Chapter 8 Homework

1. Chapter 8 Homework Numbers 1, 5, 10, and 13

2. Chapter 8 Appendix How does all this relate to my other business classes???

3. More terms of importance • Operating Income • Also called operating profit • Measure of money a company generated from its own operations • Can be used as a gauge of general health of the business • Operating Income = gross profit – operating expenses • Net income before tax • NIBT • Net income after tax • NIAT • Final income after deducting all expenses from revenue

4. What does the statement do? • Shows business earnings • Provides insight to how effectively the firm is being run • How controlled are costs? • How much is spent in developing new products? • Is the firm moving forward or stagnant • Can calculate profit and operating margins to compare to competitors

6. So what can we do with this? • Gross Profit Margin • Measures the company’s manufacturing and distribution efficiency. • The higher the percentage the more efficient the firm is running • For John in 2004  7914/12154 = 0.65 • For John in 2005  5564/8488 = 0.66 • Tends to remain relatively stable overtime • If large swings do occur…fraud or funny business may be to blame 

7. Interest Coverage Ratio • Measurement of a company’s debt burden • The lower the ratio the higher the burden • Measures the number of times a firm could make its interest payments with its earning before interest and taxes • Safety net  looks at the short term financial health of the firm • For John in 2004  2984/332 = 8.99 • For John in 2005  2110/196 = 10.77

9. Net Profit Margin • Shows how much profit a company makes for every $1 it generates in revenue • Higher is better • For John in 2004  2096/12154 = 0.17 • For John in 2005  1355/8488 = 0.16

10. Can we do it? • In 2002, Donna Manufacturing sold 100,000 widgets for $5 each, with a COGS for $2 each. It had $150,000 in operating expenses, and paid $52,500 in taxes. What is the net profit margin? • TR = 100,000*5 = 500,000 • TC = 100,000*2 = 200,000 • Gross Profit = 500,000-200,000 = 300,000 • NIBT = 300,000-150,000 = 150,000 • NIAT = 150,000 – 52,500 = 97,500 • NPM = 97,500/500,000 = 0.195

11. Return on Equity (ROE) • Reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet • Shareholder equity = total assets – total liabilities • A high ROE typically signals that a firm is capable of generating cash internally • The higher the number the more return you are getting on your equity the better

12. Can we do it?? • Martha Stewart Living reported net earnings for 2004 to be $21,906,000 while shareholder equity for 2004 and 2005 was $222,192,000 and $196,166,000 respectively. What is the ROE? • Is this good? • Management is earning a 10.47% return on shareholder equity • Most S&P 500 firms average ROEs of 10 – 15%

13. Why is ROE important? • Helps you cut to the chase on annual reports • Many CEOs will state that they achieved “record earnings” • What does that mean? • Each year a successful firm creates profits • If they would take this money and put it in a simple savings account earning very little interest… • The interest gained on it would be enough to set a new record earnings status for the next year. • Big deal • ROE allows investors to see how effectively their capital is being reinvested

14. Return on Assets • ROA tells an investor how much profit a company generated for each $1 in assets • Looks at the asset intensity of a business • Do you need big, expensive pieces of machinery to make your product or not? • Looks earnings in relation to all of the resources the company had at its disposal • Shareholders’ capital plus long and short term borrowed funds • If a company has no debt  ROE = ROA

15. Two ways to calculate ROA Asset turnover measures the total sales [revenue] for every dollar of assets a company owns TR/average assets

16. Calculate the ROA for 2001

18. Now let’s analyze Abercrombie and Fitch

21. What do we see?? • Gross Margin in 2005: gross profit /net sales • Gross Margin = 558034/1364853 = 41% • Gross Margin in 2004 = 509375/1237604 = 41.2% • Gross Margin in 2003 = 450383/1030858 = 43.7% • Investors will question why is the gross margin falling??? • What has happened in the industry? • What is happening to competitor’s gross margin?? • Interest coverage ratio: EBIT/total interest expense

22. ICR = 276522/5064 = 53.60 • The company can afford to make its interest payments 53+ times before having financial issues • Looks financially stable. • Net Profit Margin = NIAT/TR • NPM in 2005 = 168672/1364853 = 12.4% • NPM in 2004 = 158133/1237604 = 12.8% • NPM in 2003 = 149604/1030858 = 14.5% • Must compare to competitors to gain insight on what is a good number • ROE in 2005= net profit/average shareholders’ equity • ROE in 2005 = 168672/((595434+422700)/2) = 33% • Management is earning 33% return on retained profits

23. Is that good? • An investor would want to go with the firm in the industry that is earning the highest return on shareholder equity • Average corporations earn between 10 and 15% • Abercrombie is doing FANTASTIC!! • Asset Turnover = TR/average assets • AT in 2005 = 1364853/((770546+589577)/2) = 2 • This number is meant to be a measure of a company’s efficiency in using assets • The higher the number the better (but compare to other firms in the industry) • The higher the asset turnover the lower the profit margin tends to be

24. ROA = Net profit Margin * Asset Turnover • ROA in 2005 = 0.124*2 = 0.248 or 24.8% • So is this a good company to invest in?? • Sales, gross profit, and operating profit all have been increasing • Gross and profit margins have been decreasing • Higher return on shareholders’ equity • Looks really good!!

25. Managerial Economics & Business Strategy Chapter 9 Basic Oligopoly Models

26. Oligopoly Environment • Relatively few firms, usually less than 10. • Duopoly - two firms • Triopoly - three firms • The products firms offer can be either differentiated or homogeneous.

27. Role of Strategic Interaction • Your actions affect the profits of your rivals. • Your rivals’ actions affect your profits.

28. An Example • You and another firm sell differentiated products. • How does the quantity demanded for your product change when you change your price? • Depends on whether or not your rival changes their price as well • Demand will be more inelastic if other firms DO match • Amount of product bought will change but not by much

29. P0 Q0 D2 (Rival matches your price change) P D1 (Rival holds its price constant) Q

30. What usually happens • Rivals will not match price increases • Rivals will match price decreases • Why? • Causes a KINK in the demand curve • Sometimes called Kinky Oligopoly Theory 

31. D2 (Rival matches your price change) P P0 D1 (Rival holds its price constant) Q Q0 Demand if Rivals Match Price Reductions but not Price Increases D

32. Key Insight • How much you sell with a price reduction depends upon whether your rivals cut their prices too! • How much you sell with a price increase depends upon whether your rivals raising their prices too! • Strategic interdependence • You aren’t in complete control of your own destiny!