MB 664 UVG-TAMU May 2009

12. Least Cost Decision Rule This decision rule holds for a larger number of inputs as well… 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 capital = MB 664 UVG-TAMU May 2009

13. Least Cost Input Choice for 100 Units 7 60 MB 664 UVG-TAMU May 2009

14. What Happens if Wage Rate Declines? As a consequence, the firm would desire to use more labor and less capital… MB 664 UVG-TAMU May 2009

15. What Inputs to Use for a Specific Budget? Page 141 MB 664 UVG-TAMU May 2009

16. Short Run Enterprise Decisions MB 664 UVG-TAMU May 2009

17. Combination of Products The profit maximizing combination of two products is found where the slope of the production possibilities frontier (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 iso- revenue line MB 664 UVG-TAMU May 2009

18. Profit Maximization Product Choice 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. MB 664 UVG-TAMU May 2009

19. Profit Maximization Product Choice 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 MB 664 UVG-TAMU May 2009

20. Profit Maximization Product Choice 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. MB 664 UVG-TAMU May 2009

21. Long Run Capacity Decisions MB 664 UVG-TAMU May 2009

22. Growth of the firm…How much should we expand? Is this firm size earning a profit? Page 17 in booklet MB 664 UVG-TAMU May 2009

23. Growth of the firm…How much should we 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? MB 664 UVG-TAMU May 2009

24. Growth of the firm…How much should we expand? Firm size 2, 3 and 4 would earn a profit at price P…. Q3 MB 664 UVG-TAMU May 2009

25. Growth of the firm…How much should we expand? At size #2, the firm’s profit would be the green area shown above… Q3 MB 664 UVG-TAMU May 2009

26. Growth of the firm…How much should we expand? At size #3, the firm’s profit would be the area shown above… Q3 MB 664 UVG-TAMU May 2009

27. Growth of the firm…How much should we expand? Q3 At size #4, the firm’s profit would be the area shown above… MB 664 UVG-TAMU May 2009

28. Growth of the firm…How much should we expand? If price were to fall to PLR, only size 3 would not lose money; it would break-even. MB 664 UVG-TAMU May 2009

29. Growth of the firm…How much should we expand? 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 MB 664 UVG-TAMU May 2009

30. Expanding the Firm’s Capacity Page 19 in booklet Optimal input combination for output=10 MB 664 UVG-TAMU May 2009

31. Expanding the Firm’s Capacity • Two options if doubling output: • Point B ? • Point C? MB 664 UVG-TAMU May 2009

32. Expanding the Firm’s Capacity Optimal input combination for output=20 with budget FG Optimal input combination for output=10 with budget DE MB 664 UVG-TAMU May 2009

33. Expanding the Firm’s Capacity This combination costs more to produce 20 units of output since budget HI exceeds budget FG MB 664 UVG-TAMU May 2009

34. Expanding the Firm’s Capacity Growth expansion path MB 664 UVG-TAMU May 2009

35. Capacity Concepts MB 664 UVG-TAMU May 2009

36. Definitions • Engineering capacity – maximum output for which enterprise was designed • Economic capacity – output given economic objectives and normal operating policy • Capacity utilization rate – ratio of actual output to engineering capacity • Capacity efficiency rate – ratio of actual output to economic capacity • Desired utilization rate – ratio of economic to engineering capacity • Bottleneck – constraint on economic capacity MB 664 UVG-TAMU May 2009

37. Concept of Capacity Utilization at Market Level Price S1 Engineering capacity MB 664 UVG-TAMU May 2009

38. Concept of Capacity Utilization at Market Level Price S1 D1 P1 Economic capacity Engineering capacity MB 664 UVG-TAMU May 2009

39. Concept of Capacity Utilization at Market Level Price S2 S1 D1 P1 Actual output Economic capacity Engineering capacity MB 664 UVG-TAMU May 2009

40. Concept of Capacity Utilization at Market Level Price S2 S1 D1 P2 P1 Actual output Economic capacity Engineering capacity MB 664 UVG-TAMU May 2009

41. Concept of Capacity Utilization at Market Level Price S2 S1 D1 P2 Bottleneck P1 Actual output Economic capacity Engineering capacity MB 664 UVG-TAMU May 2009

42. Market Price/Quantity Relationships MB 664 UVG-TAMU May 2009

43. Stochastic Relationship Between Output and Price An example of potential market outcomes MB 664 UVG-TAMU May 2009

44. An interpretation of potential price variability MB 664 UVG-TAMU May 2009

45. Pro Forma Analysis of Future Trends A necessary element to evaluating potential investment alternatives. MB 664 UVG-TAMU May 2009

46. Evaluation Methods • Stochastic analysis of commodity prices and unit input costs • Risk and required rates of return • Risk adjusted capital budgeting • Pro forma financial statement analysis MB 664 UVG-TAMU May 2009