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Chapter 1
Introduction and Goals of the Firm
Solutions to Exercises
1. The ability to switch technologies is a real option for the Southern Company. By
switching to clearer fuels, Southern may not achieve a positive net present value
(NPV), but if the change is made it may create opportunities for expanded sales of
tradable pollution assets when later cap-and-trade bills impose tighter restrictions. In
this case, historically, that is exactly what happened. This additional possibility for
future cash flows is an embedded option that augments the current NPV of the
decision to change to a clean fuel or cleaner technology to burn the fuel. Increases in
both real option value and NPV flow to the shareholders, so the shareholders are
pleased when firms adopt projects with strategic flexibility.
2. Shareholders want high long-term profits. Managers want job security and wonderful
perks and amenities. Since risk and return tend to be positively correlated, managers
may wish to avoid risks that shareholders want the managers to undertake. To
encourage managers to take on risks, compensation committees can place a greater
weight in setting managerial compensation on long-term incentives such as stock,
options to buy stock, and bonuses based on surpassing the performance of
comparable firms over several years. All of the compensation in salary and fringe
benefits would induce managers to start only low risk projects to avoid making any
mistakes and stay away from higher risk, potentially high-valued projects.
3. When the bonus is tied to the short-run earnings of the manager’s firm, then the
bonus declines even if the manager did everything he or she could do in the midst of
an economic downturn. Accordingly, bonus pay should relate to the performance of
other comparable companies for a longer period to remove any incentive to boost
short-term cash flows at the expense of long-term profitability. The bonus should be
designed for mangers that exceed their industry averages over the last several years.
4. Southern could (1) buy carbon allowances, (2) install smokestack scrubbers, or (3)
adopt fuel-switching technology to burn higher-priced low-sulfur coal whenever it
Full download please contact or qidiantiku.com 1
, Full download please contact or qidiantiku.com
becomes cheaper. Alternative 3 was the lowest in cost and offered the greatest real
option to be able to sell tradable pollution assets in the future, depending on changes
in coal prices, regulations and laws. Installing scrubber technology forfeits the
opportunity to switch back and forth among low and high sulfur coal depending on
the coal prices and regulatory changes.
5. High profits in the drug industry are explained by the risk-bearing theory of profit,
the innovation theory of profit, and the monopoly theory of profit. Medical R&D
tends to be expensive with no assurance the Food & Drug Administration will find
new treatments to be safe or effective – this shows the risk in the industry. But when
a new drug, new medical device or treatment works, this gives firms an innovative
advantage. Furthermore, patents granted for the development of drugs provide the
firm with a monopoly position in the production and marketing of that drug. In the
absence of patents, it is likely that the drug industry would still have higher than
average profitability due the risk-bearing and innovative theory of profits.
6. The following events will change shareholder wealth:
a. More competition is likely to lower prices and thereby reduce the value of the firm.
b. In general, higher costs on the firm are likely to lower the value of the firm. If
these requirements are imposed equally on all firms, some of the cost burden will
be borne by the firm and some by consumers, depending on the nature of the
demand function. If the impact of the requirements is substantially different from
one firm to another in an industry, the value of some firms may be enhanced
relative to those at a competitive disadvantage because of the standards.
c. If the union is effective in raising wages without improving productivity, then
the value of the firm is decreases. However, labor costs may rise but be offset by
increases in productivity, then the change in the value of the firm depends on
which increased more, wages or productivity. Unfortunately, sometimes a union
may impede productivity when unions succeed in getting work rules that slow
output or increase the number of workers needed to do a job.
d. Inflation tends to increase costs and increase prices. The full impact is
indeterminate depending on the ability of the firm to pass along higher costs to
consumers and on the specific impact of inflation on a firm's costs.
e. Lower costs, other things equal, will raise the value of the firm. At some point,
competitors wiil imitate if they can and also adopt this new technology.
Full
2 download please contact or qidiantiku.com
Chapter 1
Introduction and Goals of the Firm
Solutions to Exercises
1. The ability to switch technologies is a real option for the Southern Company. By
switching to clearer fuels, Southern may not achieve a positive net present value
(NPV), but if the change is made it may create opportunities for expanded sales of
tradable pollution assets when later cap-and-trade bills impose tighter restrictions. In
this case, historically, that is exactly what happened. This additional possibility for
future cash flows is an embedded option that augments the current NPV of the
decision to change to a clean fuel or cleaner technology to burn the fuel. Increases in
both real option value and NPV flow to the shareholders, so the shareholders are
pleased when firms adopt projects with strategic flexibility.
2. Shareholders want high long-term profits. Managers want job security and wonderful
perks and amenities. Since risk and return tend to be positively correlated, managers
may wish to avoid risks that shareholders want the managers to undertake. To
encourage managers to take on risks, compensation committees can place a greater
weight in setting managerial compensation on long-term incentives such as stock,
options to buy stock, and bonuses based on surpassing the performance of
comparable firms over several years. All of the compensation in salary and fringe
benefits would induce managers to start only low risk projects to avoid making any
mistakes and stay away from higher risk, potentially high-valued projects.
3. When the bonus is tied to the short-run earnings of the manager’s firm, then the
bonus declines even if the manager did everything he or she could do in the midst of
an economic downturn. Accordingly, bonus pay should relate to the performance of
other comparable companies for a longer period to remove any incentive to boost
short-term cash flows at the expense of long-term profitability. The bonus should be
designed for mangers that exceed their industry averages over the last several years.
4. Southern could (1) buy carbon allowances, (2) install smokestack scrubbers, or (3)
adopt fuel-switching technology to burn higher-priced low-sulfur coal whenever it
Full download please contact or qidiantiku.com 1
, Full download please contact or qidiantiku.com
becomes cheaper. Alternative 3 was the lowest in cost and offered the greatest real
option to be able to sell tradable pollution assets in the future, depending on changes
in coal prices, regulations and laws. Installing scrubber technology forfeits the
opportunity to switch back and forth among low and high sulfur coal depending on
the coal prices and regulatory changes.
5. High profits in the drug industry are explained by the risk-bearing theory of profit,
the innovation theory of profit, and the monopoly theory of profit. Medical R&D
tends to be expensive with no assurance the Food & Drug Administration will find
new treatments to be safe or effective – this shows the risk in the industry. But when
a new drug, new medical device or treatment works, this gives firms an innovative
advantage. Furthermore, patents granted for the development of drugs provide the
firm with a monopoly position in the production and marketing of that drug. In the
absence of patents, it is likely that the drug industry would still have higher than
average profitability due the risk-bearing and innovative theory of profits.
6. The following events will change shareholder wealth:
a. More competition is likely to lower prices and thereby reduce the value of the firm.
b. In general, higher costs on the firm are likely to lower the value of the firm. If
these requirements are imposed equally on all firms, some of the cost burden will
be borne by the firm and some by consumers, depending on the nature of the
demand function. If the impact of the requirements is substantially different from
one firm to another in an industry, the value of some firms may be enhanced
relative to those at a competitive disadvantage because of the standards.
c. If the union is effective in raising wages without improving productivity, then
the value of the firm is decreases. However, labor costs may rise but be offset by
increases in productivity, then the change in the value of the firm depends on
which increased more, wages or productivity. Unfortunately, sometimes a union
may impede productivity when unions succeed in getting work rules that slow
output or increase the number of workers needed to do a job.
d. Inflation tends to increase costs and increase prices. The full impact is
indeterminate depending on the ability of the firm to pass along higher costs to
consumers and on the specific impact of inflation on a firm's costs.
e. Lower costs, other things equal, will raise the value of the firm. At some point,
competitors wiil imitate if they can and also adopt this new technology.
Full
2 download please contact or qidiantiku.com
