Transcript Managerial Economics & Business Strategy

Chapter 8 Homework
Numbers 1, 5, 10, and 13
Chapter 8 Appendix
How does all this
relate to my other
business classes???
More terms of importance
• Operating Income


Also called operating profit
Measure of money a company generated from its own
operations
• Can be used as a gauge of general health of the business
• Operating Income = gross profit – operating expenses
• Net income before tax

NIBT
• Net income after tax

NIAT
• Final income after deducting all expenses from revenue
What does the statement do?
• Shows business earnings
• Provides insight to how effectively the firm is
being run


How controlled are costs?
How much is spent in developing new products?
• Is the firm moving forward or stagnant

Can calculate profit and operating margins to compare to
competitors
So what can we do with this?
• Gross Profit Margin

Measures the company’s manufacturing and distribution efficiency.
• The higher the percentage the more efficient the firm is running
Gross Profit Margin

Gross Profit
Total Revenue



For John in 2004  7914/12154 = 0.65
For John in 2005  5564/8488 = 0.66
Tends to remain relatively stable overtime
• If large swings do occur…fraud or funny business may be to blame 
Interest Coverage Ratio
• Measurement of a company’s debt burden

The lower the ratio the higher the burden
• Measures the number of times a firm could make its interest
payments with its earning before interest and taxes

Safety net  looks at the short term financial health of the firm
ICR 
EBIT
Interest


For John in 2004  2984/332 = 8.99
For John in 2005  2110/196 = 10.77
Expense
Net Profit Margin
• Shows how much profit a company makes for every $1 it
generates in revenue

Higher is better
Net Profit Margin

Net income
after taxe s
Revenue


For John in 2004  2096/12154 = 0.17
For John in 2005  1355/8488 = 0.16
Can we do it?
• In 2002, Donna Manufacturing sold 100,000
widgets for $5 each, with a COGS for $2 each. It
had $150,000 in operating expenses, and paid
$52,500 in taxes. What is the net profit margin?






TR = 100,000*5 = 500,000
TC = 100,000*2 = 200,000
Gross Profit = 500,000-200,000 = 300,000
NIBT = 300,000-150,000 = 150,000
NIAT = 150,000 – 52,500 = 97,500
NPM = 97,500/500,000 = 0.195
Return on Equity (ROE)
• Reveals how much profit a company earned in
comparison to the total amount of shareholder equity
found on the balance sheet



Shareholder equity = total assets – total liabilities
A high ROE typically signals that a firm is capable of generating cash
internally
The higher the number the more return you are getting on your equity the
better
ROE 
Net Profit
Average Shareholde
r Equity for Period
Can we do it??
• Martha Stewart Living reported net earnings for 2004 to be
$21,906,000 while shareholder equity for 2004 and 2005 was
$222,192,000 and $196,166,000 respectively. What is the ROE?
ROE 
21 ,906 , 000
 222 ,154 , 000  196 ,116 , 000 


2


 0 . 1047
• Is this good?


Management is earning a 10.47% return on shareholder equity
Most S&P 500 firms average ROEs of 10 – 15%
Why is ROE important?
• Helps you cut to the chase on annual reports



Many CEOs will state that they achieved “record earnings”
What does that mean?
Each year a successful firm creates profits
• If they would take this money and put it in a simple savings
account earning very little interest…
• The interest gained on it would be enough to set a new record
earnings status for the next year.
• Big deal

ROE allows investors to see how effectively their capital is
being reinvested
Return on Assets
• ROA tells an investor how much profit a company
generated for each $1 in assets

Looks at the asset intensity of a business
• Do you need big, expensive pieces of machinery to make your
product or not?

Looks earnings in relation to all of the resources the company
had at its disposal
• Shareholders’ capital plus long and short term borrowed funds

If a company has no debt  ROE = ROA
Two ways to calculate ROA
ROA 
net income
average assets for period
or
ROA  Net profit margin * Asset Turnover
Asset turnover measures the total sales [revenue] for
every dollar of assets a company owns
TR/average assets
Calculate the ROA for 2001
Net Profit Margin

469,500,00 0
 0 . 025
18,427,200 ,000
Asset Turnover

18,427,200 ,000  TR
 9,911,500, 000  9,428,000, 000 

  average assets
2


 1 . 90
ROA  0 . 25 * 1 . 90  0 . 0475 or 4 . 75 %
ROA 
net income
average assets of the period

469 ,500 , 000
 9,911,500, 000  9,428,000, 000 


2


 0 . 04859 or 4 . 85 %
Now let’s analyze Abercrombie
and Fitch
What do we see??
• Gross Margin in 2005: gross profit /net sales




Gross Margin = 558034/1364853 = 41%
Gross Margin in 2004 = 509375/1237604 = 41.2%
Gross Margin in 2003 = 450383/1030858 = 43.7%
Investors will question why is the gross margin falling???
• What has happened in the industry?
• What is happening to competitor’s gross margin??
• Interest coverage ratio: EBIT/total interest expense
• ICR = 276522/5064 = 53.60


The company can afford to make its interest payments 53+
times before having financial issues
Looks financially stable.
• Net Profit Margin = NIAT/TR




NPM in 2005 = 168672/1364853 = 12.4%
NPM in 2004 = 158133/1237604 = 12.8%
NPM in 2003 = 149604/1030858 = 14.5%
Must compare to competitors to gain insight on what is a good
number
• ROE in 2005= net profit/average shareholders’
equity

ROE in 2005 = 168672/((595434+422700)/2) = 33%
• Management is earning 33% return on retained profits
• Is that good?



An investor would want to go with the firm in the industry that
is earning the highest return on shareholder equity
Average corporations earn between 10 and 15%
Abercrombie is doing FANTASTIC!!
• Asset Turnover = TR/average assets

AT in 2005 = 1364853/((770546+589577)/2) = 2
• This number is meant to be a measure of a company’s efficiency
in using assets
– The higher the number the better (but compare to other firms in the
industry)
– The higher the asset turnover the lower the profit margin tends to
be
• ROA = Net profit Margin * Asset Turnover

ROA in 2005 = 0.124*2 = 0.248 or 24.8%
• So is this a good company to invest in??




Sales, gross profit, and operating profit all have been
increasing
Gross and profit margins have been decreasing
Higher return on shareholders’ equity
Looks really good!!
Managerial Economics &
Business Strategy
Chapter 9
Basic Oligopoly Models
Oligopoly Environment
• Relatively few firms, usually less than 10.


Duopoly - two firms
Triopoly - three firms
• The products firms offer can be either
differentiated or homogeneous.
Role of Strategic Interaction
• Your actions affect
the profits of your
rivals.
• Your rivals’ actions
affect your profits.
An Example
• You and another firm sell differentiated products.
• How does the quantity demanded for your product
change when you change your price?


Depends on whether or not your rival changes their price as well
Demand will be more inelastic if other firms DO match
• Amount of product bought will change but not by much
P
D2 (Rival matches your price change)
P0
D1 (Rival holds its
price constant)
Q0
Q
What usually happens
•
•
•
•
Rivals will not match price increases
Rivals will match price decreases
Why?
Causes a KINK in the demand curve

Sometimes called Kinky Oligopoly Theory 
P
D2 (Rival matches your price change)
Demand if Rivals Match Price
Reductions but not Price Increases
P0
D1
D
Q0
(Rival holds its
price constant)
Q
Key Insight
• How much you sell with a price reduction
depends upon whether your rivals cut their
prices too!
• How much you sell with a price increase
depends upon whether your rivals raising their
prices too!
• Strategic interdependence

You aren’t in complete control of your own destiny!