Deck 19: Strategic Behavior: the Application of Games

Question 1

The manager of Global X is contemplating the purchase of a new machine that will cost $300,000 and has a useful life of five years. The machine is expected to yield cost reductions to Global X of $50,000 in year 1, $60,000 in year 2, $70,000 in year 3, and $80,000 in each year in years 4 and 5. Will the acquisition of the machine add value?

Answer 1

Added value:
Added value is the difference between the price of the service or the product and the cost incurred for the production. It is the difference between the final price of a product and the indirect and direct inputs used in production.
Situation:
The manager of Company G contemplates the purchase of a machine. The machine's cost will be $300,000; its useful life is expected to be five years. The cost reductions for the machine will be $50,000 for the first year, $60,000 for the second year, $70,000 in the third year, and $80,000 for the fourth and fifth year.
Determine whether the acquisition of the asset will add value:
The cost of the machine will be deducted from the sum of the cost reductions for the five years.
Hence, the purchase of the machine adds value of
. It is a profitable condition for the company.

Question 2

Using the following balance sheet and income statement information, calculate accounting profit and economic profit:

Answer 2

Not answer

Question 3

Explain what occurs when a new technology makes another one obsolete in terms of economic profit. Consider firmAto be an existing firm using the old technology. Firm B is the new firm with the new technology. Firm A earned positive profits for years, but with the entrance of Firm B, Firm A's goods and services are no longer desired.

Answer 3

Economic profit:
Economic profit is not calculated according to the generally accepted accounting principles. Economic profit considers implicit costs along with the explicit costs. Normally, economic profit will be used to evaluate the total value of a company. Hence, the economic profit can show the real worth and performance of the company.
Situation:
Firm A is an existing firm; it is depending on the old technology. Firm B is a new firm and it is using technology that is more advanced. For the past few years, Firm A has earned positive profits. After the entrance of Firm B, the Firm A has lost its market and the services and goods were no longer desired.
Determine the outcome when a new technology makes another one obsolete in terms of economic profits:
Nowadays, the market became more competitive. Each day new firms are entering into the market with advanced technologies. By adopting advanced technologies, a firm will be able to produce more products with reduced cost and increased quality. Naturally, with the introduction of new technology, the old technology will become obsolete.
All the firms will try to make their technology up-to-date. If the technology of a company is not updated, then the firm will be thrown out of the market. The firms are competing each other to win over the market.
Here Firm A made profit in the market for few years. Firm A lost its market, at the time when Firm B introduced new technology. In order to retain the market, Firm A should adopt a technology similar to Firm A or any other advanced technology than that of Firm A.
By adopting the new technology, Firm B will be able to provide its goods at a lower price than before. With the existing technology, Firm A will not be able to provide its products at lower price. In order to resolve this situation, Firm A should find some other strategy. Firm A either can change its technology or can go for product differentiation.
Conclusion:
By adopting advanced technologies, a firm can make more profit. Hence, it is necessary for all the firms to make their technology up to date. Otherwise, the competitors will grab the market.

Question 4

In measuring economic profit:
a. How do you deal with a one-time event?
b. How do you deal with money provided by relatives to get the business started?
c. How do you handle off-balance-sheet expenses-that is, expenses that are incurred by the firm but are not measured as part of the firm's balance sheet?

Question 5

The following type of report occurs each quarter as firms announce their earnings: Weaker-than-expected results last week from Exxon Mobil have set a gloomy backcloth for results on Thursday from Royal Dutch/Shell. A consensus of Wall Street analysts polled by Thomson Financial/ First Call had projected ChevronTexaco would report earnings of 70 cents per share. However, the company said that after excluding special items and merger-related expenses in both periods, operating earnings were $931 million (88 cents). Using that math, the company beat the analysts' figure by 18 cents. The company said it lost $154 million in the first quarter, compared with the yearago quarter, in refining, marketing, and transportation operations. The company said its profit margins in that sector were at their lowest levels since the mid-1990s. Chevron stock closed up 90 cents, to $85.90, yesterday on the New York Stock Exchange.
a. Why does the stock market react to earnings reports?
b. What do the earnings reports mean?

Question 6

The manager of Global X is contemplating the purchase of a new machine that will cost $300,000 and has a useful life of five years. The machine is expected to yield cost reductions to Global X of $50,000 in year 1, $60,000 in year 2, $70,000 in year 3, and $80,000 in each year in years 4 and 5. Will the acquisition of the machine add value?

Question 7

You have just been hired as a consultant to help a firm determine which of three options to take to increase shareholder wealth. The following table shows year-end profits for each option. Assume that the risk-free cost of capital is 5 percent and the risk premium is 8 percent.

a. Calculate the economic profit for each option.
b. Suppose that the profit figures are based on earnings figures of 10 times profits and that there are 100,000 shares of stock outstanding. What are the earnings per share for each option?

Question 8

It is often stated that free cash flow is the same as economic profit. Define free cash flow. Demonstrate whether it is or is not the same as economic profit.

Question 9

Using the formula given in the text for stock price determination, explain why stock prices move up or down in response to quarterly earnings reports.

Question 10

Considering the Cost of Capital
When Roberto Goizueta became Coke's CEO in 1981, he took over a poorly performing company that had diversified into unrelated businesses ranging from water purification to shrimp farming. One of his first initiatives was to analyze Coke's various businesses using economic profit. The analysis concluded that only Coke's core carbonated beverage business was creating shareholder value. The other businesses, while generating revenue, were actually consuming value. Consequently, they were divested or shut down. Goizueta then focused on Coke's core beverage business using its substantial competitive advantages: global brand, worldwide distribution system, and sales and marketing expertise. The result was 18 years of success.
Similarly, when Bob Lane took over a poorly performing John Deere in August 2000, he quickly identified Deere's biggest problem: spending too much money to make money. Factories tended to overproduce, leading to a large number of very expensive, large farming machines simply sitting on dealer floors. Lane began looking at economic profit. He decided managers were treating capital as a free resource. He charged each division manager 1 percent each month of the cost of the assets they used and required that at the end of the year their financial results exceed the charges. Deere has done well in the succeeding years
What is the appropriate measure of a firm's performance?

Question 11

Use the following data to calculate economic profit in year 1.

Question 12

Calculate the added value for each of the following firms.

Question 13

Calculate the WACC-the weighted average cost of capital-using the following data:

Question 14

Considering the Cost of Capital
When Roberto Goizueta became Coke's CEO in 1981, he took over a poorly performing company that had diversified into unrelated businesses ranging from water purification to shrimp farming. One of his first initiatives was to analyze Coke's various businesses using economic profit. The analysis concluded that only Coke's core carbonated beverage business was creating shareholder value. The other businesses, while generating revenue, were actually consuming value. Consequently, they were divested or shut down. Goizueta then focused on Coke's core beverage business using its substantial competitive advantages: global brand, worldwide distribution system, and sales and marketing expertise. The result was 18 years of success.
Similarly, when Bob Lane took over a poorly performing John Deere in August 2000, he quickly identified Deere's biggest problem: spending too much money to make money. Factories tended to overproduce, leading to a large number of very expensive, large farming machines simply sitting on dealer floors. Lane began looking at economic profit. He decided managers were treating capital as a free resource. He charged each division manager 1 percent each month of the cost of the assets they used and required that at the end of the year their financial results exceed the charges. Deere has done well in the succeeding years
What does a focus on economic profit as opposed to a focus on accounting profit mean for a firm and its investors

Question 15

You have the following betas for firms. Calculate the cost of capital for each.

Question 16

Following is some standard accounting information for each of the firms shown. Can you tell which firm is the most successful? Explain.

Question 17

You are analyzing the beta for Hewlett-Packard and have broken the company into four business groups with equity value and betas for each group. Calculate the beta for HP as a company. If the Treasury bond rate is 7.5 percent, calculate the cost of capital.

Question 18

A cost of capital figure for each of the firms is listed below. Explain what this figure means.

Question 19

Would it make a difference in the calculation of the cost of capital whether you looked at the short-term U.S. government rate rather than the long-term U.S. government rate as your risk-free rate? Under what conditions would you choose long term? Short term?

Question 20

Listed below are financial figures for Abbott Labs. How well is Abbott doing? Explain your answer.

Question 21

Evaluate the following statements:
a. The price of a firm's stock is a function of the expected earnings of that firm.
b. Changes in the stock price result from surprises rather than realized expectations.
c. If everyone had the same expectations, no stocks would be traded

Question 22

Explain why economic profit provides a better measure of profit than accounting profit.