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Principles of Finance

3.1 Microeconomics

Principles of Finance3.1 Microeconomics

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Identify equilibrium price and quantity.
  • Discuss how changes in demand will impact equilibrium price and quantity.
  • Discuss how changes in supply will impact equilibrium price and quantity.

Demand

Microeconomics focuses on the decisions and actions of individual agents, such as businesses or customers, within the economy. The interactions of the decisions that businesses and customers make will determine the price and quantity of a good or service that is sold in the marketplace. Financial managers need a strong foundation in microeconomics. This foundation helps them understand the market for the company’s products and services, including pricing considerations. Microeconomics also helps managers understand the availability and prices of resources that are necessary for the company to create its products and services.

A successful business cannot just create and manufacture a product or provide a service; it must produce a product or service that customers will purchase. Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a given time period, ceteris paribus (a Latin phrase meaning “all other things being equal”).

Let’s consider what the demand for pizza might look like. Suppose that at a price of $30 per pizza, no one will purchase a pizza, but if the price of a pizza is $25, 10 people might buy a pizza. If the price falls even lower, more pizzas will be purchased, as shown in Table 3.1.

Price ($) Quantity
30 0
25 10
20 20
15 30
10 40
5 50
Table 3.1 Demand Schedule for Pizza

The information in Table 3.1 can be viewed in the form of a graph, as in Figure 3.2. Economists refer to the line in Figure 3.2 as a demand curve. When plotting a demand curve, price is placed on the vertical axis, and quantity is placed on the horizontal axis. Because more pizzas are bought at lower prices than at higher prices, this demand curve is downward sloping. This inverse relationship is referred to as the law of demand.

A graph shows the Demand Curve for pizzas as the price increases.A downward sloping line shows that as the price of pizzas go down, the demand increases.
Figure 3.2 Demand Curve for Pizzas

The inverse relationship between the price of a good and the quantity of a good sold occurs for two reasons. First, as you consume more and more pizza, the amount of happiness that one more pizza will bring you diminishes. If you have had nothing to eat all day and you are hungry, you might be more willing to pay a high price for a pizza, and that pizza will bring you a great deal of satisfaction. However, after your hunger has been somewhat satisfied, you may not be willing to pay as much for a second pizza. You may only be willing to purchase a third pizza (to freeze at home) if you can get it at a fairly low price. Second, demand depends not only on your willingness to pay but also on your ability to pay. If you have limited income, then as the price of pizza rises, you simply cannot buy as much pizza.

The demand curve is drawn as a relationship between the price of the good and the quantity of the good purchased. It isolates the relationship between price and quantity demand. A demand curve is drawn assuming that no relevant factor besides the price of the product is changing. This assumption is, as mentioned above, ceteris paribus.

If another relevant economic factor changes, the demand curve can change. Relevant economic factors would include consumer income, the size of the population, the tastes and preferences of consumers, and the price of other goods. For example, if the price of hamburgers doubled, then families might substitute having a pizza night for having a hamburger cookout. This would cause the demand for pizzas to increase.

If the demand for pizzas increased, the quantities of pizza purchased at every price level would be higher. The demand schedule for pizzas might look like Table 3.2 after an increase in the price of hamburgers.

Price ($) Quantity
30 9
25 19
20 29
15 39
10 49
5 59
Table 3.2 Demand Schedule for Pizzas after the Price of Hamburgers Doubles

This change leads to a movement in the demand curve—outward to the right, as shown in Figure 3.3. This is known as an increase in demand. Now, at a price of $25, people will purchase 19 pizzas instead of 10; and at a price of $15, people will purchase 39 pizzas instead of 30.

The previous Demand Curve for pizzas is labelled as Demand 1. A second demand curve, labelled Demand 2. Both lines slope downard at the same rate, but Demand 2 is shown to the right of Demand 1. This represents an increase in demand for pizzas.
Figure 3.3 An Increase in Demand Represented as a Movement of the Demand Curve to the Right

A decrease in demand would cause the demand curve to move to the left. This could happen if people’s tastes and preferences changed. If there were, for example, increased publicity about pizza being an unhealthy food choice, some individuals would choose healthier alternatives and consume less pizza.

Supply

Supply is the quantity of a good or service that firms are willing to sell at various prices, during a given time period, ceteris paribus. Table 3.3 is a fictional example of a supply schedule for pizzas. In some cases, higher prices encourage producers to provide more of their product for sale. Thus, there is a positive relationship between the price and quantity supplied.

Price ($) Quantity
30 60
25 50
20 40
15 30
10 20
5 10
Table 3.3 Supply Schedule for Pizzas

The data from the supply schedule can be pictured in a graph, as is shown in Figure 3.4. Because a higher price encourages suppliers to sell more pizzas, the supply curve will be upward sloping.

The supply curve shows the relationship between the price of pizzas and the quantity of pizzas supplied. It shows that the price of pizzas increases as the supply of pizzas increases.
Figure 3.4 Supply Curve for Pizzas

The supply curve isolates the relationship between the price of pizzas and the quantity of pizzas supplied. All other relevant economic factors are assumed to remain unchanged when the curve is drawn. If a factor such as the cost of cheese or the salaries paid to workers changes, then the supply curve will move. A shift to the right indicates that a greater quantity of pizzas will be provided by firms at a particular price; this would indicate an increase in supply. A decrease in supply would be represented by a shift in the supply curve to the left.

Equilibrium Price

Demand represents buyers, and supply represents sellers. In the market, these two groups interact to determine the price of a good and the quantity of the good that is sold. Because both the demand curve and the supply curve are graphed with price on the vertical axis and quantity on the horizontal axis, these two curves can be placed in the same graph, as is shown in Figure 3.5.

Graph of demand and supply of pizza showing equilibrium price and quantity when supply and demand curves intersect each other. The point where the demand and supply graphs meet is known as the intersection point. In this graph, the equilibrium occurs when the price of pizza is fifteen dollars and the quantity of pizzas is 30.
Figure 3.5 Graph of Demand and Supply Showing Equilibrium Price and Quantity

The point at which the supply and demand curves intersect is known as the equilibrium. At the equilibrium price, the quantity demanded will equal exactly the quantity supplied. There is no shortage or surplus of the product. In the example shown in Figure 3.5, when the price is $15, consumers want to purchase 30 pizzas and sellers want to make 30 pizzas available for purchase. The market is in balance.

A price higher than the equilibrium price will not be sustainable in a competitive marketplace. If the price of a pizza were $20, suppliers would make 40 pizzas available, but the quantity of pizzas demanded would be only 20 pizzas. This would be a surplus, or excess quantity supplied, of pizzas. Restaurant owners who see that they have 40 pizzas to sell but can only sell 20 of those pizzas will lower their prices to encourage more customers to purchase pizzas. At the same time, the restaurant owners will cut back on their pizza production. This process will drive the pizza price down from $20 toward the equilibrium price.

The opposite would occur if the price of a pizza were only $5. Customers may want to purchase 50 pizzas, but restaurants would only want to sell 10 pizzas at the low price. Quantity demanded would exceed quantity supplied. At a price below the equilibrium price, a shortage would occur. Shortages drive prices up toward the equilibrium price.

Think It Through

Graphing Demand and Supply

Consider the demand and supply schedules for sweatshirts shown below. Sketch a graph of demand and supply, placing quantity on the horizontal axis and price on the vertical axis. What will the equilibrium price for sweatshirts be? Table 3.4 provides the demand and supply schedules for the sweatshirts.

Demand Schedule for Sweatshirts Supply Schedule for Sweatshirts
Price ($) Quantity Price ($) Quantity
55 0 55 45
50 4 50 40
45 8 45 35
40 12 40 30
35 16 35 25
30 20 30 20
25 24 25 15
20 28 20 10
15 32 15 5
10 36 10 0
5 40    
Table 3.4 Demand and Supply Schedules for Sweatshirts

Changes in Equilibrium Price

A price that is either too high (above the equilibrium price) or too low (below the equilibrium price) is not sustainable in a competitive market. Market forces pull prices to the equilibrium, where they stay until either supply or demand changes.

If supply increases and the curve moves outward to the right, as in Figure 3.7, then the equilibrium price will fall. With the original supply curve, Supply1, the equilibrium price was $15; quantity demanded and quantity supplied were both 30 pizzas at that price. If a new pizza restaurant opens, increasing the supply of pizzas to Supply2, the equilibrium will move from Equilibrium1 E1E1 to Equilibrium2 E2E2. The new equilibrium price will be $10. This new equilibrium is associated with a quantity demanded of 40 pizzas and a quantity supplied of 40 pizzas.

Graph of demand and supply of pizza showing equilibrium price and quantity when supply increases. The line for the original supply is labbeled Supply 1 and the line for the increased supply is labelled Supply 2. Both lines slope upward at the same rate; however Supply 2 is to the right of Supply 1. It shows that the equilibrium drops to a lower price level if the supply increases.
Figure 3.7 Supply Curve Changes When Supply Increases An increase in supply leads to a lower equilibrium price and an increase in quantity demanded.

It is important to note that the demand curve in Figure 3.7 does not move. In other words, demand does not change. As the equilibrium price falls, consumers move along the demand curve to a point with a combination of a lower price and a higher quantity. Economists call this movement an increase in quantity demanded. Distinguishing between an increase in quantity demanded (a movement along the demand curve) and an increase in demand (a shift in the demand curve) is critical when analyzing market equilibriums.

Equilibrium price will also fall if demand falls. Remember that a decrease in demand is represented as a shift of the demand curve inward to the left. In Figure 3.8, you can see how a decrease in demand causes a change from E1E1 to E2E2.

Graph of demand and supply of pizza showing equilibrium price and quantity demand decreases. The line for the original demand is labbeled Demand 1 and the line for the decreased demand is labelled Demand 2. Both lines slope downward at the same rate; however Demand 2 is to the left of Demand 1. The intersection of Supply and Demand 2 is labelled Equilibrium 2 and shows how the equilibrium drops to a lower price level if the demand drops.
Figure 3.8 A Decrease in Demand

At the new equilibrium, E2E2, the price of a pizza is $10. The new equilibrium quantity is 20 pizzas. Note that the supply curve has not moved. Producers moved along their supply curve, producing fewer pizzas as the price dropped; this is known as a decrease in quantity supplied.

Think It Through

Graphing Demand

Suppose that the demand for sweatshirts in our previous example changes, and the demand schedule becomes the data shown in Table 3.5.

Price ($) Quantity
55 18
50 22
45 26
40 30
35 34
30 38
25 42
20 46
15 50
10 54
5 58
Table 3.5 Demand Schedule for Sweatshirts

Has the demand for sweatshirts increased or decreased? Show this movement in a graph. What happens to the equilibrium? What are some reasons you can think of that may have caused this change in demand?

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