Maximum Points: 60
Grade:
Let G be the smaller number between 6 and
(achieved points+10)/10
Round G exactly to quarters of a grade to
get your grade.
Examples:
32 points give a 4.25,
31 points give a 4
Solution to Homework Set 1
Managerial Economics Fall 2011
Conceptual and Computational Questions
4 points 2. What is the maximum amount you would pay for an asset that gen- 2 pt for a
erates an income of $150,000 at the end of each of five years if the reasonable
opportunity cost of using funds is 9 percent? formula,
The maximum you would be willing to pay for this asset is the present 2 points for the
value, which is correct result
150, 000 150, 000 150, 000 150, 000 150, 000
PV = + 2
+ 3
+ 4
+
1 + 0.09 (1 + 0.09) (1 + 0.09) (1 + 0.09) (1 + 0.09)5
= $583, 447.69.
6 points 3. Suppose that the total benefit and total cost from an activity are, re-
spectively, given by the following equations: B(Q) = 150 + 28Q − 5Q2
and C(Q) = 100 + 8Q.
(a) Write out the equation for the net benefits. 1 point per correct
Net benefits are N (Q) = 50 + 20Q − 5Q2 . result
(b) What are the net benefits when Q = 1? Q = 5?
Net benefits when Q = 1 are N (1) = 50 + 20 − 5 = 65 and when
Q = 5 they are N (5) = 50 + 20 · 5 − 5(5)2 = 25.
(c) Write out the equation for the marginal net benefits.
Marginal net benefits are MNB(Q) = 20 − 10Q.
(d) What are the marginal net benefits when Q = 1? Q = 5?
Marginal net benefits when Q = 1 are MNB(1) = 20 − 10 = 10
and when Q = 5 they are MNB(5) = 20 − 10 · 5 = −30.
(e) What level of Q maximizes net benefits?
Setting MNB(Q) = 20 − 10Q = 0 and solving for Q, we see that
net benefits are maximized when Q = 2.
(f) At the value of Q that maximizes net benefits, what is the value
of marginal net benefits?
When net benefits are maximized at Q = 2 , marginal net benefits
are zero. That is, MNB(2) = 20 − 10 · 2 = 0.
1
4 points 4. A firm’s current profits are $550,000. These profits are expected to 2 points (1 for a
grow indefinitely at a constant annual rate of 5 percent. If the firm’s formula, 1 for the
opportunity cost of funds is 8 percent, determine the value of the firm: correct result)
(a) The instant before it pays out current profits as dividends.
The value of the firm before it pays out current dividends is
1.08
P Vfirm = $550, 00
0.08 − 0.05
= $19.8million.
(b) The instant after it pays out current profits as dividends.
The value of the firm immediately after paying the dividend is 2 points (same as
above)
Ex-Dividend 1.05
P Vfirm = $550, 00
0.08 − 0.05
= $19.25million.
10 points 7. It is estimated that over 90,000 students will apply to the top 30
M.B.A. programs in the United States this year.
(a) Using the concept of net present value and opportunity cost, ex-
plain when it is rational for an individual to pursue an M.B.A.
degree.
The net present value of attending school is the present value of 2 points
the benefits derived from attending school (including the stream
of higher earnings and the value to you of the work environment
and prestige that your education provides), minus the opportu- 2 points
nity cost of attending school. As noted in the text, the oppor-
tunity cost of attending school is generally greater than the cost
of books and tuition. It is rational for an individual to enroll in
graduate when his or her net present value is greater than zero. 2 points
(b) What would you expect to happen to the number of applicants if
the starting salaries of managers with M.B.A. degrees remained
constant but salaries of managers without such degrees increased
by 15 percent? Why?
Since this increases the opportunity cost of getting an M.B.A., 2 points
one would expect fewer students to apply for admission into 2 points
M.B.A. Programs.
4 points 8. Jaynet spends $20,000 per year on painting supplies and storage space.
She recently received two job offers from a famous marketing firm—
one offer was for $100,000 a year, and the other was for $90,000.
However, she turned both jobs down to continue a painting career. If
Jaynet sells 20 paintings per year at a price of $10,000 each:
2
(a) What are her accounting profits?
Her accounting profits are $180,000. These are computed as the 2 points
difference between revenues ($200,000) and explicit costs ($20,000).
(b) What are her economic profits?
By working as a painter, Jaynet gives up the $100,000 she could
have earned under her next best alternative. This implicit cost of 2 points
$100,000 is in addition to the $20,000 in explicit costs. Since her
economic costs are $120,000, her economic profits are $200,000 -
$120,000 = $80,000.
Problems and Applications
4 points 14. Tara is considering leaving her current job, which pays $56,000 per
year, to start a new company that manufactures a line of special pens
for personal digital assistants. Based on market research, she can
sell about 160,000 units during the first year at a price of $20 per
unit. With annual overhead costs and operating expenses amounting
to $3,160,000, Tara expects a profit margin of 25 percent. This margin
is 6 percent larger than that of her largest competitor, Pens, Inc.
(a) If Tara decides to embark on her new venture, what will her ac-
counting costs be during the first year of operation? Her implicit
costs? Her opportunity costs?
Accounting costs equal $3,160,000 per year in overhead and oper-
ating expenses. Her implicit cost is the $56,000 salary that must
be given up to start the new business. Her opportunity cost in-
cludes both implicit and explicit costs: $3,160,000 + $56,000 = 2 points
$3,216,000.
(b) Suppose that Tara’s estimated selling price is lower than origi-
nally projected during the first year. How much revenue would
she need in order to earn positive accounting profits? Positive
economic profits?
To earn positive accounting profits, the revenues per year should
greater than $3,160,000. To earn positive economic profits, the 1 point per
revenues per year must be greater than $3,216,000. number
Additional discounting exercises
8 points 1. A prospective house owner is interested in taking up a 30 year fix
rate mortgage of CHF 500’000. This type of mortgage offers a fix
yearly interest rate and will be payed off within 30 years. Each year
the borrower pays the amount X to the lender and interest on the
remaining dept Dt at time t is It . Thus, X − It is then deducted from
3
the dept. How big does X have to be, if the yearly interest rate is 6%,
and the mortgage has to payed back in 30 years?
Write Dt as a function of X:
D0 = 5000 000
D1 = (1 + i)D0 − X
A formula similar to
D2 = (1 + i)D1 − X = (1 + i)2 D0 − (1 + i)X − X
the highlighted
... ones, or
t−1
!
t
X
s
"PV of payments X
Dt = (1 + i) D0 − X (1 + i) . = D_0": 4 points
s=0
Solve D30 = 0 for X:
29
!
X
30
0 = (1 + i) D0 − X (1 + i)s
s=0
29 s !
X 1
(1 + i)30 D0 = X(1 + i)29
1+i
s=0
29 1 1
= X(1 + i) 1− 30 1
(1 + i) 1 − 1+i
(1 + i)30 − 1 1 + i
=X
(1 + i) i
30
(1 + i) − 1
=X
i
(1 + i)30
X = iD0
(1 + i)30 − 1 The exact result: 4
= 360 324.46. points.
20 points 2. A potential student of a Fachhochschule faces the following two choices:
Either he takes a job right away which pays him CHF 60’000.– in the
first year. Given his education level he can expect his wage to increase
by 1% each year. Alternatively, he could go to Fachhochschule. If he
does, he earns nothing for 4 years. After Fachhochschule, he can get a
job which also pays CHF 60’000.– in the first year, but he can expect
the wage to increase by 2% each year. The student is 20 years old and
will work until the end of the year in which he turns 65.
(a) What should the student choose to do, if he can lend and borrow
money at an interest rate of 3%?
4
The present value of the income for taking a job right away is
45
1.01 t
X
P V = CHF 600 000
1.03
t=0
∞ t X ∞ t !
X 1.01 1.01
= CHF 600 000 −
1.03 1.03
t=0 t=46
46 ! X∞
1.01 t
0 1.01
= CHF 60 000 1 −
1.03 1.03
t=0
46 !
1.01 1
= CHF 600 000 1 −
1.03 1 − 1.01
1.03
46 !
1.01 1.03
= CHF 600 000 1 −
1.03 1.03 − 1.01
CHF 600 000 1.0346 − 1.0146
=
1.03 − 1.01 1.0345
0 0
= CHF 1 836 196.91.
For going to Fachhochschule first, it is
45
0
X 1.02t−4
P V = CHF 60 000
1.03t
t=4
41
1.02 t
0 1 X
= CHF 60 000
1.034 1.03 Solution with
t=0
CHF 600 000
! ∞
1.02 42 X 1.02 t
formulas on paper:
= 1− 10 pt
1.034 1.03 1.03
t=0
Reasonable
CHF 600 000 1.0342 − 1.0242 1.03 formulas, but some
= 4 42
.
1.03 1.03 1.03 − 1.02 errors: 5pt
CHF 600 000 1.0342 − 1.0242 Solved in Excel or
=
1.03 − 1.02 1.0345 other Software: 5 pt
0 0
= CHF 1 845 968.97.
The young man should therefore choose to go the Fachhochschule
for four years.
(b) What is the rate of lending and borrowing that makes the student
indifferent between the two options? Complete the Excel work- PV or (1=i)^45*PV
sheet hw1.xls to compute the wages for the different years in is computed: 5pt
one column. In another column calculate the present value (PV) Solver applied and
of future wages depending on the interest rate. Solve for the in-
i=0.0313 has been
terest rate that equates the PV of the two options.
found: 5 pt
See fachhochschule sol.xls
