Chapter 10 - Chapter 10 1 An artistic entrepreneur has...

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Chapter 10: 1. An artistic entrepreneur has invested $10,000 of his savings in developing a line of gold jewelry and he has produced prototype rings. He has not foregone any explicit wages as he worked on his jewelry designs during the evenings. His day job pays $75 an hour, although he is eligible for overtime pay of $100 per hour, and could have devoted his effort to working overtime. He spent $3000 on machinery and $7,000 on gold, which is valued at $300 dollars per oz. Gold is easily marketable, but the machinery can only fetch $4000 once used. In attempting to value the venture, the entrepreneur calculates the present value of the expected cash flows from his business and adds his $10,000 investment. A) Critique the entrepreneur’s approach for valuing the venture. B) What is the entrepreneur’s opportunity cost of having undertaken the venture? Provide a conceptual approach for determining the cost (do not worry about coming up with an exact dollar amount). Answer: A) The entrepreneur is overvaluing the venture by double counting. If the venture operates, he will receive only the present value of the cash flows. If it is liquidated, he will receive proceeds equal to the liquidated asset value. The fact that he spent money on gold and machinery is irrelevant to the valuation. B) The entrepreneur’s opportunity cost is the sum of: foregone overtime pay at $100 per hour plus the opportunity cost of the $10,000 (he could have invested in at some positive rate of interest). 2. In the previous problem, which of the entrepreneur’s investments are “sunk?” Answer: Labor cost is sunk at the overtime rate of $100. The machinery and gold have some market value. The portion of the cost of the machine that cannot be recovered if the machine is resold is sunk. The salvage value of gold is probably close to its acquisition cost and is not a sunk cost. 3. Assume that after six months of trying to sell his jewelry line, the entrepreneur discovers that no one likes the design and he cannot sell his products. Assume gold is now selling at $320 per oz. What is the value of the venture now? Answer: The venture is approximately worth the current value of the gold (not its historical value) plus the salvage market value of the machinery. Based on the information in problem 1, the total is $11,467. The entrepreneur’s labor is sunk.
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In the following questions, identify the effect of each of the factors on the value of the venture to an entrepreneur (indicate increase, decrease, no change, or uncertain). Assume that the venture is financed entirely by the entrepreneur, that the entrepreneur divides wealth between the venture and a market index, and that the project is small enough that the entrepreneur can always duplicate the risk of the portfolio that includes the venture by leveraging an investment in the market.
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