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Decision Rule:
If NPV < 0: Reject project
NPV > 0: Accept projec
demo problem 1-1
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(4) Present Value of indefinitely Lived Assets
Some decisions generates cash flows that
continue indefinitely. The PV of such cash flows
is
PV assets = CF0 + CF
1
+ CF
2 +
(1+i) (1+i)
2
If all future cash flows are identical CF1=CF2=
then
PV
perpetuity
= CF/ i
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(5) FIRM VALUATION
The value of a firm equals the present value of current
and future profits.
PV
firm
= t
0 +
t
1
+ t
2 +
(1+i) (1+i)
2
PV
firm
= E
t
t
/ (1 + i)
t
Profit maximising goal also means firms want to
maximise its value which is PV of current and
future profits
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
(5) FIRM VALUATION
If profits is expected to grow at a constant rate of
g percent each year which is less than the interest
rate, i ;(g < i) and current period profits are
t
o
:
then the PV of the firms is
0
0
1
before current profits have been paid out as dividends;
1
immediately after current profits are paid out as dividends.
Firm
Ex Dividend
Firm
i
PV
i g
g
PV
i g
t
t
+
=
+
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Firm Valuation
If the growth rate in profits < interest rate
and both remain constant, maximizing the
present value of all future profits is the same
as maximizing current short term profits.
Eg demo problem 1-2
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal (Incremental) Analysis
Control Variables
Output
Price
Product Quality
Advertising
R&D
Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
Marginal (Incremental) Analysis
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
MARGINAL ANALYSIS
OPTIMAL MANAGERIAL DECISIONS INVOLVES
Comparing the marginal (incremental) benefits
with the marginal (incremental ) costs
Note:
B(Q)-total benefits derived from Q units of variable
C(Q)- total costs corresponding level of Q
Managers objective: maximise net benefits
Net Benefits = Total Benefits - Total Cost
= B(Q)-C(Q)
Profits = Revenue - Costs
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
MARGINAL defined
MB additional benefit arise by using an additional
unit of managerial control variable
MC additional costs incurred by using an additional
unit of the managerial control variable
MNB(Q) the change in net benefits that arise from
a one unit change in Q OR
MNB(Q) = MB(Q)-MC(Q)
Refer table 1-1 p20
Note When net benefit is maximised,
MNB(Q)=0 since MB(Q)=MC(Q)
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal Benefit (MB)
Change in total benefits arising from a change
in the control variable, Q:
Slope (calculus derivative) of the total benefit
curve.
Q
B
MB
A
A
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal Cost (MC)
Change in total costs arising from a change
in the control variable, Q:
Slope (calculus derivative) of the total cost
(TC) curve
Q
C
MC
A
A
=
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
Marginal Principle
To maximize net benefits, the managerial
control variable should be increased up to the
point where MB = MC.
MB > MC means the last unit of the control
variable increased benefits more than it
increased costs.
MB < MC means the last unit of the control
variable increased costs more than it
increased benefits.
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
The Geometry of Optimization
Refer fig 1-2
Q
Total Benefits
& Total Costs
Benefits B(Q)
Costs C(Q)
Q*
B
C
Slope = MC
Slope =MB
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
The Geometry of Optimization
MB,MC
& NB
NB
Q
N(Q)=B(Q)-C(Q)
NB
MB(Q)
MC(Q)
MNB(Q)
Q)
Maximum
NB
At level of Q where the MB curve
intersect the MC curve, MNB is
zero, that Q maximises NB
Q*
Q*
Slope of a function
is the derivative of
a given function
MB= dB(Q)
dQ
MC= dC(Q)
dQ
MNB= dN(Q)
dQ
Michael R. Baye, Managerial Economics and Business Strategy, 5e. Copyright 2006 by The McGraw-Hill Companies, Inc. All rights
reserved.
CONCLUSION
Make sure you include all costs and benefits
when making decisions (opportunity cost).
When decisions span time, make sure you are
comparing apples to apples (PV analysis).
Optimal economic decisions are made at the
margin (marginal analysis).