Deck 13: Market Structure and Competition

Question 1

In the Using the Theory section,we calculated the present value of attending a private college,under the assumption that each year's costs are paid at the end of the year. Recalculate the present value of these costs under the assumption that all costs are paid at the beginning of each year.

Answer 1

When the present value of an annual investment or annual cost is calculated at the end of each financial year,then the interest on the first lending is provided/charged. But when the present value of an annual cost is calculated at the beginning of each financial year,then there is no legit interest imposed.
The usual formula for computing the present value is shown as:
Continuing with using the theory section,the total annual cost or attending a private college is $46,474 that has to be paid in four years.
So there is no discounting on the first lending which is assumed to be 5%. In this way the present value of attending the private college is given by:
The present value of attending the private college in this case,amounts to $173,034.

Question 2

In the Using the Theory section,we calculated the present value of the costs of attending a private college,with no financial aid.
a. Using Table 1,what would have been the present value of the cost of college if we had done the analysis for a four-year public institution,with no financial aid? (Hint: Assume that future income does not depend on the type of college.)Table 1 Average Out-of-Pocket Cost of a Year of College,2010-2011
Source: Trends in College Pricing ,2010,The College Board,New York,NY.
Notes: Averages are enrollment-weighted by institution to reflect the average experience among students across the United States. Average tuition and fees at public institutions are for in-state residents only. Room and board charges are for students living on campus at four-year institutions and off-campus (but not with parents)at two-year institutions. Four-year private includes nonprofit only.
b. What is the percentage difference between the present value of costs at a private versus a public institution?
c. Private college tuition is about four times higher than public college tuition. Explain briefly why the (present value)cost figures do not differ this widely.

Answer 2

The cost of attending the college includes the implicit cost that is not explicitly paid but is counted as an opportunity cost of not working after passing high school and an explicit cost of attending the college. For a public institution,the total opportunity cost of attending amounts to $20,339.
a)The usual formula for computing the present value is shown as:
Compute the present value of the cost of attending a in-state public university as:
The usual formula for computing the present value is shown as:
Hence,a total of $72,121 will have to be spent in acquiring a degree through public institution,which is quite lower than the cost of attending private college.
b)The present value of the cost of attending private college is $164,794 while the same cost in public institution is $72,121. This indicates that there is difference in the two costs of about 128 percent (Private college is more costly).
c)This is true that the private college tuition is almost four times higher than the public institution. Yet the difference in the present values suggests that it is about two times higher. The reason is that the cost of books,supplies,room and board,and transportation costs all are almost same at both places. This narrows down the gap between the two type of costs (In fact,Transportation cost at private college is lower).

Question 3

More Challenging
In the chapter,you learned that when future income from an asset is uncertain,the asset's value will be less than the present value of its future payments. A different way to think about uncertainty is to calculate a modified present value,which uses a higher discount rate,equal to the safe lending interest rate plus a risk premium. In Problem 1,answer (a)through (d)again,assuming that (1)each interest rate provided in the problem is for riskless lending; and (2)the risk premium for developing new drugs is 20 percentage points.
Problem 1
A drug manufacturer is considering how many of four new drugs to develop. Suppose it takes one year and $10 million to develop a new drug,with the entire cost being paid up front (immediately). The yearly profits from the new drugs will begin in the second year (with profits,as always,assumed to come at the end of the year)and are given in the table below:
These profits,which are certain,accrue only while the drug is protected by a patent; once the patent runs out,profit is zero.
a. If the annual interest rate is 10 percent and patents are granted for just two years,which drugs should be developed?
b. If the annual interest rate is 10 percent and patents are granted for three years,which drugs should be developed?
c. Answer (a)and (b)again,this time assuming the discount rate is 5 percent.
d. Based on your answers above,what is the relationship between new drug development and (1)the discount rate; (2)the duration of patent protection?
e. Would the relationships in (d)still hold in the more realistic case where profits from new drugs are uncertain?
f. Is there any downside to a change in patent duration designed to speed the development of new drugs? Explain briefly.

Answer 3

The project has an upfront cost of $10 million and it will start earning profit only after the second year. Hence,in the first year there is only a cost of $10 million and at the end of second year,profits for the respective drugs will begin to realize. The interest rate and the risk premium for developing the drug are provided for each drug type.
a)The interest rate is 10 percent with patent protection for two years. There is a risk premium of 20 percent which is to be considered in riskless lending so that the discounting factor is 1.3.
The usual formula for computing the present value is shown as:
Use this to compute the present value of each drug. For example,drug A,if gets patent for 2 years,will have the present value:
If the total cost of manufacturing is paid,the firm earns a net loss of approximately $2.6 million. The cost and profit of the other drugs is summarized in Table 1
Table 1
Note that all the drugs are unable to earn any profit (after paying for the cost). Hence,no drug should be manufactured.
b)Now the patent is granted for three years and so profits will continue to occur for three years. Use this to compute the present value of each drug. For example,drug A,if gets patent for 3 years,will have the present value:
If the total cost of manufacturing is paid,the firm earns a net loss of approximately $0.2 million. The cost and profit of the other drugs is summarized in Table 2
Table 2
Again observe that all the drugs are unable to earn any profit (after paying for the cost). Hence,no drug should be manufactured.
c)When the discounting factor is 1.25,the interest rate being 5%,the present value of each type of drug will rise. Table 3 displays the present values of all types of drugs with an interest rate of 5%.
Table 3
Again observe that all the drugs are unable to earn any profit (after paying for the cost). Hence,no drug should be manufactured
d)The longer is the protection period,the minimized is the loss. See that drug type A suffers a loss of $2.6 million when the patent was granted for two years and it incurred a loss of $0.2 million if patent can be extended to one additional year.
The larger the discount rate,the smaller is the present value of a project. This is so because the interest rate is the opportunity cost of money and when the interest rate is high,the opportunity cost is also high. This reduces the present value.

Question 4

You are considering buying a new laser printer to use in your part-time desktop publishing business. The printer will cost $380,and you are certain it will generate additional net revenue of $100 per year for each of the next five years. At the end of the fifth year,it will be worthless. Answer the following questions:
a. What is the value of the printer if you could lend funds safely at an annual interest rate of 10 percent? Is the purchase of the printer justified?
b. Would your answer to part (a)change if the interest rate were 8 percent? Is the purchase justified in that case? Explain.
c. Would your answer to part (a)change if the printer cost $350? Is the purchase justified in that case?
d. Would your answer to part (a)change if the printer could be sold for $500 at the end of the fifth year? Is the purchase justified in that case? Explain.

Question 5

Suppose that 1,000,000 people select which stocks to buy and hold for the year by throwing darts at the stock page. Suppose,too,that in any given year:
• The average stock price rises by 7 percent.
• In any given year,50 percent of the dart throwers will have a return that is average or better.
• In any given year and by luck alone,20 percent of the dart throwers will "beat the average" by 5 percentage points or more.
• In any given year and by luck alone,10 percent of the dart throwers will beat the average by 10 percentage points or more.
a. After five years,how many people will report that they've earned 7 percent (the market average)or more on their stocks in every one of the previous five years?
b. After five years,how many people will report that they've earned 12 percent (5 percent above the average)or more on their stocks in every one of the previous five years?
c. After five years,how many people will report that they've earned 17 percent or more on their stocks in every one of the previous five years?

Question 6

Your inventory manager has asked you to approve the purchase of a new inventory control software package. The software will cost $200,000 and will last for four years,after which it will become obsolete. If you do not approve this purchase,your company will have to hire two new inventory clerks,paying each $30,000 per year. Answer the following questions:
a. Should you approve the purchase of the inventory control software if the relevant annual interest rate is 7 percent?
b. Would your answer to part (a)change if the annual interest rate is 9 percent? Explain.
c. Would your answer to part (a)change if the software cost $220,000? Explain.
d. Would your answer to part (a)change if the software would not become obsolete until the last day of its sixth year?

Question 7

Ice Age Ice is trying to decide how many $150,000 commercial ice makers to buy. Assume that each machine is expected to last for seven years. Complete the following table for an interest rate of 5 percent (and assuming no uncertainty). How many ice makers should Ice Age Ice purchase? How low would the price per machine have to fall before the firm would buy four ice makers?

Question 8

Your firm is considering purchasing some computers. Each computer costs $2,600,and each will add to your net revenue by known amounts. Because you plan to use the computers for different purposes,you have ranked those purposes in descending order of annual additional revenue as follows:
a. Assume that each computer has a useful life of three years,and no value thereafter. If the annual interest rate is 10 percent per year,how many computers should you purchase?
b. If,before you purchased the computers,the interest rate dropped to 5 percent per year,how many computers would you purchase?

Question 9

A drug manufacturer is considering how many of four new drugs to develop. Suppose it takes one year and $10 million to develop a new drug,with the entire cost being paid up front (immediately). The yearly profits from the new drugs will begin in the second year (with profits,as always,assumed to come at the end of the year)and are given in the table below:
These profits,which are certain,accrue only while the drug is protected by a patent; once the patent runs out,profit is zero.
a. If the annual interest rate is 10 percent and patents are granted for just two years,which drugs should be developed?
b. If the annual interest rate is 10 percent and patents are granted for three years,which drugs should be developed?
c. Answer (a)and (b)again,this time assuming the discount rate is 5 percent.
d. Based on your answers above,what is the relationship between new drug development and (1)the discount rate; (2)the duration of patent protection?
e. Would the relationships in (d)still hold in the more realistic case where profits from new drugs are uncertain?
f. Is there any downside to a change in patent duration designed to speed the development of new drugs? Explain briefly.

Question 10

Good news! Gold has just been discovered in your backyard. Mining engineers tell you that you can extract five ounces of gold per year forever. Gold is currently selling for $1,000 per ounce,and that price is not expected to change. If the discount rate is 5 percent per year,estimate the total value of your gold mine.

Question 11

One year ago,you bought a two-year bond for $900. The bond has a face value of $1,000 and has one year left until maturity. It promises one additional interest payment of $50 at the maturity date. If the interest rate is 5 percent per year,what capital gain (or loss)would you get if you sell the bond today?

Question 12

Suppose a risk-free bond has a face value of $100,000 with a maturity date three years from now. The bond also gives coupon payments of $5,000 at the end of each of the next three years. What will this bond sell for if the annual interest rate for risk-free lending in the economy is
a. 5 percent?
b. 10 percent?

Question 13

Suppose a risk-free bond has a face value of $250,000 with a maturity date four years from now. The bond also gives coupon payments of $8,000 at the end of each of the next four years.
a. What will this bond sell for if the risk-free lending rate in the economy is 4 percent?
b. What will this bond sell for if the risk-free lending rate is 5 percent?
c. What is the relationship between the bond's price and the level of interest rates in the economy in this exercise?

Question 14

Suppose that people are sure that a firm will earn annual profit of $10 per share forever. If the interest rate is 10 percent,how much will people pay for a share of this firm's stock? Suppose that people become uncertain about future profit. What would happen to the price they would be willing to pay? (Your answer will be descriptive only.)

Question 15

In the market for Amazon.com stock ,explain how each of the following events,ceteris paribus,would affect the demand curve for the stock and the stock's price.
a. The interest rate on U.S. government bonds,an asset considered safe from default,rises.
b. People expect the interest rate on U.S. government bonds to rise,but it hasn't yet risen.
c. Google announces that it will soon start competing with Amazon in the market for books,DVDs,and everything else that Amazon sells.

Question 16

State whether each of the following,with no other change,would increase or decrease the economic attractiveness of going to college,and give a brief explanation for each.
a. A decrease in estimated working life.
b. An increase in the earnings of the average high school student.
c. Permanently higher interest rates in the economy.

Question 17

In the Using the Theory section,we calculated the present value of the total cost of attending a private college,under the assumption that the costs remain the same for each of the four years. Recalculate the present value of these costs under the assumption that while implicit costs remain the same,tuition and other explicit costs rise by 8 percent per year,starting with the second year's tuition and expenses. (Continue to assume that all costs are paid at the end of each year.)