Describe the effects of each of the following managerial decisions or economic i

Question

Describe the effects of each of the following managerial decisions or economic influences on the value of the firm:
1. The firm is required to install new equipment to reduce air pollution.

2. Through heavy expenditures on advertising, the firm's marketing department
increases sales substantially.

3. The production department purchases new equipment that lowers
manufacturing costs.

4. The firm raises prices. Quantity demanded in the short run is unaffected, but
in the longer run, unit sales are expected to decline.

5. The Federal Reserve System takes actions that lower interest rates
dramatically.

6. An expected increase in inflation causes generally higher interest rates, and,
hence, the discount rate increases.

Explanation / Answer

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

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