Essay Cherry: Net Present Value

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Problem Set #1
Q.1 In your own words, define the concept of scarcity and opportunity cost. What role do these concepts play in the making of management decisions?

Scarcity is a condition that exists when resources are limited relative to the wants and demands of the society.
Opportunity cost is the amount that is sacrificed for the best alternative forgone.
Management always makes decisions to work with the scarce resources with the minimum opportunity cost borne. Q.2 You manage a company that manufactures Butty Jeans. Your company paid $500,000 for a 200 year old pair of Butty Jeans—the oldest known pair of jeans—by outbidding several other bidders in an eBay Internet auction. Does this situation best represent producer-producer rivalry, consumer-consumer rivalry, or producer-consumer rivalry? Explain fully

It represents the consumer to consumer rivalry because when the firms are bidding, they all act as a consumer and the consumer (firm) willing to pay the maximum amount consumes the product.

Q.3 On Friday, the CEO of the giant Pens and PDA manufacturer, Li Inc, gave its manager, Lin, a notice of dismissal

With the company opportunity cost of funds at 7%, Lin used $20,000,000 of the company money to purchase a new equipment that has a useful life of 3 years. The machine will yield (year-end) cost reduction to the company of $7,000,000 a year

Lin’s justification for undertaking the project is that by spending $20,000,000 today, the company will reduce cost by $21,000,000 in three years. However, the CEO did not agree with this reasoning. Explain to Lin why the CEO was unhappy with the decision to purchase the machine? Show all your work.

Lin, the information you obtained about future sales is indeed accurate but you forgot to factor in your projected net present value. If we assume that there are no other cost associated with your project, the present value of your projected sales is

PV=70000001.07+70000001.072+70000001.073=$18,370,212

By purchasing the software, your company will lose 20m- 18.4m = 1.6m (roughly) on the deal. Lin, you were fired because you did not recognize the time value of money.

An alternative way of calculating it is the net present value method where:

NPV=70000001.07+70000001.072+70000001.073-20,000,000=- $1,629,788

So if NPV<0 then reject the proposal. This is
Q.4 What is meant by the goal of ‘maximization of shareholders wealth’? Why is profit maximization, by itself, considered an inappropriate goal of the firm? * Maximizing the shareholders wealth means to increase the power and position of the shareholders by increasing the present value of the shares as shareholders always look for a capital gain from the firm. * Profit maximization means maximizing the profit of the firm alone which is the economic goal which would not factor the long term goals, benefits and the risks involved. But the real profit is maximizing the market share and growth rate which means COGS and growth of the firm over time respectively.

/TAMARA’S ANSWER/
Shareholder wealth maximization is the more comprehensive of the two. Profit maximization is a period of value that may be obtained by short-term management action which could be detrimental to profits in future periods.

But a company with longer range horizons will want to consider a stream of earnings (or cash flows) over time. This stream is then discounted at the company’s cost of capital to the present to obtain the present value of this stream. This present value is the value of the firm or that of the stockholders. When such an objective is used, the company is considering the shape and duration of the cash flow stream and the return required by stockholders (i.e. the equity cost of capital). The required rate of return is affected by risk, and, thus, risk enters into the valuation. Obviously, this measure is much more inclusive than the maximization of profit for any one period.

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