1-1 ENTREPRENEURIAL FINANCE Fourth Edition Chapter 1 Financial and Economic Concepts

1-2 Opportunity Costs  The highest value that is surrendered when a decision to invest funds is made.

1-3 Choices Available for Funds Expected financial returns of investment opportunity Investment opportunityExpected annual rate of return (%) Purchase stock11 Purchase home9 Purchase bonds6 Place cash in saving account 2 Buy a new car-15

1-4 Examples of Opportunity Cost  Decide to purchase car  Opportunity cost = Stock

1-5  However, if you decided to purchase stock rather than the car  Opportunity cost = Home

1-6 Income, Expenditures, and Taxes  Gross income is all of the money received from all sources during the year. › Wages › Tips › Interest earned on savings and bonds › Income from rental property › Profits to entrepreneurs

1-7 Basic Income Calculations  Gross income - taxes = Disposable income › For most of us, disposable income is take-home pay.  Disposable income - Fixed expenses = Discretionary income › Fixed expenses are contractual obligations like rent, utilities, insurance, and car payments. › Discretionary income is cash that we can spend or save.

1-8 Taxes  Progressive taxes: larger percentage of tax paid as income increases.  Regressive taxes: smaller percentage of tax paid as income increases.  Proportional taxes: percentage of tax paid remains the same at all levels of income.

1-9 Example of Progressive Tax  Formula for tax percentage paid:  Income tax is progressive:

1-10 Example of Regressive Tax  Sales tax is regressive – it’s higher for those who consume more as a percentage of their incomes: › Income = $20,000; savings = 0; sales tax = 5% › Sales tax paid = $20,000 x 0.05 = 1,000 › Income = $60,000; savings = $10,000; sales tax = 5% › Sales tax paid = $50,000 x 0.05 = $2,500

1-11 Example of Proportional Tax  The tax we pay into Medicare is a proportional tax (percentage of tax paid remains the same at all levels of income)  Formula for tax percentage paid: › Medicare tax is 1.45% › Annual income $30,000 › Medicare tax = $30,000 x = $435 › Annual income $500,000 › Medicare tax=$500,000 x = $7,250

1-12 Factors Affecting Interest Rates  The supply of money saved is primarily the total money that is placed in demand deposit (checking) accounts, savings accounts, and money market mutual funds. › Appear in a bank’s liabilities on balance sheet  The demand for borrowed funds is all of the money that is demanded in our economy at a given price. › Appear in a bank’s assets on balance sheet AssetsLiabilities Equity Charge rates of 6% to 20% Pay rates of 0 % to 3%

1-13  Federal Reserve Policy › The Federal Reserve is the central bank of the United States. › The Fed tries to control interest rates – and therefore the rate of inflation or deflation – by purchases and sales of bonds › And by setting the overnight lending fee between banks (i.e., the “federal fund rate”) Factors Affecting Interest Rates (continued)

1-14 More on opportunity costs

1-15 Opportunity cost defined  The cost of any activity measured in terms of the best alternative forgone.  It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices.  In economics › It’s "the basic relationship between scarcity and choice.” › The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. › Opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs

1-16 Opportunity costs in consumption  Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value  E.g., In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the dinner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals.

1-17 Opportunity costs in production  Explicit costs are opportunity costs that involve direct monetary payment by producers.  The opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them.  For instance, a firm spends $100 on electrical power consumed, the opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production.

1-18 Opportunity costs in production  Implicit costs are the opportunity costs that involve only factors of production that a producer already owns.  They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent out to other firms.

1-19 Evaluation  Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all.  The unseen opportunity costs then become the implicit hidden costs of that course of action.

1-20 “This time it’s personal” (Part 1)  You graduate from the University with a dual-major BS degree in marketing and chemical engineering. › You can work for Procter & Gamble for $70,000 starting salary, or › Start your own marketing consulting business for personal care product manufacturers with starting salary of $0, but potential salary of $150,000

1-21 “This time it’s personal” (Part 2)  You took the P&G job and have been working for them for five years. You have a salary of $85,000 and a wealth of understanding of the personal care products industry. › You can continue to work for Procter & Gamble for $85,000 salary with annual 4% raises, or › Start your own marketing consulting business for personal care product manufacturers with starting salary of $0, but potential salary of $500,000

1-22 “This time it’s personal” (Part 3)  Three years later you are still working for P&G and have been working for them for eight years. You have a salary of $95,000, but heard that the company may sell off your unit to a company known for its ruthless cost cutting. › Stick with the unit and lobby the acquiring company to keep your $95,000 salary (probably no chance of a raise, though), or › Start your own marketing consulting business for personal care product manufacturers with starting salary of $0, but potential salary of $500,000