Question.3048 - 1. You are running a company that is owned by stockholders. Your goal is to maximize shareholder value. Explain how each of the following events is likely to affect shareholder value and identify uncertainties related to their effects. a. Tariffs on the product you sell are reduced and you face more foreign competition. b. Tariffs on several of the major inputs you use to produce your product are reduced. c. New pollution control requirements are implemented. d. Inflation rates rise. e. A new technology is available that reduces the cost of production. 2. Use the concepts of marginal cost and marginal revenue to derive an optimal capital budget for Company X, which has identified 7 possible investment projects and determined its cost of capital as shown below. Hint: Rank the projects according to the rate of return, and continue to invest as long as the ROI is greater than the cost of capital Table A: Alternative Projects, Required Investments, and Expected Rate of Return Project Investment Required in Millions of Dollars Expected Rate of Return on Investment A 150 12% B 300 15% C 125 10% D 75 16% E 50 20% F 500 14% G 250 18% Table B: Cost of Capital by Amount Raised Block of Funds (in Millions) Amount of Funds in Block Cost of Capital for Block First Block of Funds $500 10% Second Block of Funds $400 11% Third Block of Funds $300 12% Fourth Block of Funds $200 13% Fifth Block of Funds $100 14% Sixth Block of Funds $100 15% 3. Compare the three investments below in terms of their riskiness. What is the best way to evaluate the riskiness of an investment given the information you have on them? Project Expected Return Standard Deviation A $100,000 $25,000 B $200,000 $40,000 C $50,000 $20,000 4. Find the derivatives of each of the following functions, and their points of maximization or minimization if possible. a. TC = 1500 - 100 Q + 2Q 2 b. ATC = 1500/Q - 100 + 2Q c. MC = -100 +4Q d. Q = 550 – 0.5 P e. Profits = -1500 +1200 Q – 4Q 2
Answer Below:
Answer: 1) We have, (a) Tariffs on the product you sell are reduced and you face more foreign competition: If the tariffs on the product we sell have reduced thus adding more foreign competition, the profit on that product would also reduce and due to this net income available to shareholders would get down causing a decline in the shareholder’s wealth growth. (b) Tariffs on several of the major inputs you use to produce your product are reduced: Due to this the overall cost of goods manufactured would come down causing the profit margin to increase. Due to this the net income available to shareholder would increase causing an increase in shareholder’s wealth growth. (c) New pollution control requirements are implemented: New pollution control requirement would increase cost to curb pollution and due to this the profit margin would go down causing a reduction in shareholder’s wealth. (d) Inflation rates rise: Increase in inflation would increase the cost of capital and this in turn would reduce the value of the company and at the same time the shareholder’s wealth. (e) A new technology is available that reduces the cost of production: This will reduce the cost of production and this in turn would increase the profit margin causing an increase in shareholder’s wealth growth. 2) First of all, we Rank all the projects as per the Expected Rate of Return with the company having highest return i.e. E gets rank 1 and the company having lowest return i.e C gets rank 7. Now looking at the next table which shows the rate of Interest at which the company could raise capital. We have company would raise $500 million at 10% cost of capital, the company would fund the investments that has most return possible and with return more than or equal to 10%. Therefore the company would choose project E, project G, project D and part of project B. After this the company would raise $400 at 11% cost of capital to fund project B and part of project F. and at the end it will raise $275 at 12% to fund rest of project F. Now in the ranking the next project is Project A which needs an investment of $150 million and provides a return of 12% which is less than the cost thus the company will not invest in any further projects. 3) The coefficient of variation represents the ratio of the standard deviation to the mean, and it is a useful statistic for comparing the degree of variation from one data series to another, even if the means are drastically different from each other. The formula for co efficient of variation is In the investing world, the coefficient of variation allows you to determine how much volatility (risk) you are assuming in comparison to the amount of return you can expect from your investment. Thus we can say the lower the co efficient of variation, the better your risk- return tradeoff. ProjectExpected ReturnStandard DeviationCV A$100,000$25,0000.25 B$200,000$40,0000.20 C$50,000$20,0000.40 Thus above we have calculated co efficient of variation and we see how the risk is associated with each investment to be made. 4) Given that, (a) We have, Derivative of this equation is: (b) We have, Derivative of the equation: (c) We have, Derivative of the equation: (d) We have, Or, Derivative of the equation, (e) We have, Derivative of the equation, For cost minimization and profit maximization: Or, Or, Or, Answer: 2) Given that, Table A: Alternative Projects, Required Investments, and Expected Rate of Return Project Investment Required in Millions of Dollars Expected Rate of Return on Investment Rank A 150 12% 6 B 300 15% 4 C 125 10% 7 D 75 16% 3 E 50 20% 1 F 500 14% 5 G 250 18% 2 Table B: Cost of Capital by Amount Raised Block of Funds Amount of Funds Cost of Capital for Block (in Millions) in Block First Block of Funds $500 10% Second Block of Funds $400 11% Third Block of Funds $300 12% Fourth Block of Funds $200 13% Fifth Block of Funds $100 14% Sixth Block of Funds $100 15% We have, First of all company would raise $500 million at 10% cost of capital, the company would fund the investments that has most return possible and with return more than or equal to 10%. Therefor the company would choose project E, project G, project D and part of project B. After this the company would raise $400 at 11% cost of capital to fund project B and part of project F. and at the end it will rais $275 at 12% to fund rest of project F. 3) Given that, Project Expected Return Standard Deviation CV A $100,000 $25,000 0.25 B $200,000 $40,000 0.20 C $50,000 $20,000 0.40 Hence we can say that project C has highest risk per unit of return.More Articles From Economics
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