Solution Manual For Managerial Economics Applications Strategies and Tactics 14th Edition By James
ISBN-10: 1305506383, ISBN-13: 978-1305506381
Chapter 1: Introduction and Goals of the Firm
Solutions to Exercises
- The ability to switch technologies is a real option for the Southern Company. By switching to cleaner fuels, Southern may not achieve a positive net present value (NPV), but if the change is made it may create opportunities for expanded sales of tradable pollution assets when later cap-and-trade bills impose tighter restrictions. In this case, historically, that is exactly what happened. This additional possibility for future cash flows is an embedded option that augments the current NPV of the decision to change to a clean fuel or cleaner technology to burn the fuel. There are increases in both real option value and NPV flow to the shareholders, so the shareholders are pleased when firms adopt projects with strategic flexibility.
- Shareholders want high long-term profits. Managers want job security and wonderful perks and amenities. Since risk and return tend to be positively correlated, managers may wish to avoid risks that shareholders want the managers to undertake. To encourage managers to take on risks, compensation committees can place a greater weight in setting managerial compensation on long-term incentives such as stock, options to buy stock, and bonuses based on surpassing the performance of comparable firms over several years. All of the compensation in salary and fringe benefits would induce managers to start only low risk projects to avoid making any mistakes and stay away from higher risk, potentially high-valued projects.
- When the bonus is tied to the short-run earnings of the manager’s firm, then the bonus declines even if the manager did everything, he or she could do in the midst of an economic downturn. Accordingly, bonus pay should relate to the performance of other comparable companies for a longer period to remove any incentive to boost short-term cash flows at the expense of long-term profitability. The bonus should be designed for managers that exceed their industry averages over the last several years. But when there is an economic downturn retaining the best managers would mean higher costs which may lower shareholder’s wealth.
- Southern could (1) buy carbon allowances, (2) install smokestack scrubbers, or (3) adopt fuel-switching technology to burn higher-priced low-sulfur coal whenever it becomes cheaper. Alternative 3 was the lowest in cost and offered the greatest real option to be able to sell tradable pollution assets in the future, depending on changes in coal prices, regulations and laws. Installing scrubber technology forfeits the opportunity to switch back and forth between low and high sulfur coal depending on the coal prices and regulatory changes.
- High profits in the drug industry are explained by the risk-bearing theory of profit, the innovation theory of profit, and the monopoly theory of profit. Medical R&D tends to be expensive with no assurance if the Food & Drug Administration will find new treatments to be safe or effective–this shows the risk in the industry. But when a new drug, new medical device or treatment works, this gives firms an innovative advantage. Furthermore, patents granted for the development of drugs provide the firm with a monopoly position in the production and marketing of that drug. In the absence of patents, it is likely that the drug industry would still have higher than average profitability due the risk-bearing and innovative theory of profits.
- The following events will change shareholder wealth:
- More competition is likely to lower prices and thereby reduce the value of the firm.
- In general, higher costs on the firm are likely to lower the value of the firm. If these requirements are imposed equally on all firms, some of the cost burdens will be borne by the firm and some by consumers, depending on the nature of the demand function. If the impact of the requirements is substantially different from one firm to another in an industry, the value of some firms may be enhanced relative to those at a competitive disadvantage because of the standards.
- If the union is effective in raising wages without improving productivity, then the value of the firm decreases. However, labor costs may rise but be offset by increases in productivity, then the change in the value of the firm depends on which increased more, wages or productivity. Unfortunately, sometimes a union may impede productivity when unions succeed in getting work rules that slow output or increase the number of workers needed to do a job.
- Inflation tends to increase costs and increase prices. The full impact is indeterminate. It depends on the ability of the firm to pass along higher costs to consumers and on the specific impact of inflation on a firm’s costs.
- Lower costs, other things being equal, will raise the value of the firm. At some point, competitors will imitate if they can and adopt this new technology.
- The following relates to decisions faced by the CEO of FedEx.
- Lower jet fuel may permit reducing shipping rates by FedEx. If shipping demand is elastic (as we will see in Chapter 3), reducing rates will increase revenue. This strategy depends on the nature of demand and the likely responses of other competitors. In general, if profit rises each period, then the value of the firm rises in equation [1.1].
- Increasing deliveries per day will add cost. The question is whether increasing deliveries increases customer’s adoption of FedEx for shipping. If delivery costs increase more than the added deliveries add to sales, then profit in each period may decline.
- If the price of jet fuel and diesel fuel is at a low point, a long-term contract to buy these protects the firm if prices start to rise in future. If this occurs, competitors that have not entered into these contracts will have to raise prices when FedEx does not, and future profits will rise for FedEx. It is also possible that fuel prices decline further, in which case the long-term contract is a burden. Given that FedEx is a large user of jet fuel, it will have to weigh the likely chance of higher and lower prices.
- Each of the following would affect shareholder wealth:
- If Southern Company adopts the fuel-switching technology, it can use whichever fuel is cheapest. This offers flexibility, which is a real option. For example, a generator than can only use coal is tied to the price and laws adopted on coal use. A generator that can be modified to other fuels, such as natural gas, propane, low sulfur coal, and high sulfur coal is more flexible as prices and regulatory restrictions change.
- The Ford acquisition of Jaguar would increase shareholder wealth if the expected present value of cash flows that could be generated from the Jaguar investment exceeded the cost.
- Automobile rebates are a form of temporary price reduction. If demand for automobiles is elastic (which it appears to be), sales increase during these periods. If GM’s profits are higher using rebates, then shareholder wealth increases. As customers begin to “expect” rebates, they will time their purchases to rebates. GM is also impacted by rebates offered by competitors.
- An increase in interest rates should cause shareholder wealth to decline in equation [1.1], because projected future cash flows would be discounted at a higher rate.
- In the near term, import restrictions should help Napa wineries because the price on the available French wine would be bid up (reflecting their short supply due to an effective limit on the amount of French wine imported). This would give domestic wineries an opportunity to increase prices and market share. The long-term impacts of import restrictions are less clear since import restrictions may be placed on Napa Valley wine by Europe in retaliation for the US trade restrictions in a trade war.
- A drop in expected inflation, ceteris paribus, should result in a lower risk-free rate, which is a component of capital costs and hence should result in a greater present value of future cash flows.
- The impact of this new machine on shareholder wealth should be positive in the near-term. However, when competitors also follow this action, there will be pressure to reduce prices to reflect the lower costs. The more competitive an industry is, the less likely it is that any one firm can sustain cost advantages for a long time. It should be noted that if Wonder Bread can make and sell bread more cheaply, it may expand by hiring in other parts of the firm involved in packaging, shipping, and delivery of their bread.
Solution to Case Exercise: Designing a Managerial Incentives Contract
This case exercise is challenging. Rather than building demand for the advanced insights that arise from principal-agent modeling, some instructors may prefer to use it as a capstone exercise at the end of the course (see the Case Exercises following chapter 15).