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