Chapter 2

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Lecture 2

Ch. 2 Fundamental Economic Concepts

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Demand and Supply Review Total, Average, and Marginal Analysis Finding the Optimum Point Present Value, Discounting & Net Present Value Risk and Expected Value Probability Distributions Standard Deviation & Coefficient of Variation The Relationship Between Risk & Return

Economic vs. Accounting Profits

—  Accounting Profits

—  Total revenue (sales) minus dollar cost of producing

goods or services.

—  Reported on the firm’s income statement.

—  Economic Profits

—  Total revenue minus total economic (opportunity) cost.

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Opportunity Cost

—  Accounting Costs

—  The explicit costs of the resources needed to produce

goods or services.

—  Reported on the firm’s income statement.

—  Opportunity Cost

—  The cost of the explicit and implicit resources that are

foregone when a decision is made.

—  Economic Profits

—  Total revenue minus total opportunity cost.

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The Time Value of Money

—  Present value (PV) of a future value (FV)

lump-sum amount to be received at the end of “n” periods in the future when the per-period interest rate is “i”:

PV =

FV

(1 + i ) n

•  Examples:

   

*Present value recognizes that a dollar received in the future

is worth less than a dollar in hand today.

Lotto winner choosing between a single lump-sum payout of $104 million or $198 million over 25 years. Determining damages in a patent infringement case.

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Present Value of a Series

—  Present value of a stream of future amounts

(FVt) received at the end of each period for “n” periods:

PV =

FV1

(1 + i )

1

+

FV2

(1 + i )

n

2

+ ...+

FVn

(1 + i ) n

—  Equivalently,

PV = ∑

FVt

t 1 t =1 ( + i )

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Net Present Value

—  Suppose a manager can purchase a stream

of future receipts (FVt ) by spending “C0” dollars today. The...