ECON 546 Lecture Notes - Lecture 18: Matching Principle, Capital Asset, Net Present Value

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27 Jun 2018

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Lecture 18

If you do the project for each year, how much extra cash flow would I have relative to if you did

not pursue the project?

A sunk cost is something that you have already spent and not going to get back whether you

pursue the project or not. If you hire a consulting company and spent 1M on the study, the 1M

is a sunk cost. Whether you pursue the project or not, you already paid 1M. It should not be

incremented in the calculation of cash flows.

Cannibalization in business is when you introduce a new product and when people, who were

previously buying old products, only buy the new product.

Story of diet coke and coke zero:

Men were not buying a lot of diet coke because it was viewed as kind of feminine. Coca-Cola

decided to launch Coke Zero (black label, commercials) to target men.

A loss leader at a supermarket: When you sell a particular item at below cost (selling at a loss)

because you can highly advertise the product to track people to the store and then buy other

products. If you do an analysis on the loss leader, you cannot decide to stop selling it because

you only sell it at loss. You need to take everything into account (the revenues it brings from

bringing people to the store, who purchase other products that aren't selling at loss).

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When you buy a building, it is not considered as an expense. It is just transforming one asset

(money) to another (buildings).

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This course focuses on straight-line depreciation.

However, the salvage value is not necessarily the same as the worth of the asset at the end of its

life.

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Document Summary

A sunk cost is something that you have already spent and not going to get back whether you pursue the project or not. If you hire a consulting company and spent 1m on the study, the 1m is a sunk cost. Whether you pursue the project or not, you already paid 1m. It should not be incremented in the calculation of cash flows. Cannibalization in business is when you introduce a new product and when people, who were previously buying old products, only buy the new product. Men were not buying a lot of diet coke because it was viewed as kind of feminine. Coca-cola decided to launch coke zero (black label, commercials) to target men. A loss leader at a supermarket: when you sell a particular item at below cost (selling at a loss) because you can highly advertise the product to track people to the store and then buy other products.

Related Questions

Q. Write your opinion about the below paragraph? Also, mention any example?

Topic: Your accountant has just told you that your company is losing money. Why might you decide to stay in business anyway?

I would decide to stay in the business because in the short run most costs are fixed in nature. If the business is wound up even then committed fixed cost (unavoidable cost) will continue. After winding up, it is difficult to restart the same business as it would require huge capital and will have fewer customers' confidence.

Whereas if the business is continued during loss or boom period, the business can recover the variable cost (avoidable) and some contribution towards the fixed costs.

Therefore I will consider some situations like shut down or break-even point.

Break-even point is a level of output for a price where firms do not make loss or profit.

Shutdown point occurs when the price of the product is comparatively very low to average total cost (ATC). In this scenario, temporary shut down is the good option.

Q. Write your opinion about the below paragraph? Also, mention any example?

Government bailouts are both good and bad. Good because it infuses cash into the company and instead of all their costs being sunk costs, they can recover some of the capital spent on the government bail out. Moreover, with new capital manufacturers could resume production. However, infusing cash artificially into the system could lead to waste as some managers would to be lazy and not actively adopt cost-saving methods. However, the chances of economic inefficiency during the 2002 bailout would have been low since with government bailouts there was tight oversight and the manufacturing companies were under pressure to bounce-back quickly. So firms bailed out during that period laid off a lot of employees and cut down wages to save costs. This type of drastic cost saving methods can disrupt the optimal level of production along the expansion path, as the labor vs. capital changes would disproportionate.

#1 (5pts, 1pt each) [circle all that apply, there may be more than one correct answer] The monthly payment of rent in the amount of $800 is a:

a) Fixed cost

b) Variable cost

c) Sunk cost

d) Recurring cost

e) Life-cycle cost

Engineering economic analysis is appropriate when:

a) The amount of money involved is significant

b) The situation is too complex for simple âback of envelopâ calculations

c) Social and environmental impacts are the most significant considerations

d) The problem is economic in nature

e) Quantifying political goals

After a new product or process is put in place the production cost per unit tends to _______as manufacturing methodology improves over time. This is known as the _______.

a) Increase, Ramp up effect

b) Decrease, Start-up effect

c) Decrease, Learning curve

d) Be flat, Opportunity cost

e) Vary widely, Chaos effect

Why is $100 today worth more than a rock solid guarantee to receive $100 in 10 years?

a) Inflation may erode the purchasing power of the $100
b) If you have the money you could put it to use
c) If you have the money you could invest it and collect interest
d) There is always some risk that the future payment may not happen
e) No telling what your circumstances might be in 10 years, i.e. you may not be around

Which of the following activities could be categorized as backward planning?

a) Figuring that you will need $1000 by June 1st to go on vacation and determining how many extra hours you need to work over the next few months.

b) Saving 10% of your salary.

c) Planning a drive that will hit the least amount of traffic, allow you to stop for dinner, and make it to a meeting in Austin by 7pm.

d) Renewing the lease on your apartment because a discount was offered.
e) Focusing on alternate activities while you are waiting for a supplier to provide a quote.

#2 (5 pts) Below is a plot of total cost and revenue versus the quantity made and sold. Fill in the correct answers.

What is the fixed cost? ____________
At what volume will the project break even? ___________
What is the profit (or loss) if 100 units are produced and sold? __________
What is the price charged per unit? ___________
What is the incremental total cost between producing 50 units and producing 100 units? _________

#3 (10 pts) A certain index for the cost of purchasing and installing utility boilers is keyed to 1988, where its baseline value was arbitrarily set at 100. Company XYZ installed a 50,000-lb/hour boiler for $525,000 in 2010 when the index had a value of 468. This same company must install a boiler of the same size in 2017. The index in 2017 is 542. What is the approximate cost of the new boiler?

#4 (10pts) Draw the cash flow diagram reflecting the following car ownership. Please draw neatly with the length of the arrows corresponding to the magnitude of the amounts (but not necessarily fully to scale). Label the amounts different from the standard monthly payments.You purchase the car at time zero for $2000 down plus 24 monthly payments of $200. In month 4 you have an unexpected repair bill of $250. In month 18 you have to purchase new tires for $400. At 30 months you are offered $700 for the car and happily sell it.

100 word answer needed from the question and artile below.

Question:

Explain whether, and if so how, you would expect laws that prohibit the buying and selling of organs to affect the overall wellbeing of society.

Article: "Should there be a market in organs?"

Some years ago, a Boston newspaper reported the story of Susan Stephens, a woman whose son needed a kidney transplant. When the doctor learned that the mother's kidney was not compatible, he proposed a novel solution: If Stephens donated one of her kidneys to a stranger, her son would move to the top of the kidney waiting list. The mother accepted the deal and soon two patients had the transplant they were waiting for.

The ingenuity of the doctor's proposal and the nobility of the mother's act cannot be doubted. But the story raises many intriguing questions. If the mother could trade a kidney, would the hospital allow her to trade a kidney for an expensive, experimental cancer treatment that she could not afford otherwise? Should she be allowed to exchange her kidney for free tuition for her son at the hospital's mediacal school? Should she be able to sell her kidney so she can use the cash to trade in her old Toyota for a new Lexus?

In many countries, including Australia, it is illegal for a person to sell their organs. In essence, in the market for organs the government has imposed a price ceiling of zero. The result, as with any binding price ceiling, is the shortage of the good. The deal in the Stephens case did not fall under this prohibition because no cash exchanged hands.

Some countries, however, have illicit markets in organs. The World Health Organizations estimates that 10% of all organ transplants, including arount 15 000 kidneys each year, involve a patient from a rich country buying an illegal organ from a citizen of a poorer nation. The temptation to the world's poorest people to sell their 'spare' organs in high. A kidney can sell for around $1500 or more in the illegal trade. This may not sounds like much to you or me. But it can be many years income to a person living in dire poverty.

Some economists believe that there would be large benefits to allowing a free market in organs. People are born with two kidneys but they usually need only one. Meanwhile, a few people suffer from illnesses that leave them wiithout any working kidneys. Despite the obvious gains from trade, the current situation is dire. In Ausralia, the average wait for a kidney transplant is 3.8 years and there are up to 50 deaths a year from people on the waiting list because a kidney cannot be found. In Europe, on average, 12 people die each day waiting for an organ transplant. If those needing a kidney were allowed to buy one from those who have two, the price would rise to balance supply and demand. Sellers would be better off with the extra cash in their pockets. Buyers would be better off with the rgan they need to save their lives. The shortage of kidneys would disappear.

Such a market would lear to an efficient allocation of resources, but critics of this plan worry about fairness. A market for organs, they argue, would benefit the rich at the expense of the oor, because organs would then be allocated to those most willing and able to pay. But you can also question the fairness of the current system.Now, most of us walk around with an etra organ that we don't really need, while some of our fellow citizens are dying to get one. Is that fair?

ECON 546 Lecture Notes - Lecture 18: Matching Principle, Capital Asset, Net Present Value

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