1. BUSINESS ECONOMICS Class 6 1 and 2 December, 2009

2. Recap  Production-Cost Theory  Factors of Production  Cobb-Douglas, Linear function  Opportunity costs, Marginal costs  Accounting costs, Transaction costs  Optimum product  Isoquants  Isocosts

3. Optimal choice of input  The point of tangency between the isocost line and the isoquant shows the minimum cost required to produce a given output.  This equality shows that the firm adjusts resource use so that the rate at which one input can be substituted for another in production, that is, the MRTS equals the rate at which one resource can be traded for another in resource markets, that is the resource price ratio w/r.  MP L /w = MP K /r  The points of tangency between isoquants and isocost lines each show the least expensive way of producing a particular level of output. Connecting these tangency points gives the firm’s expansion path.

4. Profit Theories  Profit in economics means difference between a firm’s total revenue and its opportunity cost  Profit maximization firm will produce that quantity of output at which marginal revenue, MR, equals marginal cost, MC  In a perfect competition market structure Price (P) = Demand (D) = Marginal revenue (MR)

5. Capital Budgeting  The planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.  It is budget for major capital, or investment, expenditures

6. Techniques for Capex  Net Present Value  Internal Rate of Return  Payback Period  Profitability Index  Real Options

7. Net Present value  This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discounted to determine their present value  The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time.  For example, 100 dollars of today's money invested for one year and earning 5 percent interest will be worth 105 dollars after one year.  Present value (PV) = Future Value (FV) – (rate x PV)

8. NPV decisions If…It Means…Then…. NPV > 0Investment will add value to the firmAccept the project NPV < 0Investment will reduce value to the firmReject the project NPV = 0No gain, no lossLook at other criteria Weighted average cost of capital is often considered as the discounted rate for calculating NPV Where E is equity, D is debt, y is expected rate of return on equity, d is cost of borrowing before tax

9. IRR  Internal rate of return is used to measure and compare the profitability of investments.  In the context of savings and loans the IRR is also called the effective interest rate.  The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation)  In more familiar terms, the IRR of an investment is the interest rate at which the costs of the investment lead to the benefits of the investment.  This means that all gains from the investment are inherent to the time value of money and that the investment has a zero NPV at this interest rate.

10. IRR Example YearCash Flow 0-4000 11200 21410 31875 41050  Useful for evaluating single project and not for comparison  Does not consider the reinvestment of positive cash flows Cash FlowsIRR shortcomings The IRR r is given by 14.3%

11. Profitability Index  PI is the relationship of investment to payoff of a project  If PI > 1, select the project  If PI < 1, reject the project

12. Payback period  Payback period in business and economics refers to the period of time required for the return on an investment to "repay" the sum of the original investment.  It intuitively measures how long something takes to "pay for itself." Shorter payback periods are obviously preferable to longer payback periods (all else being equal).  It is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour.  When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing," payback period has no explicit criteria for decision-making.  Does not consider the time value of money, hence not accurate.

13. Returns to Scale  Returns to scale refers to changes in output subsequent to a proportional change in all inputs, where all inputs increase by a constant factor.  If all inputs increase by a factor of 2, new values for output should be twice the previous output, then it is a constant return to scale (CRTS).  Assuming that the factor costs are constant, a firm experiencing CRTS will have constant average costs,  If all inputs increase by a factor of 2, new values for output is less than twice the previous output, then it is a decreased return to scale (DRS)  a firm experiencing DRS will have increasing average costs  If all inputs increase by a factor of 2, new values for output is more than twice the previous output, then it is an increased return to scale (IRS)  A firm experiencing IRS will have decreasing average costs.

14. Economies of Scale  Economies of scale refer to an economic property of production that affects cost if quantity of all input factors are increased by some amount.  If costs increase proportionately, there are no economies of scale  If costs increase by a greater amount, there are diseconomies of scale  If costs increase by a lesser amount, there are positive economies of scale.  When combined, economies of scale and diseconomies of scale lead to ideal firm size theory, which states that per-unit costs decrease until they reach a certain minimum, then increase as the firm size increases further.  Economies of scale refers to the decreased per unit cost as output increases. More clearly, the initial investment of capital is spread over an increasing number of units of output, and therefore, the marginal cost of producing a good or service decreases as production increases.

15. Law of Diminishing Returns  Also known as Law of Variable proportions  The law states “the marginal product of each unit of input will decline as the amount of that input increases holding all other inputs constant”