CHAPTER NO 1:

TECHNICAL PROBLEMS:
Question 3: Over the next three years, a firm is expected to earn economic profits of $120,000 in the first year,
$140,000 in the second year, and $100,000 in the third year. After the end of the third year, the firm will go out of
business.
a. If the risk-adjusted discount rate is 10 percent for each of the next three years, the value of the firm is $________ .
The firm can be sold today for a price of $_______ .
b. If the risk-adjusted discount rate is 8 percent for each of the next three years, the value of the firm is $________ .
The firm can be sold today for a price of $_______ .
Answer:
a)

Using the formula of present value of a series;

PV = FV1 + FV2 + FV3
(1+i) (1+i) (1+i)
PV = 120000 + 140000 + 10000 = 109,090.90 + 115,702.47 + 75,131.48 = 299,924.85
(1+0.1) (1+0.1) (1+0.1)
Present value of firm is $299,924.85 and the firm can be sold atleast at $299,924.
b) Using the formula of present value of a series;
PV = FV1 + FV2 + FV3
(1+i) (1+i) (1+i)
PV = 120000 + 140000 + 10000 = 111,111.11 + 120,027.43 + 79,383.22 = 310,521.76
(1+0.08) (1+0.08) (1+0.08)
Present value of firm is $310,521.76 and the firm can be sold atleast at $310,521.76.
APPLIED PROBLEMS:
Question 1: At the beginning of the year, an audio engineer quit his job and gave up a salary of $175,000 per year in
order to start his own business, Sound Devices, Inc. The new company builds, installs, and maintains custom audio
equipment for businesses that require high-quality audio systems. A partial income statement for the first year of
operation for Sound Devices, Inc., is shown below:
Revenues
Revenue from sales of product and services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$970,000
Operating costs and expenses
Cost of products and services sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... . . .
$355,000
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... . .
$155,000
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... ... .
$45,000

Total operating costs and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... .

Income from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense (bank loan) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Legal expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Corporate income tax payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$555,000
$415,000
$45,000
$28,000
$165,000
$177,000

To get started, the owner of Sound Devices spent $100,000 of his personal savings to pay for some of the capital
equipment used in the business. During the first year of operation, the owner of Sound Devices could have earned a
15 percent return by investing in stocks of other new businesses with risk levels similar to the risk level at Sound
Devices.
a. What are the total explicit, total implicit, and total economic costs for the year?
b. What is accounting profit?
c. What is economic profit?
d. Given your answer in part c, evaluate the owners decision to leave his job to start Sound Devices.
Answer:
a) Total explicit cost = (Administrative expenses + Total operating costs and expenses+ Legal expenses + Corporate
income tax payments) (45,000 + 555,000 + 28,000 + 165,000) = $793,000
Total implicit cost = (Salary + Returns from stocks) (175,000 + 0.15 100,000) = $190,000
Total economic cost = (Total explicit + Total implicit) (793,000 + 190,000) = $983,000
b) Accounting profit = (Total revenue Explicit cost) (970,000 793,000) = $177,000
c) Economic profit = Total revenue Total economic cost) ( 970,000 983,000) = $13,000
d) The owner made a economic loss of $13,000 with this business. whereas, he would have made $190,000 if he
had kept the job and invested his $100,000 in stocks. So he made a wrong decision to start Sound Devices.
Question 3: When Burton Cummings graduated with honors from the Canadian Trucking Academy, his father gave
him a $350,000 tractor-trailer rig. Recently, Burton was boasting to some fellow truckers that his revenues were
typically $25,000 per month, while his operating costs (fuel, maintenance, and depreciation) amounted to only
$18,000 per month. Tractortrailer rigs identical to Burtons rig rent for $15,000 per month. If Burton was driving trucks
for one of the competing trucking firms, he would earn $5,000 per month.
a. How much are Burton Cummingss explicit costs per month? How much are his implicit costs per month?
b. What is the dollar amount of the opportunity cost of the resources used by Burton Cummings each month?
c. Burton is proud of the fact that he is generating a net cash flow of $7,000 (5 $25,000 $18,000) per month, since
he would be earning only $5,000 per month if he were working for a trucking firm. What advice would you give Burton
Cummings?
Answer:

a) Explicit cost's (fuel, maintenance, and depreciation) are $18,000 per month. Implicit costs (driving trucks + rent)
($15,000 + $5,000) = $20,000
b) Opportunity cost = (Implicit costs) = ($15,000 + $5,000) = $20,000
c) Burton Cummings current profit is $7000 ($25,000 18,000). Rather than making $7,000 per month, Burton can
rent his rig ($15,000 per month) and drive trucks for another firm (make $5,000 per month). With this use of his
resources he can earn $20,000 per month.
Question 7: Fortune magazine reported that SkyWest, an independent regional airline, negotiated a financial
arrangement with Delta and United to provide regional jet service for the two major airlines. For its part of the deal,
SkyWest agreed to paint its jets the colors of Delta Connection and United Express and to fly routes specified by the
two airlines. In return, Delta and United agreed to pay SkyWest a predetermined profit margin and to cover most of
the regional airlines costs. Fortune explained that while the deal limited the amount of profit SkyWest could earn, it
also insulated the smaller airline from volatility in earnings since Delta and United covered SkyWests fuel costs,
increased its load factor (the percentage of seats occupied), and managed its ticket prices. Fortune suggested that
Wall Street liked the deal because SkyWests market valuation increased from $143 million to $1.1 billion after it
began its service with the two major airlines. Explain carefully how this arrangement with Delta and United could have
caused the value of SkyWest to increase dramatically even though it limited the amount of profit SkyWest could earn.
Answer:
Even though the financial arrangement with Delta and United limited the growth in SkyWests economic profits in
future years, but the agreement decreased the risk associated with SkyWests profits. The lower level of risk reduces
the adjusted discount rate, and, for a given stream of profits, the value of the SkyWest rises.
MATHEMATICAL PROBLEMS:
Question 1: Using a discount rate of 6.5 percent, calculate the present value of a $1,000 profit payment to be
received at the end of;
a. One year
b. Two years
c. Three years
Answer:
a) PV = FV/(1 + i)n = $1,000/(1.065) = $938.97
b) PV = $1,000/(1.065) = $881.66
c) PV = $1,000/(1.065) = $827.85
Question 2: What is the present value of a firm with a five-year life span that earns the following stream of expected
profit? (Treat all profits as being received at year-end.) Use a riskadjusted discount rate of 12 percent.
Year
1
2
3
4

Expected profit
$10,000
$20,000
$50,000
$75,000

$50,000

Answer:
PV = FV1 + FV2 + FV3 + ............
(1+i) (1+i) (1+i)

PV = 10000 + 20000 + 50000 + 75000 + 50000 =

(1+0.12) (1+0.12) (1+0.12) (1+0.12) (1+0.12)
$8,929 15,944 35,589 47,664 28,371 $136,497

CHAPTER NO 2:
TECHNICAL PROBLEMS:
Question 1: The general demand function for good A is;
Qd = 600- 4PA - 0.03M - 12PB + 157 + 6PE + 1.5N
where Qd = quantity demanded of good A each month, PA = price of good A, M = average household income, PB = price of
related good B, 7 = a consumer taste index ranging in value from 0 to 10 (the highest rating), PE = price consumers expect to
pay next month for good A, and N = number of buyers in the market for good A.
a. Interpret the intercept parameter in the general demand function.
b. What is the value of the slope parameter for the price of good A? Does it have the correct algebraic sign? Why?
c. Interpret the slope parameter for income. Is good A normal or inferior? Explain.
d. Are goods A and B substitutes or complements? Explain. Interpret the slope parameter for the price of good B.
Answer:

a) The intercept parameter in the given demand function is 600 and it is the value of y at the point, where the line crosses
the y axis.This means that keeping all given variables zero, good A will have a demand of 600 per month.

b) Slope parameter for price of good A is (-4). Negagative sign here is showing negative association between quantity
demanded for good A and its price (As price increases for good A the demand decreases). Algebric sign is correct in
this regard.
c) Slope parameter for income of good A is (-0.03). Negagative sign here is showing negative association between
quantity demanded for good A and household income (As income increases the demand decreases for good A). It is
an inferior good, as the relation between demand and income is negative.
d) Good A and B are substitutes because as price for good B increases the demand for good A decreases. Where as for
complement goods the relationship is in same direction. The slope parameter for good B is (-12), showing negative
relation with demand of good A.
Question 2: Consider the general demand function:
Qd = 8,000 - 16P + 0.75M + 30PR
a. Derive the equation for the demand function when M = $30,000 and PR = $50.
b. Interpret the intercept and slope parameters of the demand function derived in part a.
c. Sketch a graph of the demand function in part a. Where does the demand function intersect the quantity-demanded
axis? Where does it intersect the price axis?
d. Using the demand function from part a, calculate the quantity demanded when the price of the good is $1,000 and
when the price is $1,500.

e. Derive the inverse of the demand function in part a. Using the inverse demand function, calculate the demand price
for 24,000 units of the good. Give an interpretation of this demand price.
Answer:
a) Qd = 8,000 - 16P + 0.75M + 30PR
So;
Qd = 8000 16(P) + 0.75(30000) + 30(50)
Qd = 32,000 16P.
b) Qd = 32,000 16P.
Here 32,000 is the y intercept, which means that if P is zero the demand will be 32,000. Where as (-16) is the slope
parmater, which shows a negative relationship between demand and price ( for price of $1 the demand will decrease
by 16).
c) Y intercept will be 32,000 whereas it will interscet price axis at 2000.

Demand
40000
30000
quantity 20000
10000
0

500

1000 1500 2000 2500

price

d) Qd = 32,000 16P.
Qd = 32,000 16(1000)
= 16,000
Qd = 32,000 16P.
Qd = 32,000 16(1500).
= 8,000
e) Qd = 32,000 16P.
P = 32,000 Qd = 32,000 24,000 = $500
16
16

Question 9: The following general supply function shows the quantity of good X that producers offer for sale (Qs):
Qs = 19 + 20Px - 10PI + 6T - 32Pr - 20Pe + 5F
where Px is the price of X, PI is the price of labor, T is an index measuring the level of technology, Pr is the price of a
good R that is related in production, Pe is the expected future price of good X, and F is the number of firms in the
industry.
a. Determine the equation of the supply curve for X when PI = 8, T = 4, Pr = 4, Pe = 5, and F = 47. Plot this supply
curve on a graph.
b. Suppose the price of labor increases from 8 to 9. Find the equation of the new supply curve. Plot the new supply
curve on a graph.
c. Is the good related in production a complement or a substitute in production? Explain.
d. What is the correct way to interpret each of the coefficients in the general supply function given above?
Answer:
a) Qs = 19 + 20Px - 10PI + 6T - 32Pr - 20Pe + 5F
Qs = 19 + 20Px 10(8)+ 6(4) 32(4) 20(5) + 5(47)
Qs = 130 + 20Px

supply
300
200
QUANTITY SUPPLY

100
0

PRICE

b) Qs = 19 + 20Px 10(9)+ 6(4) 32(4) 20(5) + 5(47)

Qs = 140 + 20Px

supply
250
200
150
100
50
0

0.5

1.5

2.5

3.5

4.5

c) Qs = 19 + 20Px - 10PI + 6T - 32Pr - 20Pe + 5F

As price of related good increases the supply of good X decreases, so it is substitute good.
d) Qs = 19 + 20Px - 10PI + 6T - 32Pr - 20Pe + 5F
If all variables are zero the suppy quantity of good X will be 19. Price of good X and firms in industry have positive
association with supply quantity. PI is the price of labor, Pr is the price of a good R that is related in production, Pe is
the expected future price of good X, these variables have negative association with quantity supplied for good X,
increase in any of these variables will cause decrease in quantity supplied.
Question 13: Suppose that the demand and supply functions for good X are
Qd = 50 - 8P
Qs = -17.5 + 10P
a. What are the equilibrium price and quantity?
b. What is the market outcome if price is $2.75? What do you expect to happen? Why?
c. What is the market outcome if price is $4.25? What do you expect to happen? Why?
d. What happens to equilibrium price and quantity if the demand function becomes Qd = 59 - 8P?
e. What happens to equilibrium price and quantity if the supply function becomes Qs = -40 + 10P
(demand is Qd = 50 - 8P)?
Answer:
a) Qd = 50 - 8P , Qs = -17.5 + 10P
50 - 8P = -17.5 + 10P
18P = 67.5
P = $3.75

b) Qd = 50 - 8P
Qd = 50 8(2.75) = 28 (quantity demand will be 28)
Qs = -17.5 + 10P
Qs= -17.5 + 10(2.75) = 10 (quantity supply will be 10)
There will be shortage of good X at a price of $2.75.
c) Qd = 50 - 8P
Qd = 50 8(4.25) = 16 (quantity demand will be 16)
Qs = -17.5 + 10P
Qs= -17.5 + 10(4.25) = 25 (quantity supply will be 25)
There will be surplus of good X at a price of $4.25.
d) 59 - 8P = -17.5 + 10P
18P = 76.5
P = $4.25 (equilibrium price will raise to $4.25 from $3.75)
e) 50 - 8P = -40 + 10P
18P = 90
P = $5 (equilibrium price will raise to $5 from $3.75)
APPLIED PROBLEMS:
Question 4: Rising jet fuel prices recently led most major U.S. airlines to raise fares by approximately 15 percent.
Explain how this substantial increase in airfares would affect the following:
a. The demand for air travel.
b. The demand for hotels.
c. The demand for rental cars.
d. The supply of overnight mail.
Answer:
a) No effect on demand.
b) Decrease demand for hotels.
c) Demand for rental cars decreases.
d) Supply of overnight mail decreases.
Question 12: The world market for newly smelted primary aluminum (i.e., excluding scrap or recycled sources) recently
experienced a period of rising inventories and falling prices. The Wall Street Journal reported that Russian smelter Rusal, the
worlds largest aluminum producer, expected primary aluminum ingot prices would need to fall even further before worldwide
inventory accumulation could stabilize. Suppose the
demand for primary aluminum can be represented by the equation Qd = 124 0.025 P (Qd is the annual worldwide quantity
demanded in millions of metric tons of new aluminum, P is the dollar price of new aluminum per ton). Further suppose the world
supply of aluminum is Qs = -50 + 0.025 P(Qs is the annual worldwide quantity supplied in millions of metric tons of new
aluminum, P is the dollar price of new aluminum
per ton).
a. At the time of Rusals concern, primary aluminum prices were relatively high at $3,600 per ton. At this price, calculate the
monthly rate of inventory growth in the global aluminum market using the given demand and supply equations for the world
aluminum market.
b. Rusal believed the price of aluminum would fall because of the growing accumulation of inventories worldwide. Evaluate
Rusals prediction by using the demand and supply equations provided to make a prediction about the movement of world
aluminum price.

Answer:
a) Qd = 124 0.025P , Qs = -50 + 0.025P

Qd = 124 -0.025(3600)
Qd = 34 metric ton
Qs = -50 + 0.025(3600)
Qs = 40 metric ton
40-34 = 6 metric ton annually ( 0.5 metric ton monthly).
b)

If the price continues to drop the demand will increase and supply will continue to decrease, which will lead to
shortage in future.