E.

A general lowering of interest rates leads to a reduction in the cost of capital or discount rate in the valuation
model.
NAME:RHEA JOY SEVILLA
Masters in Business Administration
La Carlota City College
1. Is it appropriate to view firms primarily as economic entities?
Ans. Yes, it is appropriate to view firms primarily as economic entities. Firms represents a
combination of people, physical assets and information( financial , technical, marketing and
others). People directly involve include stockholders, managers, workers, suppliers and
customers. Business use scrace resources that would otherwise be available for other
purposes, pay income and other taxes, provide employement and are responsible for much
of the material well being of the society.Firms exist because they are useful in the process
of allocating resources, producing and distributing goods and services .

2. Describe the effects of each of the following managerial decisions on economic

influences on the value of the firm.

1. The firm is required to install new equipment to reduce air pollution.

ANS: A. The most direct effect of a requirement to install new pollution control equipment
would be an increase in the operating cost component of the valuation model. Secondary
effects might be expected in the discount rate due to an increase in regulatory risk, and in the
revenue function if consumers react positively to the installation of the pollution control
equipment in production facilities.

2. Through the heavy expenditures on advertising, the firms marketing department

increases sales satisfactorily
ANS:B. All three major components of the valuation model--the revenue function, cost
function, and the discount rate--are likely to be affected by an increase in advertising.
Revenues and cost will both increase as output is expanded. The discount rate may be
affected if the firm's profit outlook changes significantly because of increased demand
(growth) or if borrowing is necessary to fund a rapid expansion of plant and equipment to
meet increased demand.

3. The production department purchases new equipment that lowers

manufacturing costs.
ANS. C. The primary effect of newer and more efficient production equipment is a reduction
in the total cost component of the valuation model. Secondary effects on firm revenues could
also be important if lower costs make price reductions possible and result in an increase in
the quantity demanded of the firm's products. Likewise, the capitalization rate or discount
factor can be affected by the firm's changing prospects.
 4. The firms raises prices quantity demanded in the short run is unaffected, but in
the longer run, unit sales are expected to decline.

ANS. D. The time pattern of revenues is affected by such a pricing decision to raise prices in
the near term. This will alter production relationships and investment plans, and affect the
valuation model through the cost component and capitalization factor.

5. The federal reserve system takes actions that lower interest rates dramatically.

ANS. E. A general lowering of interest rates leads to a reduction in the cost of capital or
discount rate in the valuation model.

6. An expected increase in inflation causes generally higher interest rates, and

hence the discount rate increases.
ANS. F. Higher rates of inflation, leading to an increase in the discount rate, cause the present
value of a constant income stream to decline. Unless the firm is able to increase product
prices in order to maintain profit margins, the value of the firm falls as inflation and the
discount rate increases. Of course, the economic effects of inflation on the economic value of
the firm are complex, involving both asset and liability valuations, so determining the overall
effect of inflation on the economic value of individual firms is a difficult task.

3. It is reasonable to expect firms to take actions that are in public interest, but are
detrimental to stockholders? Is regulations always necessary and appropriate to induce
firms to act in the public interest?
ANS. No, it will not be a reasonable to expect firms to act on the idea of public interest when
they primarily came into existence with the idea of earning. According to the shareholder
model the objective of the firm is to maximise shareholder wealth through allocative,
productive and dynamic efficiency i.e. the objective of the firm is to maximise profits. The
criteria by which performance is judged in this model can simply be taken as the market value
(i.e. shareholder value) of the firm. Therefore, managers and directors have an implicit
obligation to ensure that firms are run in the interests of shareholders. The underlying problem
of corporate governance in this model stems from the principal-agent relationship arising from
the separation of beneficial ownership and executive decision-making. It is this separation that
causes the firm’s behaviour to diverge from the profitmaximising ideal. This happens because
the interests and objectives of the principal (the investors) and the agent (the managers) differ
when there is a separation of ownership and control.

4. “The utility derived from consumption is intangible and unobservable, therefore, the
utility concepts has no practical value”. Discuss this statement.
ANS. It is true in saying that the utility derived from consumption is intangible because there is
no standard way to measure utility. This is an ordinal concept.
 For example, if a consumer says that he prefers peaches over lemons, then the consumer is
indicating that the utility derived from peaches is greater than the utility derived from
lemons. But the amount by how much the utility from pear is greater than the utility from
lemon is not measurable.This gives an idea about a consumer’s preferences which play an
essential role in identifying his indifference curves. Thus it is wrong to say that the utility
concept has no practical value.

5. Is an increase in total utility or satisfaction following an increase in income consistent

with the law of diminishing marginal utility?
ANS. According to the law of diminishing marginal utility, the more of a good that is consumed,
the less additional satisfaction can be derived from consuming another unit; the law of
diminishing marginal utility of income suggests that as income increases, individuals gain a
correspondingly smaller increase in satisfaction
6. Describe some of the limitations of market experiment?
ANS:
A.Market experiments are costly and much time consuming. 
B. If the price rises, the consumers may switch over to the products of the rival firms. If the
price reduced to the original level, it may be difficult to regain the lost customers.
C. It is also difficult to select an area, which accurately represents the potential market.
D. Firm cannot control all the factors (i.e. bad weather, economic conditions, occupation
situations etc.) that influence demand for a product.
E. The changes in price or adverting to know consumer’s response may go unnoticed by
them in such a short period. 
F. The selected consumers may not respond accurately when they know they are a part of
an experiment being conducted and their behavior is being recorded.

 7.Explain how shifting demand and supply curves makes market demand estimation difficult.

ANS. A shift in a demand or supply curve occurs when a good's quantity demanded or supplied
changes even though the price remains the same. At any given point in time, one can observe
only one point on the demand curve, i.e., one tuple of (price, quantity) values. At different
points in time, we observe different (price, quantity) values. It makes demanrds estimation
difficult due to a decrease in the equilibrium price along with an increase in the equilibrium
quantity. (The supply curve shifts down the demand curve so price and quantity follow the law
of demand. If price goes down, then the quantity goes up.)
7. “Demand for higher education is highest among the wealthy. This has lead to an
upward-sloping demand curve for college education.The higher the tuition charged, the
greater is demand”. Discuss this statement.
ANS.Education market prices do not ration one’s access to the goods in the higher
education market. universities care a great deal about the students who attend their
university. This is because peers learn and interact with each other, and universities want to
create a stimulating and educating environment for the entire incoming class. Just because
a family can pay the full tuition price for an education does not mean the student will be
accepted and receive an education from the institution. The higher education market
actually turns away many buyers through the admissions process. Thus, the price used in
the higher education framework is the effective price, the price charged only to students
who are admitted, not to any student who is willing to pay the going price. In addition, as
stated in the previous section, the higher education market sets its price below cost. For any
market (wheat or higher education), this implies that a price set below the market-clearing
price will generate excess demand for the good or service, regardless of the slope of the
supply curve. To setup the framework of the supply and demand of higher education, one
must first define supply and demand. Supply and demand in the context of higher education
can be quite difficult to define and definitions may vary. Previous work on the topic of the
supply and demand of higher education has made some suggestions for the measurements
for supply and demand