BEC - Notes Chapter 2 http://www.cpa-cfa.

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Business Cycles and Reasons for Business Fluctuations GDP - the total market value of all final goods and services produced within the borders of a nation in a particular time period. (GM has a factory in China, doesn't count in GDP, Toyota has a factory in US, counts as GDP) Nominal GDP - unadjusted, measures the value of all final goods and services in current prices Real GDP - adjusted to account for changes in the price level by removing inflation by using a price index (called GDP deflator) Real GDP = (nominal GDP ÷ GDP deflator) * 100 Business cycle phases: Expansionary, Peak, Contractionary, Trough and Recovery B2-5 chart of the business cycle Recession - the economy experiences negative real economic growth (declines in national output) for two consecutive quarters Depression - a sever recession, long period of stagnation in business activity and high unemployment rates Leading indicators tend to predict economic activity - Avg new unemployment claims - New housing - Money supply - Order for goods - Price changes in materials Lagging indicators tend to follow economic activity - Prime rate charged by banks - Avg duration of unemployment - Bank loans outstanding Coincident indicators tent to occur during economic activity - Industrial production - Manufacturing and trade sales Draw supply & demand curve (do you remember how to label the graph, which goes where?) Increase demand (shift right) - Increase in wealth - Decreased in interest rates - Currency depreciates - Increase in government spending - Decrease in taxes Decrease demand (shift left) - Decrease in wealth - Increase in interest rates - Currency appreciates - Decrease in government spending - Increase in taxes Increase supply (shift right) - Decrease in raw materials/wages 1

BEC - Notes Chapter 2 http://www.cpa-cfa.org

- Excess supply - Increase in subsidies Decrease supply (shift left) - Increase in raw materials/wages - Supply shock - Increase in taxes The multiplier effect - increase in spending generates income for firms, which in turn spend that income, which gives other firms or households income and so on. This results from the marginal propensity to consume (MPC), The MPC is the change in consumption due to $1 increase in income, Multiplier = [1 ÷ (1 - MPC)] * change in spending Economic measures and reasons for changes in the economy The combined economic output of these four sectors comprise the GDP - Households (consumers) - Businesses - Federal, State and local governments - The Foreign sector There are two ways to measure GDP 1. Expenditure Approach - calculates the sum of the four components (GICE) Government Purchases of goods and services + Gross private domestic investment + Personal consumption expenditures + Net Exports = GDP 2. Income Approach - sum of resource costs and incomes (IPIRATED) Income of proprietors + Profits on corporations + Interest (net) + Rental income + Adjustments for net foreign income and miscellaneous items + Taxes + Employee compensation + Depreciation = GDP Either approach will yield the same GDP Net Domestic Product (NDP) - is GDP minus depreciation Gross National Product (GNP) - includes goods and services produced overseas by U.S. firms and excludes goods and services that are produced domestically by foreign firms. (GM has a factory in China, counts as GNP, Toyota has a factory in US, does not count in GNP) Disposable income (DI) - personal income less personal taxes. It is the amount of income households have available to either spend or save 2

BEC - Notes Chapter 2 http://www.cpa-cfa.org

To be counted as unemployed a person must be actively looking for work Unemployment rate = (number of unemployed ÷ total labor force) * 100 Types of Unemployment • Fictional unemployment - normal unemployment resulting from workers changing jobs or being temporarily laid off • Structural Unemployment - Jobs available do not correspond to the skills of the work force, or workers do not live where the jobs are located • Seasonal unemployment - is the result of seasonal changes in the demand and supply of labor • Cyclical unemployment - amount of unemployment resulting from declines in real GDP during a contraction or recession Fictional, structural and seasonal will always occur regardless of the economic state. Natural rate of employment - normal rate of employment around which the unemployment rate fluctuates due to cyclical unemployment Full employment - there is no cyclical unemployment Inflation is defined as the sustained increase in general prices of goods and services Consumer Price Index (CPI) - measure of the overall cost of fixed basket of goods and services purchased by an avg household Inflation rate = [(CPI this period - CPI last period) ÷ CPI last period] * 100 Demand-pull inflation is caused by increases in aggregate demand Cost-push inflation is caused by reductions in short-run aggregate supply Inflation causes purchasing power to decrease. Inverse relationship Monetary assets and liabilities (cash, A/R, Notes payable, etc) are fixed in dollars and are not affected by inflation Non-monetary assets and liabilities (buildings, land, machinery, etc) will fluctuate with inflation and deflation During a period of inflation, those receiving money (its worth less) will be hurt because purchasing power as eroded. Firms that lend money at fixed interest rates will be hurt by inflation During a period of inflation, those with a fixed amount of debt will be aided because they will repay the debt will inflated dollars. Thus inflation tends to benefit firms with a large amount of outstanding debt Stagflation - falling national output and inflation The Phillips curve - illustrates the inverse relationship between inflation and the unemployment rate B2-22 graph of Phillips curve Makes sense because high unemployment means low demand so prices should fall Cyclical budget deficit - caused by temporary low activity (poor economy means less income for people so government gets less in revenues) 3

BEC - Notes Chapter 2 http://www.cpa-cfa.org

A structural budget deficit - caused by a structural imbalance between government spending and revenue Nominal interest rate - interest rate in current prices Real interest rate - is defined as the nominal interest rate minus the inflation rate Real interest rate = nominal interest rate - inflation rate M1 and M2 are the most common measures of money supply M1 - money used for purchases of goods and services (coins, currency, deposits) M2 - M1 + liquid assets that can be converted easily into M1 Monetary policy is the use of the money supply to stabile the economy. The fed controls the money supply through 3 main ways: 1. Open Market Operations - purchase (increase M1) and sale (decrease M1) of government securities (T-bills and bonds) 2. Discount rate - the rate the fed charges banks. Raising rates discourages borrowing and decreases money supply and visa versa 3. Required Reserve Ratio (RRR) - fraction of total deposits banks must hold in reserve. Raising the RRR decrease money supply Money demand and interest rates are inversely related. As interest rates rise, it becomes more expensive to hold money (because holding money rather than saving or investing it means you do not earn interest), thus reducing the demand for money An increase in money supply will cause interest rates to fall, leading to increase in investment, increasing demand, causing GDP to increase, unemployment to fall and price level to rise Market influences on business strategies Mission statement - one or two line descriptions of what the organization is in business to do SWOT - Strength and Weakness are internal, Opportunities and Threats are external Implementing a plan can occur on various levels; Corporate lvl, Business lvl, Functional lvl, Operating lvl. [Strategic] ----------------------------------- [Tactical] The market demand curve for a good is the sum of all the individual demand curves B2-34 graph illustrating individual demand curve summed to market demand curve A change in price results in a change in quantity supplied/demanded A change in anything other than price results in a change in supply/demand B2-36 graph on surplus and shortage If price is set above the equilibrium (price floor), it will create a surplus, quantity supplied exceeds quantity demanded If price is set below the equilibrium (price ceiling), it will create a shortage, quantity demanded exceeds quantity supplied Elasticity - measure of how sensitive the demand for, or supply of, a product changes to changes in price 4

BEC - Notes Chapter 2 http://www.cpa-cfa.org

Price elasticity is measured in 2 ways: • Point method - measures price elasticity at a particular point of the demand curve Price elasticity = % change in quantity demanded ÷ % change in price

• Midpoint method - measures price elasticity of demand between any two points on a demand curve Price elasticity = [(Q2 - Q1) ÷ (Q2+Q1)] ÷ [(P2-P1) ÷ (P2+P1)] Price Inelastic < 1 Price Elastic > 1 Unit Elasticity = 1 More the substitutes more elasticity Longer the time period the more elasticity Cross elasticity - the % change in the quantity demanded (or supplied) of one good caused by the price change of another good Cross elasticity = % change in number of units of X demanded (or supplied) ÷ % change in price of Y If the coefficient is positive, then the two goods are substitutes If the coefficient is negative, then the commodities are complements Explicit costs - are documented out-of-expenses (wages, materials and utilities) Implicit costs - opportunity costs, the profits that are lost from following one business strategy vs another Accounting costs - measure the explicit costs of operating a business Economic costs - accounting (explicit) costs plus opportunity (implicit) costs Accounting profits - difference between total revenue and total accounting costs Economic profits - difference between total revenue and total economic costs, which include opportunity costs Marginal costs (incremental cost) - is the change in total cost associated with a change in output quantity over a period of time MC = change in total costs ÷ change in quantity Economies of scale - are reductions in unit costs resulting from increases size of operations Diseconomies of scale - size becomes inefficient and they are no longer cost productive Perfectly competitive market - A larger number of suppliers and customers - Little product differentiation (homogenous products) - No barriers to entry - B2-49 graph of this Monopolistic competition - Many firms with differentiated products - Few barriers to entry - Ability to exert some influence over the price and market - Competition to increase brand loyalty - B2-52 graph of this 5

BEC - Notes Chapter 2 http://www.cpa-cfa.org

Oligopoly -

Few firms with differentiated products Fairly significant barriers to entry Ability to fix prices B2-53 graph of this

Monopoly - A single firm with a unique product - Significant barriers to entry - The ability of the firm to set output and prices - No substitute products - B2-50 graph of this Regardless of the model, the firm will operate best/ maximize short run profits, Price = Marginal Revenue = Marginal Cost (P=MR=MC) B2-50 comprehensive chart showing differences between the market structures Cartels - a group of firms acting together to coordinate output decisions and control prices as if they were a single monopoly Boycotts - organized group of refusals to conduct market transactions with a target group Factors of production - Land (natural resources) - Labor (human capital) - Capital (non-human physical capital accumulated through past investment) Minimum wage causes a surplus of workers because a firm can't or don't want to pay works (minimum wage is set above equilibrium price). So it increases unemployment. Best cost provider combines the cost leadership strategy benefits with the differentiation strategy Implications of dealing in foreign currencies 3 types of exchange rate risks Transaction risk - single transaction Economic risk - government instability, nationalization B2-74 chart of currency effect on foreign currency inflows and outflows Translation risk - translation of financial statements - Temporal method (remeasurement method) - assumes function currency of the sub is that of parents - translation gains and losses flow through the income statement - if we are converting from the 3rd currency to functional, those gains flow through I/S - Current method (translation method) - functional currency of the sub is different from parent - translation gains and losses flow through other comprehensive income - if we are converting from functional to reporting currency, those gains flow through other comprehensive income Factors influencing exchange rates 6

BEC - Notes Chapter 2 http://www.cpa-cfa.org

• Relative inflation rates - when country A inflation exceeds country B inflation, country B currency appreciates as country A residents try to protect their money from eroding • Relative income levels - when country A's income increases compared to country B, country B currency appreciates as country A residents buy more of B's goods and services • Government controls - Tariffs or taxes on country B's goods will decrease the demand for B's currency, depreciating it compared to A • Relative interest rates - when country A's interest rates are lower than country B's, country B's currency appreciates as country A residents seek better returns in country B There are 3 theories explaining exchange rate risk • Purchasing Power Parity - the price of identical goods should cost the same in two different countries when measured in the same currency - Absolute form - prices will be exact between countries - Relative form - prices will be approximately equal (accounts for transportation and govt reg) • International Fischer effect - explains the fluctuation in FX rates through analysis of interest rates. • Interest Rate Parity - holds that foreign and domestic interest rates will reach equilibrium once covered interest arbitrage is no longer possible Types of hedges • Futures - trade on an exchange, smaller transaction and are denominated in standard amounts • Forwards - trade over-the-counter, larger transaction and denominated in standard amounts • Money Market Hedge - uses domestic currency to purchase a foreign currency at spot rates and invest them in securities times to mature at the same time as the payable is due B2-79 example of money market hedge Transfer pricing - transaction between subsidiaries to minimize taxation while still being legal Other SCOR Model (Supply Chain Operations Reference) • Plan – consists of developing ways to balance demand and supply (planning inventory levels, purchase of raw materials, etc) • Source – procure the resources required to meet and manage the infrastructure for the sources (selecting vendors, collecting vendor payments, quality assurance, etc) • Make – all activities that turn raw materials into finished products (manufacturing the product, changes in engineering, performing quality assurance tests) • Deliver – all activities that get the product to the consumers (managing orders, forecasting, pricing, A/R, shipping)

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