Chapter 5: Investment Decisions


All investment decisions involve a
trade-off between current sacrifice
and future gain
Before investing, we need to know
that future benefits > current costs –
to know this we use discounting
Discounting:
Present value = future value/(1+r)2
Compounding: opposite of discounting
Future value = present value x (1+r)2
Rule of 72 = interest rest x time it takes
- The higher the interest rates, money
will double in a short amount of
time
CV
$100
$100
$100
$100
$100
$100
$100

IR
2.00%
4.00%
6.00%
7.20%
10.00%
12.00%
15.00%
Yrs
36.0
18.0
12.0
10.0
7.2
6.0
4.8
FV Rate*Time
$204 72
$203 72
$201 72
$200 72
$199 72
$197 72
$196 72
Use discounting to determine
whether the investment is profitable
NPV Rule:
- Discount + future benefits and
compare with the current cost of the
investment
- If difference is positive, investment
earns more than cost of capital
Chapter 6: Simple Pricing

-
Pricing is an extent decision
Reduce price (increase quantity)
MR > MC
Increase price (decrease quantity)
MC > MR
Optimal price MR = MC
Law of Demand – consumers demand more
as price falls, assuming all other factors are
held constant
- Price and quantity demand inverse
relationship
Consumer surplus = value to customer –
price paid
Demand curves – functions that relate the
price of a product to the quantity
demanded by consumer
Compute for percentage change in price
and quantity
Midpoint method:
start value – end value / average of start
and end value
Price elasticity of demand:
e = % change in quantity / % change in price
e > 1 – demand is elastic
- Quantity changes more than price
- Price decreases, Total revenue will
increase
- Price increases, total revenue will
decrease
e < 1 – demand is inelastic
- Quantity changes less than price
- Price decreases, total revenue will
decrease
- Price increases, total revenue will
increase
Income Elasticity of demand
Positive Income Elasticity – good is normal
- Income increases, demand increase
- Income decrease, demand decreases
Negative Income Elasticity – good is inferior
- Income increases, demand
decreases
- Income decreases, demand
increases
Cross Price Elasticity of Demand
Positive Cross Price Elasticity – goods are
substitute
- Substitute Price increase, demand
increases
Negative Cross Price Elasticity – goods are
complements
- complement price increases,
demand decreases
Marginal analysis – finds the profit
increasing solution to the pricing tradeoff
- tells to whether increase or
decrease the price but not how far
to go
Five Factors that Affect Demand Elasticity
and Optimal Pricing:
1. Products with close substitutes have
elastic demand
2. Demand for an individual brand is more
elastic than industry aggregate demand
3. Products with many complements have
less elastic demand
4. In the long run, demand curves become
more elastic
5. As price increases, demand becomes
more elastic