303ex1-Notes - ECON 303 Notes for Exam 1 1. Determining the...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
ECON 303 Notes for Exam 1 1. Determining the value of a firm (Ch. 1; p. 17-18) Managerial economics is the study of how to direct limited resources in ways that would most efficiently achieve managerial goals. The role of a manager is to direct resources toward achieving the goal of maximizing the firm’s profit. Total Profit (Π ) = Total Revenue (TR) - Total Cost (TC) This measure of profit is called economic profit. TR = PQ TC = Total explicit cost + Total implicit cost = Total opportunity cost Total Accounting Profit = TR - Total explicit cost It is possible for a firm to earn accounting profits but incur economic losses. Thus, the objective is to maximize economic profit. Maximization of economic profit leads to maximization of the value of the firm. The value of a firm is calculated as follows: T Value F = Π 0 + Π 1 /(1 + i) + Π 2 /(1 + i) 2 + … + Π T /(1 + i) T = Σ Π t /(1 + i) t t=0 where Π t is profit in time period t and i is the interest rate. Numerical examples: Consider a firm whose current profit, Π 0 = $120 million. Suppose interest rate, i = 10%. A. If the firm continues for the next three years with this level of profit annually, the value of the firm is: Value F = PV Π0 = Π 0 + Π 0 /(1 + i) + Π 0 /(1 + i) 2 + Π 0 /(1 + i) 3 = 120 + 120/(1 + 0.1) + 120/(1 + 0.1) 2 + 120/(1 + 0.1) 3 = 120 + 120/(1.1) + 120/(1.1) 2 + 120/(1.1) 3 = 120 + 120/1.1 + 120/1.21 + 120/1.33 = 120 + 109.1 + 99.2 + 90.2 = $418.5 million. B. Now suppose, the annual growth rate of the firm’s profit, g = 7%. If the firm continues for the next three years, the value of the firm is: Value F = PV Π0 = Π 0 + [Π 0 (1 + g)]/(1 + i) + [Π 0 (1 + g) 2 ]/(1 + i) 2 + 0 (1 + g) 3 ] /(1 + i) 3 = 120 + [120(1 + 0.07)]/(1 + 0.1) + [120(1 + 0.07) 2 ]/(1 + 0.1) 2 + [120(1 + 0.07) 3 ] /(1 + 0.1) 3 = 120 + [120(1.07)]/(1.1) + [120(1.07) 2 ]/(1.1) 2 + [120(1.07) 3 ]/(1.1) 3 Page 1 of 8
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
ECON 303 Notes for Exam 1 = 120 + 128.40/1.1 + 137.39/1.21 + 147.01/1.33 = 120 + 116.7 + 113.5 + 110.4 = $460.6 million. C. With annual profit and growth rate as given in part A, if the firm continues for ever, the value of the firm is: Value F = PV Π0 = Π 0 + [Π 0 (1 + g)]/(1 + i) + [Π 0 (1 + g) 2 ]/(1 + i) 2 + 0 (1 + g) 3 ] /(1 + i) 3 + … = Π 0 [(1 + i)/(i - g)] = 120[(1 + 0.1)/(0.1 - 0.07)] = 120(1.1/0.03) = 120(36.67) = $4,400 million. D. With annual profit and growth rate as given in part A, if the firm pays its current profits of $120 million as dividends and continues for ever, the value of the firm on the ex-dividend date (i.e., the day after the payment of dividend) is: Ex-Div Value F = PV Π0 - Π 0 = Π 0 [(1 + g)/(i - g)] = 120[(1 + 0.07)/(0.1 - 0.07)] = 120(1.07/0.03) = 120(35.67) = $4,280 million. 2.
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 10/31/2010 for the course BUSINESS S ECON taught by Professor Xx during the Spring '10 term at VCU.

Page1 / 8

303ex1-Notes - ECON 303 Notes for Exam 1 1. Determining the...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online