MANAGERIAL ECONOMICS - PROBLEM SET 1
THEORY OF THE FIRM, ECONOMIC VALUE, TIME VALUE OF MONEY, AND AGENCY THEORY. CHAPTER 1
1. Kevin James is working for a large company earning $60,000 per year. He is trying to decide whether to leave this job and set up his own business. He estimates that renting an office would cost $10,000 per year; hiring a secretarial service $10,000; renting necessary office equipment $15,000; and other supplies, utilities, phone and internet another $5000. He further estimates that revenues from his business should be $100,000 per year.
a) What are the explicit (accounting) and implicit (economic costs) of operating the new business?
b) Does it make good economic sense for Kevin to leave his job and go into business for himself?
2. What is the present value of a firm with five years life span that earns the following expected stream of profit, treating all profits as being earned at year end and using a discount rate of 12%?
|
Year
|
Expected Profit
|
|
1
|
$10,000
|
|
2
|
20,000
|
|
3
|
50,000
|
|
4
|
70,000
|
|
5
|
50,000
|
3. Some years ago, the National Enquirer reported that, in their divorce settlement, Burt Reynolds offered Loni Anderson $10 million spread evenly over 10 years, but that she insisted instead of $5 million now. If the appropriate discount rate is 8%, which alternative is better for Burt and which for Loni? What if the discount rate is 20%?
4. An audio engineer quite his job and gave up a yearly salary of $175,000 to start his own business, Sound Devices, Inc., a new company that builds, installs, and maintains custom audio equipment for businesses. A partial income statement for Sound Devices, Inc. is shown below:
|
Revenues - sales of products and services
|
$970,000
|
|
Operating Costs
|
|
|
Cost of products and services sold
|
355,000
|
|
Selling Expenses
|
155,000
|
|
Administrative Expenses
|
45,000
|
|
Total operating costs and expenses
|
$555,000
|
|
Income from Operations
|
$415,000
|
|
Interest expense (bank loan)
|
45,000
|
|
Legal expense of start up
|
28,000
|
|
Income taxes
|
165,000
|
|
Net Income
|
$177,000
|
To get started, the owner of Sound Devices spent $100,000 of his personal savings to pay for equipment. At the same time, this owner could have earned 10% by investing in stocks with acceptable risk levels.
a) What are the total explicit, total implicit, and total economic costs of the business?
b) What is the accounting profit?
c) What is the economic profit?
Evaluate the economics of the owner's decision to leave his job and start his own business.
5. Studies show that large hotel chains such as Marriott tend to reduce the number of hotels they franchise to outsiders and increase the number of hotels it owns and operates directly. When chains require franchisees to upgrade the hotels they own, the franchisees often resist incurring this expense that Marriott considers important because "we've build our name on quality."
a) What sort of agency problem is involved in this situation?
b) Why would Marriott worry about the quality of hotels it does not own?
c) Why might Marriott tend to own its hotels in resort areas such as national parks, where there is little repeat business, and franchise in areas where there is a lot of repeat business?