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BA1
Fundamentals
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Economics
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Contents
1. National income, and the effects of economic growth rates and prices on business 3
2. International trade 19
4. Organisations 33
5. Prices 43
11. The effects of interest rates and exchange rates on business performance 113
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CHAPTER 1
NATIONAL INCOME, AND THE EFFECTS
OF ECONOMIC GROWTH RATES AND
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PRICES ON BUSINESS
1 Introduction to macroeconomics
The term ‘macroeconomics’ refers to the branch of economics that deals with national and
international economics. ‘Microeconomics’, which will be dealt with later, deals with the
study of specific markets for products and services.
2 National income
National income can be defined as:
the total value a country’s final output of all new goods and services produced in a year.
The word ‘final’ is important. If Company A sold goods to consumers, then the value of those
sales would be part of national income. However, if Company A sold to Company B and
Company B sold to the public for the same price, then the sales revenue would appear in
both company’s accounts and there would be double-counting if both amounts were
included in national income. To avoid this, only Company B’s sales would be included in
national income.
The higher the national income, the more income is available for a country’s population
There are two main measures of national income:
๏ Gross domestic product (GDP)
๏ Gross national product (GNP)
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A country’s gross domestic product refers to the total value of income or production taking
place in that country. It is calculated as:
Capital Exports of Imports of
Household Government
GDP = + investment + + goods and – goods and
spending spending
spending services services
A country’s gross national product takes into account income earned from abroad and also
profits earned in a country being sent to foreign investors. The difference between income
being earned abroad and profits being remitted to overseas investors is called the net
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Firms
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As well as money, goods, services and factors of production moving between firms and
households, there are injections and withdrawals (or leakages) from the system.
Injections:
๏ Government spending
๏ Exports (money comes from abroad)
๏ Investment (this is expenditure on goods in addition to household spending).
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Withdrawals:
๏ Taxation
๏ Savings (for example, money is earned, but simply kept and accumulated)
๏ Imports (money goes abroad)
Injections will increase the circular flow of income (for example, money flowing into the
country from the sale of exports). Similarly, withdrawals will decrease the circular flow (for
example, more people deciding to save).
If an economy is in equilibrium (meaning that the circular flows are constant) then injections
into the economy must stimulate the economy. For example, if the government suddenly
printed more money and injected it into the economy by giving each person €10 to spend,
then that additional money could be spent on goods and services, increasing both
consumption and the supply of goods. To supply more goods, more factors of production
would be bought, increasing the population’s income until a new equilibrium point is
reached.
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Prices
Aggregate
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Demand 2
Aggregate
Demand 1 Aggregate
supply
B
A
Output
We start at point A. Aggregate supply and aggregate demand meet at this point: the quantity
supplied matches the quantity of goods demanded.
When confidence in the economy rises and people are willing to spend more money, the
aggregate demand shifts to the right from aggregate demand line 1 to line 2. This means that
more goods are demanded at a given price.
The extra demand will stimulate producers to supply more and the equilibrium point moves
from A to B. Prices are slightly higher. Of course, as production increases, employment will
increase, so governments can increase employment by stimulating aggregate demand.
Demand can be stimulated by measures such as:
๏ Decreasing tax so that consumers are left with more to spend
๏ Increasing government expenditure (eg the government borrows and spends)
๏ Decreasing interest rates so that it is cheaper for consumers to borrow and spend
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Of course, aggregate supply has limits. For example, once everyone is in employment it is
difficult to satisfy further demand. Output has reached its limit
Prices
Aggregate supply,
showing where
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B
A
Aggregate
supply
Output
If no further goods can be made, yet demand keeps increasing, there will be a strong upward
inflationary pressure on the economy as output cannot adjust to meet demand. On the other
hand, if demand is lower than could be met by maximum demand, there is likely to be
unemployment.
Prices
Aggregate
Demand 2
Full employment
Aggregate
Demand 1 B
C
A
Aggregate
supply
Output
At equilibrium point A, aggregate demand is equal to aggregate supply but there is spare
productive capacity and there will be unemployment. The line showing aggregate Demand 1
would have to move to the right until it went through point C where full employment would
be reached. The rightward move in aggregate demand needed to achieve full employment is
known as the deflationary gap.
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At equilibrium point B, aggregate demand is higher than the maximum supply available.
Output can’t increase so prices rise steeply as a way of making demand and supply match.
The line showing aggregate Demand 2 would have to move leftward to go through point C
and to achieve matched demand and supply. The distance aggregate demand would have to
reduce to achieve the match at point C is known as the inflationary gap.
This section is not talking about movement along an aggregate demand curve. Such
movements are caused by changes in prices that will increase or decrease demand. We are
looking at what causes demand curves to shift to the right (eg Demand line 1 moving to
Demand line 2) or to the left.
Shifts to the right increase aggregate demand and is equivalent to an economy growing.
Similarly, shifts to the left imply the economy is contracting. Controlling economic growth or
contraction will be a key concern of all governments: fast growth can lead to inflation and can
suck in imports to meet demand; fast decline can lead to mass unemployment.
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6 Inflation
Inflation is a general increase in prices in an economy and a consequential fall in the
purchasing power of money: what can be bought for $1 now cannot be purchased by $1 in
one year.
Inflation (in particular high rates of inflation) are undesirable. For example:
๏ It hurts people who rely on fixed incomes.
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7 Measures of inflation
7.1 Introduction
Inflation is measured using indices. So, if a product cost $210 in 2017 and $231 in 2018, the
inflation index over would be calculated as:
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2017 is the base year, and an index of 110 implies an inflation rate of 10%.
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Either method of adjustment shows that real growth in sales was illusory: after taking
inflation into account, sales values have fallen markedly.
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8 Trade cycles
8.1 The components
A trade cycle is composed of periods of good trade characterised by rising prices and low
unemployment percentages alternating with periods of bad trade characterised by falling
prices and high unemployment percentages (Keynes).
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Output
Peak / boom
Peak / boom
Trend
Trough
Time
During expansion, manufacturing and spending are increasing. There is a danger of high
inflation as demand exceeds supply and the prices of materials and labour are bid up. Imports
are likely to increase. Public finances are good because increased profits and employment
yields increased tax.
During recessions, economies shrink. Businesses are likely to fail and unemployment will
increase. Inflation might fall – though there is a phenomenon known as ‘stagflation’ which is
characterised by high inflation together with high unemployment and stagnant demand in a
country's economy. Imports are likely to fall and public
In boom periods economies are likely to ‘overheat’ with asset prices (shares, property etc)
becoming overvalued, only to cause large losses when a recession sets in.
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๏ Increase taxation
๏ Reduce government spending
๏ Decrease the money supply by tightening bank lending rules.
Recession
Attempt to stimulate the economy so that employment and incomes increase. For example:
๏ Decrease interest rates.
๏ Decrease tax.
๏ The government can borrow money to increase its expenditure.
๏ Increase the money supply be relaxing bank lending rules.
9 Public finance
9.1 Introduction
Public finance refers to how the government raises money and spends it.
9.3 Taxation
Taxes can be described as:
๏ Regressive.
๏ Proportional.
๏ Progressive.
A regressive tax takes a higher proportion of a poor person’s salary than it does for a rich
person. A simple example is VAT. If the VAT rate is 20% it doesn’t matter whether you are rich
or poor you still pay 20% on a purchase and that is proportionally more taken from a poor
person’s pay than it is from a rich person’s income.
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A proportional tax takes exactly the same proportion of income tax from all levels of income.
So you could have a flat rate tax which taxes everyone at say 10% from the very first dollar
earned, up to millions of dollars.
A progressive tax takes a higher proportion of income as income rises. So maybe for the first
$1,000 of income the tax rate is zero, for the next $4,000 of income the tax rate is 20%, and
anything beyond that is taxed at say 40%. A progressive tax would obviously be more
effective at redistributing wealth and income than either a regressive or a proportional tax.
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๏ A direct tax is paid directly by a person to the revenue authority. A good example is
income tax. A certain proportion of your income goes directly to the revenue authority.
๏ An indirect tax is collected by the revenue authority from an intermediary, normally a
supplier of some sort. A good example of an indirect tax is VAT. You buy something, you
pay over the total purchase price, and then the seller passes some of that on to the
government.
Some taxes are charged as a fixed sum per unit sold. So if you were to buy a bottle of wine it
doesn’t matter whether it costs $5, $10 or $25; a fixed sum will go to the government.
An ad valorem tax is charged as a fixed percentage of the price of the good. A good example
of an ad valorem tax is VAT
9.4 Borrowing
Governments raise funds by selling government bonds and treasury bills to investors.
Government has to pay interest on its borrowings and this can become a very significant
expense when borrowing is high. Governments with very high borrowing can find it difficult
to raise more money in this way because investors fear government default. This puts up the
interest rate that must be offered.
Most borrowing is repayable after a number of years but some bonds are irredeemable.
Borrowing is used if the government feels that taxes cannot be raised. For example, the
government might fear for its popularity. In addition, if the government takes money from
consumers through taxes then this will reduce consumer spending. Of course, the
government can spend the money raised by taxation, but the economy is unlikely to be
stimulated. Borrowing allows the government to spend more while not taking more from
consumers and this will stimulate the economy.
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Quantitative easing is used when economies are in a poor shape and need stimulating. If an
economy was doing well releasing more money through quantitative easing will cause
inflation and will reduce the purchasing power of money, penalising, in particular, savers and
those on fixed incomes.
Taxation Borrowing
In the current recession governments are seeking to spend more money and therefore to put
money into the economy to try to stimulate it. However, if they spend more by raising taxes
they may actually not end up putting very much more money into the economy. They are
taking with one hand and giving away with the other. So what most governments are doing
is increasing government borrowing. Keep taxes the same; borrow money, spend it, once it’s
spent it will be earned by people who will spend it again. And that’s the way in which
governments hope the recession will be brought to an end.
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in the economy. Say however that the reserve requirement was 50% - $1,000 in the
bank; the bank only lend on $500. That $500 is put into another account, the bank can
lend on only $250 and so on. You can see that at the end of the cycles a much smaller
amount of money will be created in the economy.
11 The multiplier
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Let’s say that a government introduces $100m into the economy by employing additional
doctors in a state health service. The extra doctors will receive salaries from the government
and will spend some and save some of their earnings.
Let’s say they spend 75% and save 25% (25% is known as the marginal propensity to save).
So, $75m is spend by doctors and earned by other people or firms. If they also had a marginal
propensity to save, they would spend 75% x $75m = $56.25, and so on. The total additional
expenditure will therefore be:
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Tests
Question 1
What word should fill the blanks, below?
National income is the total value a country’s _____________ output of all new goods and
services produced in a year
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Question 2
Which one of the following is the correct definition for gross domestic product?
+ Capital + Exports of + Imports of
Household + Government
A GDP = investment goods and goods and
spending spending
spending services services
Question 3
In the circular flow of income, there are some injections and withdrawals. Label each of
the following:
Injection Withdrawal
Tax
Exports
Imports
Savings
Government spending
Question 4
A tax which raises the same amount from each person irrespective of their income is
known as a(n):
A Progressive tax
B Regressive tax
C Ad valorem tax
D Income tax
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Question 5
If a population has a marginal propensity to save of 0.2 and the government injects $100m
into the economy, how much additional expenditure will result?
Question 6
Prices
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Aggregate
Demand 2
Aggregate
Demand 1 Aggregate
supply
B
A
Output
In the above diagram, which TWO of the following would move the aggregate demand
from position 1 to position 2?
A An increase in prices
B A decrease in prices
C Decreasing interest rates
D Increasing government expenditure
Question 7
When an economy is operating at its maximum output, but aggregate demand is
higher, what is the main economic effect?
_______________________________
Question 8
Base year Current year
Products Quantity Unit price $ Quantity Unit price $
P 30 4.00 40 5.00
Q 50 3.00 60 4.00
What are the:
(a) Base-year weighted quantity index?
(b) Current-year weighted value index?
Question 9
What are the four ways in which governments can raise money?
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CHAPTER 2
INTERNATIONAL TRADE
Almost every country trades internationally through importing and exporting both goods
and services. Other international transactions also occur, such as when a company buys or
sells a foreign subsidiary or whenever profits and interest are sent to international investors
or lenders.
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If the USA is a high net importer from China, then the USA needs continuous supplies of yuan,
the Chinese currency, to pay suppliers. How can it obtain these supplies, given that exports to
China are negligible? There are three methods:
๏ Sell assets to China. For example, companies, gold, other foreign currency holdings
๏ Borrow yuan from China eg issue government bonds to China.
๏ Sell US$ to China in exchange for yuan. However, with floating exchange rates this will
have the effect of depressing the value of the dollar and increasing the value of the
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yuan
Countries run out of assets to sell; borrowing more will mean that there are vast interest
payments and a risk of default by the country.
Control of deficits are as follows
๏ Selling US$ for yuan should provide a self-regulatory mechanism to the deficit
imbalance because imports will become more expensive, but this mechanism is often
not enough to control exchange rates. Exchange rates depend on other factors also
such as interest rates, speculators and economic stability.
๏ Deliberate devaluation (where exchange rates are fixed).
๏ Import controls to reduce the value of goods imported
๏ Deflation – reducing domestic demand so that consumers buy less in general –
including less imports.
๏ Producing goods that will successfully compete with imports and which can themselves
be exported. This is known as a supply-side mechanism because the supply of goods if
adjusted.
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Absolute advantage
A country has absolute advantage when it performs a task more efficiently than producers in
other countries. For example, because of its climate, Spain is extremely efficiency at
producing oranges, lemons, olives and tomatoes. It will always be able to produce these
goods more efficiently that they can be produced in countries such as the UK or Russia. It
makes sense to import these goods from Spain rather than having to artificially heat vast
greenhouses in your own country.
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Comparative advantage
This is a more subtle concept. Staying with fruit growing in Spain and the UK, say that the
output per hectare of ground is as follows:
Units of weight Tomatoes Oranges
Spain 1200 800
UK 700 10
Spain obviously has absolute advantage when growing both products. Now let’s say that in
each country we look at one hectare being planted with tomatoes and another hectare
planted with oranges. Assume that the two hectares in each country are the only resources
available.
Total output will be:
Units of weight Tomatoes Oranges
Spain 1200 800
UK 700 10
Total 1900 810
However, the UK is much, much, much better at producing tomatoes than oranges, so should
specialise wholly in that so that both hectares are used for tomatoes, allowing 2 x 700 = 1400
units of tomatoes to be produced there. If total demand for tomatoes in both countries stays
at 1,900, Spain will have to product only 500 units of tomatoes and can shift 7/12 of its
tomato production to orange production. This will allow additional orange production of
7/12 x 800 = 467 units.
Total production, with the same total resources of four hectares is now
Units of weight Tomatoes Oranges
Spain 500 1267
UK 1400 0
Total 1900 1267
So total output is much higher and the use of the land much better. Now, of course the UK
can export tomatoes to Spain and Spain can export oranges to the UK.
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because they will have to pay more for cars – but the new factory will provide several
thousand jobs for Americans.
๏ The promise to repatriate jobs by placing impediments to importing is very powerful
and seductive – particularly amongst blue-collar workers, a category which particularly
suffered by off-shoring manufacturing or allowing free import of foreign goods.
5 Exchange rates
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An exchange rate shows how much one currency is in terms of another. For example:
๏ GBP1/USD = 1.34 or GBP1 = USD1.34 or just £1 = $1.34
๏ Means that 1 GB Pound can be changed for 1.34 US dollars
Banks quote exchange rates showing a spread as follows:
๏ GBP1 = $1.34 – $1.31
๏ One rate is for changing £ to $ and the other for changing $ to £. Banks always use the
rate that leaves customers worst off, so if you went into a bank with £1,000 you would
be given only $1,310 in exchange, not $1,340.
๏ Some exchange rates are fixed (or pegged) but most float so that they change
constantly. Floating exchange rates present problems for importers and exporters when
they are buying or selling in a foreign currency. A UK firm might have agreed to export
goods to a USA customer for $10,000 when at the time of the contract the exchange
rate was £1 = $1.34. The firm would therefore budget to receive $10,000/1.34 = £7,463.
If, however, by the time payment was received, the US$ had weakened so that the
exchange rate was £1 = $1.42, the amount received would be worth only $10,000/1.42
= £7,042. There are methods that can be used to eliminate or substantially reduce this
uncertainty (covered more fully in Chapter 11).
Apart from difficulties arising from uncertainty in exchange rates, exchange rates have the
following effects on businesses:
๏ A strengthening home currency makes exports more expensive to foreign buyers and
less competitive. Conversely, a weakening home currency makes exports less expensive
and more competitive.
๏ A strengthening home currency makes imports cheaper and these are then more
competitive compared to goods domestically produced. Note that a company does not
have to import or export itself to suffer from the effect of cheaper imports. Conversely, a
weakening home currency makes imports more expensive.
๏ Dividends remitted from foreign subsidiaries become more valuable if the home
currency weakens.
๏ Interest to be paid on foreign loans will become more expensive f the home currency
weakens.
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Tests
Question 1
Fill in the blank:
It makes sense for the UK to import oranges from Spain rather than grow them in
greenhouses domestically. In terms of explaining the advantages that can rise from
international trade this is known as _________________ advantage.
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Question 2
Fill in the blank:
The general name for trying to reduce international trade by quotas, tariffs and other means
is known as _____________________________.
Question 3
Which one of the following is NOT an advantage of international trade?
A Greater opportunities for economies of scale
B Exploiting comparative advantage
C Guaranteed access to strategic resources
D Greater competition
Question 4
An exchange rate is quoted as GBP1 =€1.25 –€1.22
If you wanted to change €120,000 to GBP, how many GBP would you receive?
Question 5
If a country’s home currency strengthens, which TWO of the following effects will be
experienced?
A The company’s exports will be more competitive
B The company’s exports will be less competitive
C The company might face more competition from imports
D The company might face less competition from imports
Question 6
The current exchange rate between country A$ and country B$ is A$1 = 1.5B$
If country A’s inflation rate is higher than country B’s inflation rate, will the exchange
rate move towards A$1 = 1.4B$ or A$1 = 1.6B$
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CHAPTER 3
ECONOMIC DEVELOPMENT AND
GLOBALISATION
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2 Globalisation
Globalisation can be defined as:
“The process by which the countries and businesses throughout the world are becoming
increasingly interconnected because of increased trade. Globalisation has increased the
production of goods and services. The biggest companies are multi-national companies with
subsidiaries in many countries throughout world.”
Globalisation has been caused by:
๏ Improved communication (both physical and the transfer of information, for example,
over the Internet).
๏ Political alliances (such as the European Union).
๏ The growth of global industries. Some of this is driven to achieve economies of scale
and to allow increasingly complex products to be developed and sold economically.
๏ Cost differentials. For example, making use of low labour costs in some countries.
๏ Trade and political agreements allowing freer movement of goods, money and people.
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majority of Apple iPhones are assembled by Foxconn in China. Most Nike trainers are
made in Indonesia, China and Vietnam. The process of sending manufacturing abroad is
known as off-shoring.
๏ Alternatively, they can set up many manufacturing operations near their markets and
this can reduce transport costs and improve the speed of delivery. For example, there is
little point in a company like Coca Cola having all its production in the USA and
spending a fortune transferring its product, which by weight is mainly flavoured,
carbonated water, across the globe. Local production makes much more sense. Even is
not all of a product is made abroad components might be and only assembly is done
locally.
๏ Manufacturing or sub-contacting/licensing. Setting up a factory abroad and can be risky
because local laws and customs might be misunderstood. An easier way is to sub-
contract production to a firm in the country that the products will be sold in. Often the
manufacturer is also given marketing rights and a royalty is paid to the company
owning the brand or the process. Franchising is another form of international expansion
but is rather more hand-on than a simply royalty agreement. For example, many
McDonalds branches are franchises where a local business is given the right to set up as
a McDonalds outlet. They have to comply closely with McDonalds ways of doing
business.
On the downside, many people are becoming increasingly sceptical about the benefits of
globalisation as is can be seen as:
๏ The export of jobs.
๏ Crushing of local industries by powerful multi-nationals.
๏ Undermining democracy as large multi-national companies are larger, richer and
therefore more powerful than many national economies.
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4 Trade agreements
Trade agreements are treaties between countries on their reciprocal tariffs, quotas etc. The
purpose of the agreements is to reduce the barriers to trade. For example, two countries
could agree to import/export cars from one another without tariffs, or with the same tariffs, so
that there is a level playing field. These arrangements should simplify international trade,
improve economic efficiency and provide consumers with more choice. They reduce
protectionism.
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5 PESTEL
PESTEL is a way of appraising the macro-environment of countries. This is important when
decisions are being made about whether to invest in a country or to export to it.
PESTEL stands for:
๏ Political
๏ Economic
๏ Social
๏ Technological
๏ Ecological
๏ Legal.
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Examples of PESTEL factors, all of which will affect how attractive it is to trade with a country
or to set up a manufacturing company there:
๏ Political: elections and changes of government, war, European Union expansion, Brexit.
For example, if a country is ruled by a dictator, property rights are likely to be weak and
corruption likely to be high.
๏ Economic: interest rates, tax rates, exchange rates, economic boom or recession.
Countries often go through different parts of the trade cycle at different times. If a
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country seems to be coming out of recession and heading towards a period of growth,
then that might be a good time to start exporting to there if possible. Similarly,
companies can withdraw from countries which are heading for an economic trough.
๏ Social: nowadays the main social trend arises from changes in populations. In most
western countries the birth rate has fallen and there is an increasing proportion of
elderly people. This can affect recruitment but it can also affect the economies of
companies that they have to support a larger number of retirees. It can of course affect
the marketing of products. Products suited to older people may become more popular
while those suited to younger people may become less popular. However, taste and
culture are also important influences. For example, there is little point in trying to export
pork products to Muslim countries!
๏ Technological: technological changes often come out of the blue, but once they are
invented there is really no turning back. Think how the internet has profoundly affected
the fortunes of organisations like travel agents. Think how banks have responded by
closing branches and encouraging their clients to do more and more banking online.
Some products would require a certain level of technical sophistication in user countries
and Amazon has made great use of the Internet to expand internationally.
๏ Ecological: carbon emission restrictions/taxes, more stringent laws governing air and
water solution, concern about the possible effects of global warming. Unfortunately,
some companies are suspected of locating their manufacturing facilities in countries
which have less stringent ecological rules. It is also worth noting that Facebook is
currently building a server farm (a very large number of computer storage devices) in
Luleå, Sweden. The sub-artic climate there allows Facebook to save large amounts of
money by using the naturally cold air into the building to cool overheating servers
rather than having to use energy on air-conditioning systems.
๏ Legal: health and safety legislation, equality legislation, regulation of industries, quotas,
tariffs, bureaucracy.
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Tests
Question 1
What is meant by the term ‘off-shoring’?
Question 2
What does the following describe?
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“The process by which the countries and businesses throughout the world are becoming
increasingly interconnected because of increased trade.“
Question 4
What does the ‘S’ in PESTEL stand for?
Question 4
What does the following describe?
“A global international organisation dealing with the rules of trade between nations.”
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CHAPTER 4
ORGANISATIONS
1 Introduction to organisations
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2 Types of organisations
You need to be aware of the characteristics of several types of organisation.
๏ Commercial organisations are profit-seeking. They can be sole traders, partnerships,
limited liability partnerships and limited companies. The main advantage of limited
liability partnerships and limited companies is that if the organisation hits hard times
and has to go to liquidation, the owners of the organisation are protected. Creditors and
banks can pursue only the assets which are in the company. Sole traders and partners,
on the other hand, have unlimited liability for all the business’s debts.
๏ Not-for profit organisations do no seek to make profits. An example of a not-for-profit
organisation could be a charity, such as a charitable hospital where objectives such as
curing patients is their aim. Instead of producing a profit and loss account, they tend to
produce income and expenditure accounts. Ultimately their income has to exceed their
expenditure or they will run out of money.
๏ Public sector organisations are owned by the state either at a national level or at a
local level. Examples could be the defence department, many health services and
educational systems. In some economies other industries or businesses are also owned
by the state. For example, many national airlines are state-owned. Public sector
organisations can therefore be either profit-seeking or not-for profit organisations.
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for example, set up co-operatives to market their products more effectively than they
could on their own. Usually they seek some sort of profit, but the ownership is shared
widely amongst the people who are working in the organisation.
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The amounts of dividend and interest that has to be paid to suppliers of capital compared to
the amount of capital raised is known as the cost of capital.
It can be thought of as being similar to an interest rate: capital is deposited at a bank and a
return is earned. If the company is to increase in value any return it earns must exceed the
cost of capital so that the company has a surplus left for investment. If the returns earned are
below the cost of capital the company will not be able to pay the interest and dividends that
the suppliers of capital require and the company will lose value.
In general, the riskier a company’s activities the higher the cost of capital required by
suppliers of capital.
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The higher the ROCE the better the company is at using its capital to generate profits.
Usually the closing equity figure is used. This measure focuses more on how the company
performance affects shareholders.
In the example above ROE =
3,000
x 100 = 17.6%
17,000
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products would have been developed (you need research and development to do that), good
staff leave because they are not receiving the training they want and need, and the premises
look shabby and unappealing to customers.
This is an example of what can be called the short term-long term conflict: short term results
are improved at the expense of long term results. It is a particular problem for listed
companies where directors might be in office temporarily and want good current
performance to allow them to move to a better job. It is less of a problem in private and
family companies where emphasis is more likely to be for the long-term benefit of the
company and for future generations.
To avoid undue pressure from short term influences, longer term measures of performance
are needed. One of the most commonly used is to try to estimate all future cash inflows that
the company will receive and to base share values on that. So, although research and
development might hurt this year’s results, the promise of a successful new product and the
additional cash flows that will arise from that will increase the value of the company, its
shares and its shareholders.
Of course, receiving an inflow of cash in 10 year’s time is not as valuable as receiving it now
and the technique of discounting is used to reduce the important co future inflows to their
present value equivalents. The share price is supported by the present value of future inflows
to the company.
5 Stakeholders
The term “stakeholder” refers to any person or institution in any way affected by organisation.
Stakeholders can be broken down into three groups though this is not particularly helpful:
๏ Internal stakeholders are those who are definitely inside the organisation. Examples
are employees, directors and the managers.
๏ Connected stakeholders are outside the organisation but connected by way of a
contract of some sort. Good examples here will be suppliers, customers, and lenders.
Shareholders are usually regarded as connected stakeholders.
๏ External stakeholders are entirely outside the organisation with no contractual
relationship. The best example for this is will be the people living nearby a factory. They
are obviously affected, but have very limited contractual rights over what the factory
does. The government is also an external stakeholder.
Why is the study of stakeholders important? Really the reason is that usually what
stakeholders want will be in conflict. Shareholders want higher profits but employees want
higher wages; customers want better quality at lower prices, shareholders want better profit;
customers may want the operation to run 24 hours a day, 7 days a week but employees might
want to only work 5 days a week, 8 hours a day. If your organisation was an airport the local
populace would want you to run fewer flights (and certainly not after about 11 o’clock at
night), whereas your customers and your shareholders may want you to run services more
frequently.
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There is no easy way of resolving these conflicts. Basically it comes down to management
trying to get stakeholders to compromise. They have to try and keep most people happy
most of the time, bearing in mind, however, that some stakeholders may be able to stop co-
operating altogether. For example when employees want better wages, they could go on
strike and ultimately this can affect the profits which are enjoyed by the shareholders.
Management has to be aware that there are conflicts and try its best to manage these.
About the only tool or model available for the analysis of stakeholders is Mendelow’s matrix.
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Level of interest
Low High
Low
Power
High
It sets out on one axis the power that a stakeholder can wield. And along the other axis their
interest, by which we mean how likely is it that the stakeholder will take action.
Stakeholders who have high power and high interest are known as key players. Management
really needs to keep those people happy. They have the power and they have the willingness
to do something about it if they are upset.
Some stakeholders have high power but they are not likely to take action even if
management does something which they dislike. They may be unwilling to take action
because of professional or ethical reasons. For example, medical staff in hospitals are very
unlikely to take industrial action. Management doesn’t have to be quite so careful with these
people. However they have to be kept satisfied, otherwise they could be provoked to take
action and turn into key players.
People with low power but high interest have to be kept informed. They can’t do much about
it themselves but they might be able to influence key players to take action on their behalf.
Finally we have people with low power and low interest. Management can nearly ignore
these people. After all, what are they going to do if they don’t like what’s happening?
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Shareholders and directors are two types of stakeholder and what they want can be in
conflict. For example:
๏ Shareholders want larger profits but directors want larger fees, flashy cars and first class
travel.
๏ Shareholders want a certain level of risk but the directors might want to take an
unjustifiable gamble on the company’s future because if it comes off their reputation
will be enhanced.
The conflict is known as the principle-agent problem and it has been very serious in some
companies.
Corporate governance can be defined as “The way in which companies are directed and
controlled” and this should be in ways that ensure that shareholder requirements are
paramount. After a number of high profile financial scandals, many countries brought in
corporate governance rules. In the UK these rules are known as the UK Corporate Governance
Code and all listed companies are expected to comply with it otherwise their listing on the
Stock Exchange will be jeopardised if they can’t justify why they have departed from the
code.
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Tests
Question 1
Is the following statement true or false?
“Limited liability means that the company’s liability for its debts is limited”
Question 2
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Question 3
What are the two main types of capital that a company can raise?
Question 4
Fill in the blank:
The amounts of dividend and interest that has to be paid to suppliers of capital compared to
the amount of capital raised is known as ______________________
Question 5
Allocate the following stakeholders to the correct categories
Internal External Connected
Employees
Suppliers
Customers
Government
Lenders
Directors
Shareholders
Question 6
Match the terms “principals” and “agents” to the gaps in the following sentence:
Shareholders are the_____________, directors are the ________________
Question 7
If a listed company has 6 executive directors, approximately how many non-executive
directors should it have?
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Question 8
What is the return on capital employed for the company shown below?
Statement of profit and loss $000
Revenue 30,000
Cost of sales (18,000)
Gross profit 12,000
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CHAPTER 5
PRICES
Microeconomics is the branch of economics that deals with the price and cost of
manufacturing of goods, and with the reactions of suppliers and customers to prices.
It’s probably self-evident that as the price of a product rises, the quantity demanded is likely
to fall. For example, if airfares rise, fewer people will choose to travel. Similarly, if a market
trader is left at the end of the day with fruit that will soon go off, the price of fruit will be
lowered to try to stimulate demand.
This chapter looks at how prices and sales quantities can depend on one another. It also
examines how prices can affect supply (higher prices will encourage more production) and
will how price mechanisms can ensure that demand equals supply.
2 Demand curves
P, price
Q, quantity
For most goods, as price increases the quantity demanded will reduce. This diagram shows a
linear decrease; in practice the demand curve is likely to be curved.
Movement along the demand curve depends on the price of goods. As the price, P, increases,
the quantity demanded, Q, decreases. We are moving along the demand curve
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A shift in the demand curve, from the solid to the dotted line below can be caused by:
๏ Consumers’ income. In general higher incomes will shift the demand curve to the right
so that at a given price, more goods are sold. There are some goods, known as inferior
goods, where the demand curve would move leftwards as income increases because
people change to better goods in preference. For example, you could argue that the
demand for cheap brands of coffee will suffer as income rises and consumers more
often pick premium brands.
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P, price
Q, quantity
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P, price
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Relatively inelastic
(a change in price
causes a small
change in demand)
Relatively elastic,
or price sensitive
Q, quantity
If demand is inelastic, then demand for the good is price insensitive and a change in price will
have a relatively small effect on demand.
Elasticity largely depends on whether the goods are essential or luxury. If goods are essentials
(like basic food) then higher prices will not affect demand greatly. If goods are luxuries (or at
least purchase of them is discretionary), then a rise in price can cause a steep fall in demand.
For example, the purchase of foreign holidays is markedly affected by the price of those
holidays.
The price elasticity of demand is defined as:
The proportional (or percentage) change in demand
The proportional (or percentage) change in price
Because an increase in price will normally cause a decrease in demand, technically this
measure is negative, but the negative sign is usually ignored.
Price elasticity of demand >1 means that a relatively small change in price will cause a
relatively large change in demand, so demand is elastic.
This has the consequent that revenue will increase if prices are reduced because the increase
in demand more than compensates for the fall in price.
Price elasticity of demand 0 < 1 means that a relatively small change in price will cause a
relatively small change in demand, so demand is inelastic.
This has the consequent that revenue will decrease if prices are reduced because the increase
in demand will not compensate for the fall in price.
Price elasticity of demand = 1 means that revenue will be constant if the price is changed
slightly.
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P, price
12
10
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In the above diagram, say that at a price of $8, demand is 1,200 and that at a price of 6,
demand is 2,200.
There are two approaches to calculating the elasticity:
Arc elasticity uses the mid-point of the two quantities and prices as the basis point ie
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For example, in the table below, demand increases by 1,000 units for each $1 decrease in
price:
Price $ Demand Q
12 5,000
11 6,000
10 7,000
9 8,000
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8 9,000
7 10,000
6 11,000
5 12,000
4 13,000
3 14,000
2 15,000
1 16,000
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Q, output or supply
As you would expect, the higher the price offered to suppliers, the more goods will be
produced. Suppliers increase production and more suppliers enter the market because they
see more profits at higher prices.
P, price
Q, output or supply
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A shift to the left in which less will be supplied at every price could be caused by:
๏ Increase in average cost of production
๏ Taxation of raw materials
๏ A switch in production to more profitable products – productive capacity is simply
removed.
Price elasticity of supply >1 means that a relatively small change in price will cause a
relatively large change in supply, so supply is elastic.
Supply could be elastic if:
๏ There is spare capacity in producers’ factories.
๏ If inventory available that can be easily released and sold.
๏ If it is easy to employ more factors of production.
๏ Additional sources of the product are easy to create
Price elasticity of supply 0 < 1 means that a relatively small change in price will cause a
relatively small change in supply, so supply is inelastic.
Supply could be inelastic if:
๏ Suppliers are operating close to full capacity.
๏ There are low levels of stocks so that there are no surplus goods to sell.
๏ Additional sources of supply are difficult to create eg expensive, complex factories are
needed.
๏ If it is difficult to employ factors of production, e.g. if highly skilled labour is needed and
this is in scarce supply
๏ With agricultural products supply is inelastic in the short run because food takes time to
grow. Imports would relieve shortages.
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Supply
Demand
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Q Q, quantity
At a price P, the quantity supplied will exactly match the quantity demanded: quantity
supplied and demanded = Q. This is the point in which the market is in equilibrium.
In the diagram below, if the market price were P1 then there would be excess demand:
P, price
Demand
Supply
P1
Qs Qd Q, quantity
Qd would be demanded, but only Qs would be supplied and obviously Qd > Qs. The excess
demand is Qd – Qs.
The market is now in disequilibrium and the excess demand will cause rises to rise and, in
turn, cause supply to increase until equilibrium is reached again
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In the diagram below, if the market price were P2 then there would be excess supply:
P, price
Demand
P2
Supply
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Qs Qd Q, quantity
Qs would be supplied but only Qd would be demanded and obviously Qs > Qd. The excess
supply is Qs – Qd.
The market is now in disequilibrium and the excess supply will cause rises to fall and, in turn,
cause demand to increase until equilibrium is reached again.
Supply and demand curves can be applied to many markets to explain the equilibrium points
and also movements in prices:
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Tests
Question 1
Which of lines A or B in the diagram below shows the product with the greater price
elasticity of demand?
P, price
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Q, quantity
Question 2
P, price
P, price
Demand
P2 Supply
Demand
Supply
P1
Qs Qd Q, quantity Qs Qd Q, quantity
With respect to the diagrams above, which TWO of the following statements are
correct?
A At price P2 there is excess demand
B At price P1 there is excess supply
C At price P2 there is excess supply
D At price P1 there is excess demand
Question 3
Is the following statement true or false?
When the price elasticity of demand is greater than one, an increase in price will cause an
increase in revenue
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Question 4
Calculate the arc elasticity of demand for the data below:
Price Quantity sold
15 20,000
20 16,000
Question 5
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Would the following normally shift a demand curve to the left or right?
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CHAPTER 6
MARKET FAILURE AND THE
REGULATIONS OF MARKETS
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2 Monopolies
A monopoly occurs when there is only one supplier of a good or service.
An example could be a pharmaceutical company which has a patent on a uniquely effective
drug. Other suppliers cannot start production because they have no patent rights. This allows
the pharmaceutical company to charge very high prices because demand for this very
desirable product will be high. The supplier can make ‘super profits’ and there will be
permanent excess demand.
In a properly functioning market, more producers could have entered to increase supply and
to reduce prices. More patients could benefit from the drug at lower prices and this is a much
more desirable allocation of resources.
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3 Public goods
A public good is a product or service that one individual can consume without reducing its
supply to another individual, and from which no one is excluded.
Examples include public roads, street lighting, defence and law enforcement.
Public goods are:
๏ Non-rivalrous, meaning that one person’s consumption does not affect another’s:
consumers are not rivals.
๏ Non-excludable: no consumer can be excluded from consumption – even if they have
not contributed to its supply.
๏ Public goods can also be considered to be non-rejectable: even if you don’t want a
nuclear deterrent you might have one.
Public goods are not supplied by markets because of the difficulty of charging inevitable
consumers who might not actually want the product or service and who will benefit anyhow
even with making a contribution. This is the ‘free-rider’ problem. Public goods are therefore
provided by the state and are financed by tax revenues. Governments must decide on the
appropriate levels of tax and service.
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4 Externalities
An externality is the cost or benefit that affects a party who did not choose to incur that cost
or benefit.
For example:
๏ People living near airports bear the cost of noise and air pollution.
๏
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Minimum prices
Let’s say that a government is concerned about the future of the dairy industry and that many
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farmers are stopping milk production. One way to keep farmers in business is to set a
minimum price per litre of milk so that farmers are more or less guaranteed goods profits.
However, a minimum price for producers is also a minimum price for buyers and there is likely
to be excess supply: lots of farmers will produce at the artificially high price, but many
consumers will not want to buy at that high price.
The consequences are therefore:
๏ Over-production
๏ Producers being attracted to a business where there is already surplus supply
๏ Waste of resources. Perhaps the land and farmers could be employed for something
that consumers did want.
๏ Inefficiency on production: why be efficient if the selling price is so high and price
competition is non-existent?
Maximum prices
Let’s say that a government is concerned about the high price of petrol (opinion polls might
have shown that this of major concern to voters and the government wants to stay popular).
So the government sets a maximum price per litre. Or the government might want to set
maximum prices to try to hold down inflation.
The maximum price will increase demand, but will suppress production because profits for
producers are held down. Furthermore, the development of new sources of energy for cars
will be inhibited because the new technology has to compete with artificially suppressed
prices.
When there are maximum prices, demand will begin to exceed supply and there is no price
mechanism to correct this.
Demand and supply do have to be balances (simply a matter of physical quantities having to
match) and this can only be achieved by:
๏ Rationing
๏ Queuing
๏ Providing vouchers to limit supply to quotas for each person
These approaches then usually give rise to black markets for goods where some people will
be willing to pay very high prices to get their hands on scarce goods. An example is seen with
ticket touts for very popular shows or sports events.
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Tests
Question 1
What is meant by the term ‘predatory pricing’?
Question 2
What does the following sentence describe?
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“A product or service that one individual can consume without reducing its supply to another
individual, and from which no one is excluded.”
A A merit good
B A public good
C An externality
D A market allocation
Question 3
Indicate whether the following effects are likely consequences from minimum or
maximum prices being set
Minimum price set Maximum price set
Rationing
Over-production
Queueing
Wasted resources
Question 4
What does the following sentence describe?
“A commodity or service that is regarded by society or government as deserving public
finance because otherwise they will be under-consumed.”
Question 5
What does the following sentence describe?
“The cost or benefit that affects a party who did not choose to incur that cost or benefit.”
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CHAPTER 7
DATA AND INFORMATION
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๏ Timely. It should be timely. Information should be supplied quickly enough to help you
make a better decision. Some information has to be provided very quickly - within
seconds, or even fractions of a second in some industrial processes. For other purposes
you might easily be able to wait for a week or even two weeks before the information is
required to enable you to make a decision on time. usually faster information means
more expensive information.
๏ Easy to use. It should be well-presented and well-documented. Easy to use might mean
that it’s more beneficial to see information in the form of graphs than in the form of
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tables.
It is fairly obvious that the gap between sales and cost of sales is growing over the four years.
Even though sales have increased substantially, the rise in costs is much less.
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Line chart
Effectively this shows the same information but ‘joins up the gaps’ to product continuous
lines. The divergence is obvious.
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Scattergraph
Although a scattergraph can be used to plot a value against time, it is more often used to
show how two non-time variables relate to each other, such as sales/advertising, cost/
production volume or home fuel consumption/weather temperature.
2016
Average KWH electricity
Month
temperature consumed
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January 6 12,000
February 8 11,000
March 11 10,000
April 14 8,000
May 18 6,000
June 22 4,000
July 25 3,000
August 29 1,000
September 26 2,500
October 20 5,000
November 15 9,000
December 10 9,500
14,000
12,000
KWH electricity consumed
10,000
8,000
6,000
4,000
2,000
0
Average temperature
In the table above, the data was presented in date order, but the graph shows how electricity
consumption falls as temperatures rise.
A trend line has been drawn through the points to emphasise the relationship.
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Pie chart
S America
14% Europe
Sales
28%
Europe 1,200
Asia 1,300 N America
N America 1,250 29%
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A pie chart is good for showing the proportions of the elements that make up a population.
Here you can instantly see that South America is the smallest market segment.
This is known as a discrete frequency distribution because the number of inhabitants can only
be certain numbers: 0, 1, 2, 3. You can’t have 3.54 inhabitants.
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Continuous frequency distributions allow any values and there, values have to be lumped
together to be of any use. In the apartment block there are 294 inhabitants (= 14 x 1 + 22 x 2
+ 30 x 3 + 25 x 4 + 8 x 5 + 6 x 1). If we looked at the heights of these inhabitants we could
have something like this:
Frequency Height range
10 0.8 - <1.0m
22 1.0 - < 1.2m
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Histograms
A histogram looks very like a column chart, but there are no gaps between the columns. A
histogram of the above data would look like:
There is only one complication that you need to be aware of: the area of the columns
represents the frequencies, not the height. If each range of data in the distribution is the same
(above the height range ia always 0.2m), then the heights are proportional to the frequency.
However, if the data has been like this, where the 1.6 - <=2 is 4cm, not the normal 2, the
height of that bar has to be ‘halved’ but its width doubled.
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Total 294
Ogives
Ogives, or less-than curves, plot cumulative frequencies.
Using the original height table, an extra column with cumulative numbers and also change
the range to the upper end of each interval:
So, this table shows, for example, that 146 people are less than 1.6m tall.
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Plotting the cumulative frequency (y axis) against the heights give a chart like:
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Tests
Question 1
Which of the following should be more meaningful to users?
A Data
B Information
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Question 2
Good information can be described by the mnemonic ‘ACCURATE’. What do the letters
stand for?
Question 3
Name two charts used to display frequency distributions.
Question 4
Say whether the following are discrete of continuous data
Discrete Continuous
Number of children under 10 in each family
Weight of individuals in a population
Distance between cities
Family income rounded to the nearest $000
Question 5
Draw the following data on a cumulative frequency curve:
Family income Frequency
0 - <2,000 5
2000 - <3,000 20
3000 - <5,000 500
5000 - <10,000 100
10,000 - <20,0000 4
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CHAPTER 8
BIG DATA AND DATA ANALYSIS
1 Big data
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The term ‘big data’ refers to extremely large collection of data that may be analysed by
computer to reveal patterns, trends, and associations, especially relating to human behaviour
and interactions.
Note that two processes are implied:
๏ The collection of the data and its storage
๏ The analysis of the data to provide useful information
2.1 Volume
The volume of big data held by large companies such as Walmart (supermarkets), Apple and
EBay is measured in multiple petabytes. What’s a petabyte? It’s 1015 bytes (characters) of
information. A typical disc on a personal computer (PC) holds 109 bytes (a gigabyte), so the
big data depositories of these companies hold at least the data that could typically be held on
1 million PCs, perhaps even 10 to 20 million PCs. These numbers probably mean little even
when converted into equivalent PCs. It is more instructive to list some of the types of data
that large companies will typically store:
๏ Retailers. Via loyalty cards being swiped at checkouts: details of all purchases you
make, when, where, how you pay, use of coupons. Via websites: every product you have
every looked at, every page you have visited, every product you have ever bought. (To
paraphrase a Sting song “Every click you make I’ll be watching you”.)
๏ Social media (such as Facebook and Twitter). Friends and contacts, postings made,
your location when postings are made, photographs (that can be scanned for
identification), any other data you might choose to reveal to the universe.
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๏ Mobile phone companies: Numbers you ring, texts you send (which can be
automatically scanned for key words), every location your phone has ever been whilst
switched on (to an accuracy of a few metres), your browsing habits. Voice mails. Internet
providers and browser providers. Every site and every page you visit. Information about
all downloads and all emails (again these are routinely scanned to provide insights into
your interests). Search terms you enter.
๏ Banking systems. Every receipt, payment, credit card payment information (amount,
date, retailer, location), location of ATM machines used.
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2.2 Variety
Some of the variety of information can be seen from the examples listed above. In particular,
the following types of information are held:
๏ Browsing activities: sites, pages visited, membership of sites, downloads, searches
๏ Financial transactions
๏ Interests
๏ Buying habits
๏ Reaction to ads on the internet or to advertising emails
๏ Geographical information
๏ Information about social and business contacts
๏ Text
๏ Numerical information
๏ Graphical information (such as photographs)
๏ Oral information (such as voice mails)
๏ Technical information, such as jet engine vibration and temperature analysis
๏ This data can be both structured and unstructured:
‣ Structured data: this data is stored within defined fields (numerical, text, date
etc) often with defined lengths, within a defined record, in a file of similar records.
Structured data requires a model of the types and format of business data that will
be recorded and how the data will be stored, processed and accessed. This is
called a data model. Designing the model defines and limits the data that can be
collected and stored, and the processing that can be performed on it.
An example of structured data is found in banking systems, which record the
receipts and payments from your current account: date, amount, receipt/
payment, short explanations such as payee or source of the money.
Structured data is easily accessible by well-established database structured query
languages.
‣ Unstructured data: refers to information that does not have a pre-defined data-
model. It comes in all shapes and sizes and this variety and irregularities make it
difficult to store it in a way that will allow it to be analysed, searched or otherwise
used. An often quoted statistic is that 80% of business data is unstructured,
residing it in word processor documents, spreadsheets, PowerPoint files, audio,
video, social media interactions and map data.
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2.3 Velocity
Information must be provided quickly enough to be of use in decision making. For example,
in the above store scenario, there would be little use in obtaining the price-comparison
information and texting customers once they had left the store. If facial recognition is going
to be used by shops and hotels, it has to be more-or less instant so that guests can be
welcomed by name.
You will understand that the volume and variety conspire against the third, velocity. Methods
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๏ Better marketing
๏ Better customer service and relationship management
๏ Increased customer loyalty
๏ Increased competitive strength
๏ Increased operational efficiency
๏ The discovery of new sources of revenue.
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Other sorts of study measure two variables and try to see how one variable moves with the
other (eg cost and production volume, or advertising expenditure and sales).
For simple patterns, linear regression and the coefficient of correlation are used to provide
information about how two variables are related. More complex patterns, particularly
longitudinal studies, such as sales over time are likely to require investigation using time
series analysis.
5 Linear regression
Linear regression is a method of fitting the best straight line through a set of points.
In business, typically the line would connect points showing:
๏ Cost and volume
๏ Selling price and sales volume
๏ Hours worked and units produced
Linear regression will give constants which fit a line of the type:
y = ax + b
where:
y is the dependent variable (cost, hours, volume sold)
x is the independent variable (units made, selling price).
The constant ‘a’, for example, could be the additional cost for each additional unit made; ‘b’
would be the cost even if no units were made (the fixed cost).
Be warned: linear regression will give the best straight line it can through any set of points.
For example, if you numbered the days in the year 1 – 365 and you noted the day each person
was born and the amount of money they had in their bank account, linear regression would
suggest the best relationship it could between these variables. Obviously there would not
actually be a good relationship.
To test the relationship you must calculate the coefficient of correlation (r), or the coefficient
of determination (r2). r can vary between:
๏ r = +1, meaning perfect positive correlation where all points lie on the line and as one
variable increases, so does the other.
๏ r = -1, meaning perfect negative correlation where all points lie on the line and as one
variable increases, the other decreases.
๏ r = 0 means no correlation.
๏ If r = 0.7, the coefficient of determination, r2 = 0.49 or about 50%. This means that 50%
of the change in one variable is explained by the change in the other.
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You should be aware of the following before you rely on any prediction based on linear
regression:
๏ If r2 is low, then one variable is not well-associated with the other, so any predictions are
liable to be poor.
๏ The more points (readings) the better: simply more evidence for the association.
๏ Extrapolation (predicting outside the range examined) is dangerous as we have no
direct evidence of what happens in other regions. For example, costs might suddenly
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increase.
๏ Other known influences (such as inflation) should be removed before the analysis.
๏ Even good correlation does no prove cause and effect: both variables might have
moved together under the influence of another variable.
n∑ xy − ∑ x ∑ y
b=
n∑ x 2 −(∑ x )
2
a=
∑ y − b∑ x
n n
[Note that the symbol ∑ means ‘the sum of’]
Example 1
The following table shows the number of units produced each month and the total cost incurred:
Units $000
January 100 40
February 400 65
March 200 45
April 700 80
May 600 70
June 500 70
July 300 50
Calculate the regression line, y = a + bx
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The correlation coefficient may be calculated using the following formula (which is given to
you in the examination)
n∑ xy − ∑ x ∑ y
r=
⎡n x 2 −
⎢⎣ ∑ (∑ x ) ⎤⎥⎦ ⎡⎢⎣ n∑ y 2 −(∑ y ) ⎤⎥⎦
2 2
Example 2
Using the data in the previous example calculate the correlation coefficient
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⎡ 6∑ d2 ⎤
r = 1− ⎢ 2
⎥
⎢⎣ n( n −1) ⎥⎦
where n is the number of pairs of data and d is the difference between the rankings in each
set of data.
r will be between -1 and +1 and it is interpreted in the same way as for Spearman’s
coefficient.
Example 3
The positions of seven students in their examinations in accountancy and law are as follows
Student Accountancy position Economics position
A 1 3
B 4 7
C 2 1
D 5 6
E 3 2
F 7 4
G 6 5
Judge whether the position of the students in Statistics correlates with their position in
Economics.
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summer, autumn and winter, or sales for each day of the week.
3 Cyclical variations: cycles of variation repeating in more than a year. Typically, the long-
term trade cycle is given as an example.
4 Random effects: non-repetitive and non-predictable variations.
Time series analysis investigates the first two of these.
Time series analysis – graph
The figure below shows a rising trend with regular seasonal variations.
“High” seasons
Sales
Trend
Time
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3 3 994.0
4 4 1015.0
2013 1 5 1030.0
2 6 1042.5
3 7 1036.0
4 8 1056.5
2014 1 9 1071.0
2 10 1083.5
3 11 1079.5
4 12 1099.5
2015 1 13 1115.5
2 14 1127.5
3 15 1123.5
4 16 1135.0
2016 1 17 1140.0
You can see from the graph that there is some sort of trend (the line increases overall) and
there are seasonal variations with a dip occurring at times 7, 11, 15, corresponding to the 3rd
quarter each year. Quarter 2 tends to look high each year. So, if we are going to try to forecast
what sales will be in the third quarter of 2010, we would first try to project the trend then
superimpose the seasonal effect on that to decrease it appropriately.
Performing a time series analysis is rather tedious and it is likely that in any exam question,
much of the work will have been done for you and you have to interpret and apply the
results. However, for the purposes of explanation, we will carry out the full process on this
data.
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2012 1 1 989.0
-8.1 = 994 – 1002.1
2 2 990.0 0.9919 = 994/1002.1
997.0
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2016 1 17 1140.0
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This example yields a very smooth trend; you would not always expect such a linear result.
The trend figure has gone from 1002.1 to 1120.9 in 11 seasonal increments, so the increase
per season is (1120.9 – 1002.1)/11 = 1.7.
The seasonal variations are obtained by comparing the raw data for each season to the
trends. The comparisons can either be done by subtraction (the additive model) or by
proportions (the multiplicative model).
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-8.1 1.2
4.4 6.4 -10.4 -0.1
3.8 5.5 -9.4 -0.5
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4.5 6.6
Average 4.2 6.2 -9.3 0.2
The analysis has now been completed, and the results can be used to make forecasts. Let’s
say we want to forecast season 3 for 2016. The approach is:
1 Project the trend
2 Adjust for the seasonal variation appropriate for that season.
The last trend figure we have is for season 2 of 2015 and that was 1120.9. Season 3 of 2016 is
five seasons further on, so the predicted trend figure would be:
1120.9 + 5 x 1.7 = 1129.4
Season 3 has an adjustment amount of -9.3 or 0.9957. Applying these adjustments to the
trend would result in predictions of:
Additive: 1129.4 – 9.3 = 1120.1
Multiplicative: 1129.4 x 0.9911 = 1119.4
This method of predicting future amounts is more sophisticated than linear regression, but
neither, of course, guarantees an accurate answer. However, they are at least using historical
evidence on which to base forecasts and this must surely be better than pure guesswork.
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Tests
Question 1
What are the 4Vs of big data?
Question 2
A sales director has carried out a linear regression exercise to examine the connection
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Question 3
A comparison of the ratings of two guests who each visited four hotels show the
following rankings:
Guest 1 Guest 2
ranking ranking
Hotel 1 2 3
Hotel 2 4 5
Hotel 3 3 1
Hotel 4 1 2
Question 4
The seasonal variations for the sales of a product are:
Season 1: -$20,000
Season 2: $4,000
Season 3: $25,000
Season 4: - $9,000
The trend has been calculated as $2,000 per season and the trend figure for season 3 of 2017
is $73,000
What is the forecast figure, including the seasonal adjustment for Season 4 of 2018?
Question 5
Which of the following elements of a time series are analysed sing the moving averages
technique?
A Cyclical variations
B Seasonal variations
C The trend
D Random variations
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CHAPTER 9
FINANCIAL MARKETS AND
INSTITUTIONS
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1 Introduction
Financial markets and institutions primarily deal with money, investments and risk
(insurance). They are an essential part of any modern economy – despite the excesses that led
to the 2008 financial crash.
2 Financial intermediaries
2.1 The purpose of money
Money has a number of important functions:
๏ It is a means of exchange. If there were no money then all transactions would be by
bartering ie the exchange of goods. Money immeasurably frees up the flexibility with
which goods and services can be exchanged.
๏ It is a store of value. The amount of money in your current or deposit account
represents value or wealth that can be spent in the future.
๏ It is a unit of account. The price of an item represents what it is valued at. The amount of
an expense is a measure of the cost of the item or service. Comparisons can be made,
for example, when deciding to heat you home by electricity or gas.
๏ It can act as a deferred payment. Rather than paying for something immediately you
can be given credit and you can pay for the item later. The provision of credit is an
important way of stimulating an economy. If everyone were given a month’s credit on
all purchases, they could immediately go out and buy another month’s supply of goods,
which increases suppliers’ sales and profits.
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Businesses Individuals
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Financial
intermediaries
Government Overseas
The diagram shows that every sector has dealings with every other. For example:
๏ Businesses and individuals: individuals buy from businesses; businesses employ
individuals and pay wages.
๏ Businesses and government: businesses pay tax and governments sometime sprovide
grants.
๏ Businesses and overseas: imports and exports.
However, these interactions would be more difficult without financial intermediaries. For
example:
๏ A business could pay its employees cash (and this used to be common), but now it is
more convenient and more secure to pay wages and salaries into employees’ bank
accounts.
๏ Businesses could pay their tax to government by loading cash into a wheelbarrow and
delivering it to the country’s treasury, but a transfer via a bank makes more sense.
๏ When going on holiday we could take our own currency and negotiate with an
individual on a street corner, but changing currency in a bank or withdrawing cash from
and ATN might reduce the chance of being mugged.
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properly appraise the borrower for credit worthiness and to ensure that loan
documentation is in order. Additionally, each bank will lend to a wide range of
borrowers and any one debt going bad should not put the bank at risk.
๏ Maturity transformation: you might be saving for your holiday and will therefore want
to withdraw your money in a few months. However, companies might want three or five
year loans to finance their expansion. Banks can make use of lots of short-term deposits
to create long-term loans.
๏ Consolidation: lots of small deposits allow several large loans.
๏ Credit creation: by issuing credit cards and organising loans and overdrafts, banks help
to ‘create’ money by giving people the means to spend more.
๏ Intermediation: borrowers and lenders are matched. This is not on a one-to-one basis
but surplus funds are matched with parties needing to raise loans.
๏ Transfer of money: the clearing system for cheques or internet banking allow funds to
be easily transferred eg between purchaser and supplier.
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Examples are:
๏ Equity shares
๏ Preference shares
๏ Debentures and bonds
๏ Convertibles
๏ Loans and overdrafts.
๏ Lease contracts.
๏ Certificates of deposits.
๏ Government bonds.
๏ Bills of exchange.
The instruments differ in their rights and obligations and their term (ie how long they last).
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3.4 Convertibles
Convertibles start life as debentures but give investors the option of converting the
debentures to shares. This allows investors to take a ‘wait-and-see’ approach. Invest in safe
debentures, then convert to shares if the company seems to be doing well.
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$100 5% $100
This means that if you own this piece of paper you would receive $5 interest every year (5% x
$100, the nominal value).
If the current interest rate in the economy is 5%, then the market value of this bond will be
$100 so that by buying it at $100 you earn the current rate of interest. If, however, interest
rates in the economy rose to 7%, then the market value of the bond would fall as it is only
paying $5 per year. The market value will fall until a purchaser earns 7% per year if the bond is
purchased. So:
Interest 5
x 100 = x 100 = 7
Market value Market value
Market value = 5 x 100/7 = $71.43
[Buying something for $71.43 and earning $5 pa is equivalent to a rate of interest of 5/71.43 =
7%
Similarly, in interest rates fell below 5%, the market value of the bond would increase so that
investors would earn the appropriate rate of interest.
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4 Central banks
A central bank is a bank that acts for the government. In the UK the central bank is the Bank of
England; in the USA it is the Federal Reserve.
๏ Manages the national debt (Government borrowing) ensuring that repayments are
made when due and finding buys for new issues of bonds.
๏ It is the central note issuing authority.
๏ Management of foreign exchange movements and balances.
๏ Setting interest rates.
๏ Controlling credit.
๏ Overseeing the financial system (since 2014 in the UK since 2014, the independent
Financial Conduct Authority performs many regulatory tasks).
๏ A lender to the banking system. For example, if a bank suffers a ‘run’, meaning that
many people want to withdraw their money at the same time), the bank will need to
raise cash (remember that depositors’ money will have been lend on again by banks, so
is not available to repay depositors). The central bank is often known as the ‘lender of
the last resort’ because they will nearly always provide funds to banks. The interest rate
charged influences the economy’s interest rates and this is how interest rates are
controlled.
๏ Controlling inflation. In the UK it is the Bank of England’s responsibility to control the
rate of inflation.
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and that subjects you to more risk than tying up money for just 3 months.
It can also imply that interest rates are likely to rise. So, if you are going to lock money away
for ten years in a fixed interest bond, and you expect interest rates to rise over the ten years,
then you would demand a higher yield to anticipate future rises in interest rates.
The normal yield curve should therefore look something like:
Return (or yield)
Time to maturity
Time to maturity
This implied that interest rates are expected to fall, so it might be worthwhile locking into a
long-term bond at a lower interest rate because the actual interest rate might be even lower
in the future.
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So the original $1000 that the first customer had has provided funds of 750.00 + 562.50 +
421.88 +…… etc. It can be shown that if the reserve ratio is r%, then the total amount of
credit created is:
Original deposit x 1/r.
In the example above this would be 1000 x 1/0.25 = 4,000.
By altering the reserve ratio that banks must use the central banks can allow credit and the
money supply in the economy to either expand or shrink and this is an important method of
monetary control.
Higher reserve ratios also keep banks more stable because they retain a higher proportion of
cash.
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any exported goods will be fixed. However, it might be better to allow the currency to
devalue so that exports become cheaper to foreign consumers. This will stimulate the
economy (and tax receipted by the government) because more goods can be made and
successfully exported.
With floating exchange rates, the rates are allowed to change constantly in response to
market forces. This introduces uncertainty for importers and exporters but governments
never have to spend reserves to support their currency. In addition, exchange rates vary in
response to an economy’s health and this provides a self-correcting mechanism.
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In fact, no currency is wholly fixed or floating. In a fixed exchange rate regime, market
pressures can affect the exchange rate and a "black market" can develop which better reflects
supply and demand for the currency. The central bank might then then be forced to revalue
or devalue the official rate so that the rate is in line with the unofficial one. In a floating
exchange rate regime, the central bank may also intervene to ensure to dampen exchange
rate volatility
There are some variants on the pure fixed and floating approaches such as margins around an
adjustable peg. In this system the exchange rate is allowed to vary freely within a range
around a peg, but if there were a fundamental imbalance the peg would be moved (ie a
devaluation or revaluation).
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The most important foreign currency used as a reserve currency is the US$.
Typical 2016 amounts, measured in US$, of foreign currency reserves held were:
๏ China: 3,000B
๏ Japan: 1,200B
๏ Germany: 200B
๏ UK: 160B
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From time-to-time governments and central banks impose exchange controls and intervene,
not only to maintain a rate of exchange which is quite different from what would have
prevailed without such control, but also to require the buyers and sellers of foreign currencies
to dispose of their foreign funds in particular ways.
For example, if savers thought that their currency was going to devalue they could opt to
change it into US$. That will, of course, cause the currency to weaken and the government
could simply ban all currency exchange of, say, more than say $100.
In the UK in the 1960s when the economy was very weak, the government laid down a
maximum amount of £50 that citizens could change to a foreign currency when visiting
abroad.
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Tests
Question 1
What is meant by the phrase ‘maturity transformation’?
A The provision of pension funds
B Allowing short term deposits to become long term loans
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Question 2
An investor owns par value $12,000, 6% government bonds.
What will the market value of these be if the interest rate in the economy is 4%?
Question 3
Does an inverted yield curve mean that investors expect interest rates to rise or fall?
Question 4
Would you expect the rate of interest charged on a convertible to be higher or lower
than charged on a straight debenture?
Question 5
If a country wants to fix its exchange rate, but there is downward pressure on it, does
the country have to spend its reserves to buy its currency or sell its currency and earn
reserves?
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CHAPTER 10
FINANCIAL MATHEMATICS
1 Introduction
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This chapter looks at the calculation of interest on investments and also at the techniques of
present values and internal rates of return.
2 Interest
2.1 Simple interest
A sum of money invested or borrowed is known as the principal.
When money is invested it earns interest; similarly when money is borrowed, interest is
payable. Note that interest is not permitted in Islamic finance.
With simple interest, the interest is receivable or payable each year, but is not added to the
principal for the calculation of future interest.
Example 1
A man invests $200 on 1 January each year, starting 2018. On 31 December each year simple
interest is credited at 10% but this interest is put in a separate account and does not itself earn
interest.
Find the total amount standing to his credit on 31 December following his third payment of
$200.
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Example 2
A man invests $500 now for 3 years with interest at 10% p.a.
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Example 3
A man invests $800 at 6%p.a. for 5 years.
How much will be in his account at the end of 5 years?
Example 4
A credit card company charges a nominal rate of 2% per month.
If a customer has purchased $100 worth of goods on his credit, calculate the amount she will
owe after one year, and also the annual percentage rate (APR)
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However, interest rates are usually not quoted per quarter even if interest is paid
quarterly. The rate is usually quoted per annum (p.a.).
It may seem logical to quote the rate as 8.243%. After all, we computed that
$1000 accumulates to $1082.43 in a year. However, it would be common to quote 2% per
quarter as being 8% per year. 8% is the nominal rate, but that is, of course, not really the
interest rate that is actually charged.
To compute the effective interest rate from the nominal interest rate first divide the
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nominal rate by the number of periods in the year then use that rate to work out the
compound interest.
Example 5
Suppose that an account offers a nominal interest rate of 8% p.a. payable quarterly.
(a) What is the AER?
(b) What if the nominal rate is the same, but interest is payable:
(i) monthly
(ii) weekly
(iii) daily?
4 Discounting
Here is a simple choice. Would you rather have:
1. $1,000 now, or
2. $1,000 in one year’s time?
๏ Safer
๏ Gives immediate enjoyment
๏ Even if you do not need it now, you can invest it for a year.
The value of investment can be evaluated by looking at interest rates. If the money could be
placed on deposit at 6% for a year, then the two options really are:
Instead of projecting amounts into the future (which calculates the terminal values), it is more
normal to bring all amounts back to the present. So, for option 2, we want to find out how
much would need to be received now to become (be identical to) $1,000 in one year.
So, if p is received now and invested at 6% to become $1,000, the following must be true:
p x 1.06 = 1,000
p = 1,000/1.06 = 943.40.
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$943.40 is known as the present value of receiving $1,000 in 1 year at a discount rate of 6%.
This means $943.40 is equivalent to receiving $1,000 in 1 year if interest rates are 6%. [Check
$943.30 invested at 6% becomes $943.40 x 1.06 = $1,000]
1. $1,000 now, or
2. $943.30 now?
Example 6
(a) By working out the present values of the options, indicate which of the following options
is preferable:
Cash flow ×1
Present value = or [or Cash flow x (1 + r)-n
(1+r)n
where:
and
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You can see this in previous example 1 where the present value of $4,000 received in 4 years
at an interest rate (discount rate) of 7% is:
4,000×1
PV = = 4,000× 0.736 = 3,052
(1+ 0.07)4
Instead of having to work this out manually, discount tables are routinely provided. They are
at the start of this set of notes, but here is an excerpt:
You will see that with a discount rate of 7% and a period of 4 years, the discount factor is as
was previously calculated, 0.763.
It is common in investment appraisal to have a number of years with equal flows: this would
be termed an ‘annuity’. For example, the same rent might have to be paid for several years.
So, if a payment of $1,500 had to be made after one, two, and three years, with a discount rate
of 9%, the calculation could be set out as:
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However, a faster way of working this out would be to add up the discount factors and
multiply their total by $1,500:
3 1,500
1,500 2.531 3,796.50
Once again, this type of calculation is made easier by the use of tables known as Annuity
Tables or Cumulative Discount Tables. Here’s an excerpt:
You will see that at a discount rate of 9% and for three periods (n = 3), the annuity discount
factor from this table is 2.531, as was calculated above.
It is important to realise that if you are using discount factors straight from annuity tables,
then the cash flows must start after 1 year and occur every year up to the stated number off
periods.
Therefore, if any other pattern of flows occurs the discount factor will have to be adjusted.
So, if $200 is to be received in years 4 – 10 with a 5% discount rate, the required calculation
would be:
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Therefore, the present value of the cash received is $200 x 4.999 = $999.8
Note: the cumulative factor for years 1 – 3 has to be removed to leave 4 – 10. The commonest
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error made is to remove the cumulative factor for 1 – 4, but that would only leave a factor for
years 5 –10.
Example 7
(a) What is the present value if $100 is to be received in years 6 – 9?
Discount rate = 5%
(b) What is the present value if $100 is to be received in years 3 – 10 except year 5 ?
Discount rate = 4%
(c) What is the present value if $200 is to be received in years 0 – 5?
Discount rate = 10%
1−(1+ r)−n
Annuity factor =
r
1⎡ 1 ⎤
Annuity factor = ⎢1− ⎥
r ⎣ (1+ r)n ⎦
This will give the figures in the tables (a pointless exercise in itself!) but might need to be used
if the discount rate or the number of periods is no on the tables.
Example 8
(a) Work out the cumulative discount factor for n = 7 and the discount rate = 8%
(ie r = 0.08), and check to the figure in the tables.
(b) Work out the cumulative discount factor for n = 12 and the discount rate = 5.5% (ie r =
0.055).
As annuity is an annual cash flow. As the annuity becomes longer (ie more years of flow) the
annuity becomes close to a perpetuity, which is an equal cash flow for ever ie in perpetuity.
Obviously no set of flows is for ever, but after 20 years or so, at moderate discount rates,
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discount factors are so small that further flows can be ignored (for example, the 20 year 10%
factor is 0.149) and for convenience the flows can be treated as a perpetuity.
Notice what happens the annuity factor formula as n, the number of years of flow, becomes
very large
1⎡ 1 ⎤
Annuity factor = ⎢1− ⎥
r ⎣ (1+ r )n ⎦
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An n becomes large this term becomes very small and the formula can be simplified to
Perpetuity factor = 1
r
So, the present value of receiving $1,000 from time 1 to infinity at a discount rate of 10% is:
1,000
PV = =$10,000
0.1
Note that as with annuities, perpetuities start at time 1 and occur every year. So, if the pattern
is something else, the perpetuity factor will have to be adjusted.
For investment appraisal the cash outflows (usually the initial investment) and inflows
(usually the future income and sale of the non-current asset at the end of its life) are all
discounted to their present values. Outflows are negative, inflows are positive and when
added up the net total is known as the net present value (NPV).
If the NPV > 0 the present value of the inflows exceeds the present value of the outflows, so
the business would be richer. The investment would be worthwhile and should be accepted.
If the NPV< 0 the present value of the outflows exceeds the present value of the inflows and
this means that the business would be poorer if it invested. The investment should be
rejected
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Illustration
For example: an investment in new machinery would cost $25,000 and would
produce additional cash inflows of:
Year 1 $8,000
Year 2 $15,000
Year 3 $10,000.
The machinery could be sold for $2,000 at time 3.
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Solution
Time Flow Amount $ Factor@ 8% Discounted
cash flow $
0 Initial investment (25,000) 1 (25,000)
1 Additional income 8,000 0.926 7,408
2 Additional income 15,000 0.857 12,855
3 Additional income 10,000 0.794 7,940
3 Scrap proceeds 2,000 0.794 1,588
Net present value (NPV) 4,791
Example 9
An investment requires expenditure of $10,000 now and $12,000 at time 1. Income will be $5,000,
$15,000 and $7,000 in years 2, 3 and 4. There are no scrap proceeds.
Is the investment worthwhile when evaluated at a 9% discount rate?
Example 10
An investment requires expenditure of $18,000 now will yield income of $8,000 pa for times 2 - 5
Is the investment worthwhile when evaluated at a 10% discount rate?
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In particular:
๏
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Cash flows are what you need, so look at income before depreciation.
๏ Reapportionment of existing fixed costs is irrelevant.
๏ Sunk or past costs are irrelevant.
๏ Opportunity costs are relevant ie cash flows forgone because of a decision
๏ Ignore all interest and other finance flows. These are taken account of by
discounting.
Example 11
An investment requires expenditure of $15,000 now will yield income of $5,000 pa after
depreciation for times 1 – 3 then $4,000 after depreciation of year 4. The machine can be sold for
$3,000 in year 4. Research expenditure of $5,000 has been incurred on the new product that would
be made by the machine.
Is the investment worthwhile when evaluated at a 6% discount rate?
If the discount rate to be used is greater than the IRR, then the project is not worthwhile. That
would be like borrowing at 10% and investing in a project which generated 5%: obviously
you would lose out.
If the discount rate to be used is less than the IRR, then the project is worthwhile. That would
be like borrowing at 5% and investing in a project which generated 10%: obviously you
would make money.
The IRR will tell you nothing about accepting/rejecting a project that the NPV has not already
told you.
Estimating the IRR requires you to work out the NPV of the project at two discount rates.
There is nothing special about the two rates chosen, but many people try 10% and 15%, or
5% and 15% or 10% and 20%.
For example:
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NPV at 5% = $1,000
At a low discount rate the future positive cash flows stay relatively large after discounting so
the NPV is likely to be positive.
At a high discount rate the future positive cash flows are considerably reduced after
discounting so the NPV is likely to be negative
The IRR must be between 5% and 15% and this has to be estimated. However, the line joining
the two discount rates and NPVs is usually curved and this makes estimation more difficult. To
simplify matters it is assumed that the line is straight and this will result in an estimation of
the IRR rather than a precise figure.
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Our aim is to work out the distance BF as the IRR will then be estimated as 5+BF
The triangles ABF and ACD are similar, meaning that they have the same proportions.
Therefore, for each, the base/height must be equal:
BF/AB = CD/AC
BF = AB x CD/AC
= 1000 x (15 – 5) /(1,000 + 1,300) = 4.3
Therefore, point F must be 5 + 4.3 = 9.4%, and this is the estimate of the IRR.
Note that if someone had calculated the IRR using the NPVs at, say, 4% and 16%, the IRR
estimate would be slightly different.
Some people are happy sketching diagrams such as those above. Others prefer to use a
formula (not given in the exam):
NA
IRR = A%+ (B% − A%)
(NA − NB )
Where
A% = lower discount rate tried
B% = higher discount rate tried
NA = NPV at A%
NB = NPV at B%
1,000 1,000
IRR = 5%+ (15−5) = 5+ ×10 = 9.4%
(1,000 −(1,300)) 2,300
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So, NA – NB = (1,000 – (- 1,300)) = 2,300 [the two negative signs make a plus]
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Tests
Question 1
A business has five annual cash inflows of $1,500 pa starting at time 3.
What is the present value of these flows at a discount rate of 7%?
A 6,245
B 5,372
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C 4,148
D 5,021
Question 2
A business has cash inflows of $400 pa for times 0 – 8, except time 5.
What is the present value of these flows at a discount rate of 10%?
A 2,534
B 1,018
C 1,886
D 2,286
Question 3
A business will receive rent of $10,000 pa on a 500 year lease.
What is the present value of the rental receipts if the discount rate is 5%?
A $200,000
B $100 million
C $1 million
D $5 million
Question 4
A business will receive rent of $10,000 pa on a 999 year lease, starting at year 3.
What is the present value of the rental receipts if the discount rate is 5%?
A $200,000
B $172,770
C $185,900
D $181,410
Question 5
A business will receive rent of $10,000 pa on a 999 year lease, starting at year 0. At time 2 the
business will also receive $1,000 to cover the legal fees involved in setting up the lease.
What is the present value of the receipts if the discount rate is 7%?
A $153,730
B $152,857
C $143,730
D $142,857
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Question 6
A business is considering implementing solar heating throughout its factories. This will cost
$900,000 after one year and the savings are estimated to be $400,000 two years from now
and $600,000 three years from now.
Discount rate = 10%
What is the NPV of the project?
A 111,710
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B 37,100
C +37,100
D –37,510
Question 7
A business owns some land that could be sold for $1 million and which cost $800,000 two
years ago. Alternatively, the land could have apartments build on it for a present cost of $5
million. The apartments would bring in rent of $550,000 pa in perpetuity from time 1
onwards.
Discount rate = 10%
What is the NPV of the project?
A 4,700,000
B 5,500,000
C 4,500,000
D 6,500,000
Question 8
At 10% NPV = $1,200
At 20% NPV = $-500
What is the estimated IRR?
A 17%
B 27%
C 19%
D 20%
Question 9
At 8% NPV = $1,200
At 12% NPV = $500
What is the estimated IRR?
A 18.9%
B 10.8%
C 14.9%
D 17.3%
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Question 10
A project with conventional cash flows (cash out now, received in the future) has an IRR of
12%. The discount rate is 9%.
This means that;
A The NPV will be positive, but the project should be rejected
B The NPV will be negative, but the project should be accepted
C The NPV will be negative and the project should be accepted
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CHAPTER 11
THE EFFECTS OF INTEREST RATES AND
EXCHANGE RATES ON BUSINESS
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PERFORMANCE
1 Introduction
This chapter looks at how changing interest rates and interest rates can affect the
performance of a business. It also looks at how businesses can protect themselves against
unfavourable exchange rate and interest rate movements.
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Transaction risk
Transaction risk arises from currency movements affecting the amounts received and paid for
exports and imports.
For example, a UK company contracted to sell a product for $39,000 to a USA customer when
the exchange rate was £1 = US$1.3. When the payment is received (and this could be several
months after the contract was agreed) the exchange rate has moved to £1 = $1.50 so instead
of ending up with 39,000/1.3 = £30,000, the company will receive only 39,000/1.5 = £26,000.
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The £4,000 difference is a shortfall in the company’s cash flow and could have serious
consequences.
Similar cash flow uncertainty and problems arise on buying goods from a foreign supplier. If a
UK company agrees to pay a German supplier €100,000 for a piece of equipment when the
exchange rate is £1 = €1.4 and the £ has weakened to £1 = €1.2 when payment is made,
instead of the goods costing 100,000/1.4 = £71,429, the company will have to pay 100,000/1.2
= £83,333 to obtain €100,000. Around an extra £12,000.
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Remember, futures prices move with the exchange rate so to compensate for the exchange
rate loss, the company could sell futures now (at around 1.4) then buy them later (at around
1.3) to ‘close out’ the transaction. The profit on the futures will largely compensate for the loss
made on the exchange of the money.
The agreed price is known as the exercise price or the strike price.
An option to sell is a put option (think: put something up for sale); an option to buy is a call
option.
Options can be exercised ie the option owner can insist on buying or selling currency at the
exercise price or can be allowed to lapse.
For example, the US exporter above takes out an option to sell £ (a put option) at an exercise
price of 1.43. What will be done if the exchange rate available when £1m is received is:
(i) 1.50
(ii) 1.38?
(i) The exporter can either get 1m x 1.5 = $1.5m or 1m x 1.43 = $1.43m by exercising the
option. So, in this case the exporter would allow the option to lapse.
(ii) The exporter can either get 1m x 1.38 = $1.38m or 1m x 1.43 = $1.43m by exercising the
option. So, in this case the exporter would exercise the option.
Options are rather like insurance policies: they protect you from losses but you don’t have to
make a claim on them. However, like insurance policies, to acquire this protection an up-front
non-returnable premium has to be paid.
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There are three main methods to reduce risk arising from variable rate interest.
๏ Forward rate agreements
๏ Interest rate futures
๏ Interest rate options
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Tests
Question 1
A company in the US is quoted an exchange rate as 1US$ = 0.9332 – 0.9245 €
The company is going to receive €1m from the sale of machinery.
How many US$ will this produce?
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Question 2
What are the three types of currency risk that a business can experiences?
Question 3
What does the following describe: a right but not an obligation to buy or sell a certain
amount of currency on a certain date.
Question 4
What does ‘FRA’ mean and what are FRAs for?
Question 5
A company is planning to change $ to £ in three months and has taken out a currency option
at £1 = US$1.25.
In three months the rate of exchange is £1 = $1.30.
Will the company exercise its option or allow it to lapse?
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ANSWERS TO TESTS
Chapter 1
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Question 1
Final
Question 2
D
Question 3
Injection Withdrawal
Tax X
Exports X
Imports X
Savings X
Government spending X
Question 4
B
Question5
$100m/0.2 =$500m. This is the multiplier effect.
Question 6
C and D. A and B move along the demand curve but they do not change its position.
Question 7
Inflation. The excess demand pushed prices up. It can also suck in imports.
Question 8
a) Base-year weighted quantity index
Index = ∑(Current year price x Base year quantity)/∑(Base year price x Base year quantity)
= (5.00 x 30 + 4.00 x 50)/(4.00 x 30 + 3.00 x 50) = 1.296
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Question 9
๏ Taxation
๏ Borrowing
๏ Selling state assets
๏ Printing money/quantitative easing
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Chapter 2
Question 1
This is an example of absolute advantage
Question 2
Protectionism
Question 3
C
Having to import strategic resources does no give assured supplies.
Question 4
120,000/1.25 = £96,000
Question 5
B, C
Question 6
The higher inflation rate in country A means that its currency is losing value faster than
country B’s. Therefore, A$1 must buy fewer B$ in the future than it does now. Therefore the
exchange rate will move towards A$1 = 1.4B$.
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Chapter 3
Question 1
It is when company moves some of its operations abroad – usually to exploit lower
manufacturing costs.
Question 2
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Globalisation.
Question 3
Social changes and social forces
Question 4
This describes the World Trade Organisation.
Chapter 4
Question 1
False. Shareholders’ liability is limited but the company is liable for all its debts.
Question 2
False. Many state owned organisations are not-for-profit, but not all are. For example, a state
owned airline can be expected to produce a profit.
Question 3
Share capital and loan capital.
Question 4
Cost of capital
Question 5
Internal External Connected
Employees X
Suppliers X
Customers X
Government X
Lenders X
Directors X
Shareholders X
Question 6
Shareholders are the principals, directors are the agents
Question 7
There should be a balance of executive and non-executive directors, meaning a 50/50 split, so
there should be at least 6.
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Question 8
The return on capital employed is defined as:
Operating profit before tax and interest 100 x 5,000
x 100 = = 15.2%
Capital employed (26,000 + 7,000)
Chapter 5
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Question 1
B
High price elasticity of demand implies high price sensitivity. For a given change in price
product B’s demand changes more than product A’s
Question 2
C, D
Question 3
False.
Elasticity>1 means the item is price sensitive. A small change in price will lead to a relatively
large fall in quantity so that revenue falls.
Question 4
Price Quantity sold
15 20,000
20 16,000
Question 5
Shift to right Shift to left
Increased advertising X
Lower incomes X
An item becoming fashionable X
The price of a substitute falling X
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Chapter 6
Question 1
Predatory pricing is where a rich supplier drops the selling price to drive others from the
market.
Question 2
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Question 3
Minimum price set Maximum price set
Rationing X
Over-production X
Queueing X
Wasted resources X
Question 4
Merit goods
Question 5
An externality.
Chapter 7
Question 1
B Information can be defined as data with meaning
Question 2
Accurate
Complete
Cost-beneficial
User-targeted
Relevant
Authoritative
Timely
Easy to use
Question 3
Histogram; ogive (or cumulative frequency curve)
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Question 4
Discrete Continuous
Number of children under 10 in each family X
Weight of individuals in a population X
Distance between cities X
Family income rounded to the nearest $000 X
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Question 5
Cumulative
Family income Frequency
frequency
0 - <2,000 5 5
2000 - <3,000 20 25
3000 - <5,000 500 525
5000 - <10,000 100 625
10,000 - <20,0000 10 635
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Chapter 8
Question 1
Velocity, volume, variety, veracity
Question 2
No. Even a very high coefficient of correlation does not prove cause and effect. The results are
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consistent with a causal relationship but do not prove it. For example, the increase in
advertising might have coincided with an improvement in the economy and that sales might
have increased because of that.
Question 3
Guest 1 Guest 2
d d2
ranking ranking
Hotel 1 2 3 -1 1
Hotel 2 4 4 0 0
Hotel 3 3 1 2 4
Hotel 4 1 2 -1 1
∑d2 6
n = 4 n2 = 16
⎡ 6× 6 ⎤
r =1− ⎢ = 0.4(low correlation)
⎣ 4 ×15 ⎥⎦
Question 4
From season 3 2017 to season 4 2018 is 5 increments of season. The projected trend is
therefore $73,000 + 5 x 2,000 = 83,000
The appropriate seasonal adjustment is -$9,000, so the seasonally adjusted projection is
$74,000.
Question 5
B, C
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Chapter 9
Question 1
B
Question 2
Annual interest = 6% x 12,000 = $720. This must be equivalent to 4% on the amount invested:
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720/Market value = 4%
Market value must be 720/4% = $18,000
Question 3
Interest rates are expected to fall.
Question 4
It should be lower because the convertible holder enjoys a ‘wait and see’ approach to
deciding whether to convert the securities into shares. This benefit means that less interest
should be required.
Question 5
It must sell its reserves in exchange for its currency
Chapter 10
Question 1
B We need the 3 – 7 for the five flows. 1 – 7: annuity factor = 5.389; 1 – 2: annuity factor =
1.808. Factor for 3 – 7 = 5.389 – 1.808 = 3.581. PV = 3.581 x $1,500 = 5,372
Question 2
D 1 – 8 except time 5 = 5.335 – 0.621 = 4.714
0 – 8 = 1 + 4.714 = 5.714
PV = $400 x 5.714 = 2,286
Question 3
A 10,000/0.05 = 200,000
Question 4
D 1 – infinity: 1/0.05 = 20
1 – 2 5% factor = 1.859
3– infinity = 18.141
PV = 18.141 x 10,000 = $181,410
Question 5
D Rent PV factor (time 0 – infinity) = 1/.07 +1 [for time 0] = 15.2857
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Question 6
B NPV = - 900,000 x 0.909 + 400,000 x 0.826 + 600,000 x 0.751 = -37,100
Question 7
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C The cost of the land is irrelevant as that is a sunk (past) cost. However, the land could
now be sold for $1m and this is an opportunity cost of building on it as that cash inflow
will not be received.
NPV = $4,500,000
Question 8
A IRR = 10 + 1,200 x (20 – 10)/(1,200 + 500) = 17%
Question 9
C IRR = 8 + 1,200 x (12 – 8)/(1,200 - 500) =14.9%
Question 10
D If IRR > D/c rate, NPV will be positive and the project should be accepted.
Chapter 11
Question 1
If the company goes to its bank with $10,000, the bank will give it only €9,245 (worse than
€9332, and the bank always wins). So, 0.9245 is the rate for changing $ to €. Therefore 0.9332
must be the rate for changing € to £
Therefore, €1m will yield €1m/0.9332 = $1.0716m.
Question 2
Transaction, translation and economic risk.
Question 3
This is a currency option.
Question 4
FRA = forward rate agreement. They allow organisations to fix future interest rates.
Question 5
If changing $ to £ 1.3 is a less favourable rate than 1.25, so the company will exercise its
option and change $ to £ at 1.25.
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ANSWERS TO EXAMPLES
Chapter 8
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Example 1
Note: x should be the independent variable, units; y is the dependent variable, cost, because
cost depends on units.
x (000) y xy x2 y2
January 1 40 40 1 1,600
February 4 54 260 16 24,225
March 2 45 90 4 2,050
April 7 80 560 49 6,400
May 6 70 420 36 4,900
June 5 70 350 25 4,900
July 3 50 150 9 2,500
∑ 28 420 1,870 140 26,550
n∑ xy − ∑ x ∑ y
b=
n∑ x 2 −(∑ x )
2
a=
∑ y − b∑ x
n n
420 6.7857× 28
− = 32.8572
7 7
y = 32.86 + 6.79x
or: y = 32,857 + 67.9x
$32,857 represents the fixed costs per month because $32,857 will be incurred even if
nothing is produced (ie x = 0)
Each unit made then causes costs to increase by $67.90. $67.90 is the variable cost per unit.
(if × and y are actual units and $’s)
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Example 2
n∑ xy − ∑ x ∑ y
r=
(n∑ x −(∑ x ) )(n∑ y −(∑ y ) )
2 2 2 2
7 × 1,870 – 28 × 420
=
(7×140−(28)2 )(7×26,550−( 430)2 )
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1,330
= = 0.98
(196×9, 450)
Note that the coefficient of determination, r2 = 0.982 = 0.96
This implies that 96% of the variation in cost can be explained by the variation in output.
Example 3
Using Spearman's coefficient:
⎡ 6∑ d2 ⎤
r = 1− ⎢ 2
⎥
⎢⎣ n( n −1) ⎥⎦
where d is the difference between the rank in Accountancy and the rank in Economics for
each student.
Rank Rank
Student Accountancy Law d d2
A 1 3 –2 4
B 4 7 –3 9
C 2 1 1 1
D 5 5 –1 1
E 3 2 1 1
F 7 4 3 9
G 6 5 1 1
∑d = 0 2
∑d = 26
⎡ 6× 26 ⎤ 156
r = 1− ⎢ ⎥ = 1− = +0.536
⎣ 7( 49−1) ⎦ 336
The correlation is positive 0.536, meaning that as performance in one paper increases so does
performance in the other, but the correlation is not particularly strong.
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Chapter 10
Example 1
Interest for
$ Principal
the year @10%
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1/1/2018 200
31/12/2018 200 20
1/1/2019 200
31/12/2019 400 40
1/1/2020 200
31/12/2020 600 60
Total interest 120
Interest for
$ Principal
the year @10%
1/1/2018 200
31/12/2018 200 20
1/1/2019 200
31/12/2019 400 40
1/1/2020 200
31/12/2020 600 60
Total interest 120
There will be $720 in total to the investor’s credit.
Example 2
$
Now payment 500.00
Year 1 interest 50
550
Year 2 interest 55
605.00
Year 3 interest 60.50
$665.50
The amount (A) at the end of the n’th year at a rate r of interest (expressed as a decimal) is
given by:
A = P(1+r)n
So, in the above example $665.50 = $500 × (1.1)3
This is also known as the future value (or terminal value)
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Example 3
A = $1,070.58 = $800 × (1.06)5
Example 4
Amount owed after 12 months = P (1 + r)n
= 100 (1.02)12
= $126.82
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APR = actual interest over the year = (126.82 – 100)/100 × 100 = 26.82%
Example 5
For interest payable quarterly, the year is divided into four periods so:
(a) 1 + APR = (1 + 08/4)4 = 1:08243;
so the APR (or AER) is 8.243%.
This is the example we considered above.
Example 6
Option 1: Present value = $3,000
Option 2: Present value = 4,000 x 0.763 = $3,052
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Example 7
Example 8
1⎡ 1 ⎤ 1 ⎡ 1 ⎤
Annuity factor = ⎢1− n⎥
= ⎢1− ⎥ = 5.206
r ⎣ (1+ r) ⎦ 0.08 ⎣ (1.08)7 ⎦
1⎡ 1 ⎤ 1 ⎡ 1 ⎤
Annuity factor = ⎢1− n⎥
= ⎢1− ⎥ = 8.619
r ⎣ (1+ r) ⎦ 0.055 ⎣ (1.055)12 ⎦
Example 9
Time Flow $ Factor Discounted
cash flow
0 Investment (10,000) 1.000 (10,000)
1 Investment (12,000) 0.917 (11,004)
2 Income 5,000 0.842 4,210
3 Income 15,000 0.772 11,580
4 Income 7,000 0.708 4,956
Net present value -258
So, marginally, the investment is not worthwhile.
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Example 10
Required discount factor = 3.791 – 0.909 = 2.882
PV of inflows = 2.882 x 8,000 = $23,056
PV of outflow = $18,000
NPV = $5,056
Example 11
Depreciation charged = (15,000 – 3,000)/4 = 3,000
Time Flow $ 6% Factor Discounted
cash flow
1 Investment (15,000) 1.000 (15,000)
2 investment 5,000 + 3,000 = 8,000 2.673 21,384
4 Income before depreciation 4,000 + 3,000 = 7,000 0.792 5,544
4 Scrap 3,000 0.792 2,367
Net present value 14,295
Therefore the project is worthwhile.
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