QUESTION 1 (DONE)

What conditions are favorable to the formation and maintenance of cartel? Pages 417-418;
Chapter 10: Special pricing Practices.

Your response should be at least 75 words in length.

A cartel is an arrangement where firms in an industry cooperate and act together as if

they were a monopoly. Cartel arrangements may be informal or formal. But it is illegal in the

U.S according to Sherman Antitrust Act, 1890. Examples of cartels are OPEC and IATA.

(Keat & Young, 2017, p.417,418)

The conditions are favorable to the formation and maintenance of cartel are as below:

1. The formation of cartel

A Cartel is a collusive arrangement in an oligopoly market. Producers agree on unified

pricing and production actions to maximize profit and to eliminate the rigors of competition.

Conditions that influence the formation of cartels as below:

- Most common in oligopoly market structures

- Small number of large firms in the industry facilitates the policing of a collusive

agreement

- Geographical proximity of the firms is favorable

- Homogeneous products that do not allow differentiation and make it impossible for

members to cheat on one another

- Stage of the business cycle

- It is difficult to entry into industry

- Uniform cost conditions, usually defined by product homogeneity

 2. The maintenance of cartel

If cost conditions for Cartel members are similar and profitability thus will not differ

greatly among members, Cartels will be easier to maintain. However, due to the following

reasons, the maintenance Cartel is unstable

- Although all members in Cartel has collusive oligopoly and compromise, all firms will

compete each other severely. Cartels still have tendency to break down. Besides,

although the firm in the Cartel treats the other firms as its members, it still considers them

as rivalries. Cheating will be made if the there are opportunities

- To keep the loyal customers a member firm will secretly reduce the price for their loyal

customers, which violates the rules of the cartel.

- Cost to join the cartel is high.

- There may be an incentive for firms to cheat on agreements, thus cartels are unstable

- There are also additional costs facing a cartel including formation costs, monitoring costs,

enforcement costs and potential cost of punishment by authorities

In sum, the ideal cartel occurs only when pricing and profit decisions. In order to

maximize profits, the cartel as a whole should behave as a monopolist. The cartel determines

the output which equates MR = MC of the cartel as a whole. The MC of the cartel as a whole

is the horizontal summation of the members’ marginal cost curves. Price is set in the normal

monopoly way, by determining quantity demanded where MC=MR and deriving P from the

demand curve at that Q. (according to figure 10.1, page 418, Keat & Young, 2017).

Furthermore, as the case of cartels, dominant price leadership arrangement tend to

breakdown. When market grow, new firms enter the industry and decrease the independence
 among firms. Technological changes may bring changes in pricing and in the long run the

leadership of the dominant firm is very difficult.

QUESTION 2 (DONE)
Differentiate between barometric price leadership and dominant price leadership. Pages 422-424

Your response should be at least 75 words in length.

The differences between barometric price leadership and dominant price leadership are as

below: (Keat & Young, 2017, p.422-424)

1. Barometric price leadership

In oligopoly market, if one firm change the price, other firms will or will not follow up

with changing the price. Changing the price depends on firm’s decision at that time.

- One firm in an industry decides to initiate a price change in response to economic

conditions.

- The other firms may or may not follow this leader.

- The leader may change.

2. Dominant price leadership

However, with dominant price leadership, if one firm (the leader of the market) change

price, the others have to change the price too. If the others do not change price, they will not

survive and remain competitive in the market.

- One firm is the industry leader, normally the most efficient, lowest cost producer.

- This dominant firm sets price with the realization that the smaller firms will follow and

charge the same price.

- This may force some competitors out of business or allow the dominant firm to buy them

out under favorable terms.

 - This could result in investigation under the Sherman Anti-Trust Act.

Dominant Price Leadership Model is the strategy when being chosen, the company does

not consider the competitors’ reaction. Dominant strategy is not the best strategy.

According to figure 10.2, page 423, Keat & Young, 2017, DT = demand curve for entire

industry; MCD = marginal cost of the dominant firm; MCR = summation of MC of follower

firms. In setting price, dominant firm must consider the amount supplied by all firms. Then,

Demand curve facing the dominant firm is found by subtracting MCR from DT. Dominant firm

equates its MC with MR from its ‘residual demand curve’ DD. The dominant firm sells A

units and the rest of the demand (QT – A) is supplied by the follower firms. In sum, such

arrangement is satisfactory to the dominant firm. It maximizes profit and at the same time

permits the small firms to exist.

In conclusion, in the non-collusive oligopoly market, when one firm increases price, the

other will not follow to attract more customers. But when one firm reduces the price, the

other firm will follow to remain the competitive of the market. Dominant Price Leadership

Model is the strategy when being chosen, the company does not consider the competitors’

reaction. Furthermore, as the case of cartels, dominant price leadership arrangement tend to

breakdown. When market grow, new firms enter the industry and decrease the independence

among firms. Technological changes may bring changes in pricing and in the long run the

leadership of the dominant firm is very difficult. Dominant strategy is not the best strategy.

QUESTION 3 (DONE)
Project C has an expected value of $500 and a standard deviation of $50. Project D has an
expected value of $300 and a standard deviation of $10. Comment on the desirability of these
projects. 
Your response should be at least 75 words in length.

1. Project C has expected value R = $500 and σ = $50

We have Coefficient of variation a measure of risk relative to expected value

CV = σ R
CV = σ/R

Therefore, Coefficient of variation CVProject C = SD/R = 50/500

 CVProject C = 50/500 = 0.1

In sum, CVProject C is 0.1. The CV should be as low as possible.

2. Project D has expected value R = $300 and σ = $10

Therefore, Coefficient of variation CVProject D = SD/R = 10/300

 CVProjectD = 10/300 = 0.033

In sum, CVProject D is 0.033. The CVProject D is lower than CVProject C = 0.1

In conclusion, with CVProject C =0.1 and CVProjectD = 0.033, and CVProjectD = 0.033 < CVProject C

=0.1. We can conclude that Project C is riskier than Project D. The investor should choose

Project D

QUESTION 4 (DONE)
Describe the capital asset pricing model (CAPM) and how it is used in capital budgeting
decisions. 

Your response should be at least 75 words in length.

In general, in order to forecast the relationship between risk and expected return, we have

some models such as the capital asset pricing model (CAPM) and the dividend yield plus

expected growth model. All of these financial models are using for forecast. The results of
each model will be different. The investors will choose the one they get familiar and trust the

most.In this response we will go through the capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) is a model that describes the relationship

between risk and expected return and that is used in the pricing of risky securities

From Capital Asset Pricing Model (CAPM), we have formula as below

kj = Rf + β(km – Rf)

Including,

kj = required rate of return on stock j

Rf = risk-free rate

km = rate of return on the market portfolio

β = volatility of a stock’s returns relative to the return on a total stock market portfolio

Note 1: the expected market rate of return (km) is usually estimated by measuring the

arithmetic average of the historical returns on a market portfolio (e.g. S&P 500).

Note 2: the risk free rate of return (Rf) used for determining the risk premium is usually

the arithmetic average of historical risk free rates of return and not the current risk free rate

of return

The general idea behind CAPM is that investors need to be compensated in two ways:

time value of money and risk. The time value of money is represented by the risk-free (rf)

rate in the formula and compensates the investors for placing money in any investment over a

period of time. The other half of the formula represents risk and calculates the amount of

compensation the investor needs for taking on additional risk. This is calculated by taking a
 risk measure (beta) that compares the returns of the asset to the market over a period of time

and to the market premium (Rm-rf).

To understand clearly, we should find the solution for below example by using CAPM

model. Calculate the expected return on a security and evaluate whether the security is

undervalued, overvalued or properly valued.

An investor anticipates Newco's security will reach $30 by the end of one year. Newco's

beta is 1.3. Assume the return on the market is expected to be 16% and the risk-free rate is

4%. Calculate the expected return of Newco's stock in one year and determine whether the

stock is undervalued, overvalued or properly valued with a current value of $25.

Solution for the example as below:

E(R)Newco = 4% + 1.3(16% - 4%) = 20%

Given the expected return of Newco's stock using CAPM is 20% and the investor

anticipates a 20% return (from 25$ to 30$), the security would be properly valued.

Source: http://www.investopedia.com/exam-guide/cfa-level-1/portfolio-

management/capm-capital-asset-pricing-model.asp

In conclusion, if the expected return using the CAPM is higher than the investor's

required return, the security is undervalued and the investor should buy it. And, if the

expected return using the CAPM is lower than the investor's required return, the security is

overvalued and should be sold.

QUESTION 5 (DONE)
Industry demand is given by:

     QD = 1000 - P

All firms in the industry have identical and constant marginal and average costs of $50 per unit.
a. If the industry is perfectly competitive, what will industry output be? What will be
the equilibrium price? What profit will each firm earn?
b. Now suppose that there are five firms in the industry, and that they collude to set
price. What price will they set? What will be the output of each firm? What will be the profit
of each firm?
Your response should be at least 75 words in length.

Due to the condition that all firms in the industry have identical and constant marginal

and average costs of $50/unit leading to MC = AC = 50$

a. Perfectly Competitive Firm:

When profit is max (π =max)  P = MC = 50$  1000 – Q = 50

Q = 1000 – 50 = 950 units

Total profit = TR – TC = (P*Q) – (AC*Q) = (50*950) – (50*950) = 0, zero profit in long

run that means all firms earn normal profits as P = AC.

In conclusion, If the industry is perfectly competitive, the industry output will be Q=950

units, the equilibrium price P = average cost (AC)= $50, and profit each firm earn = 0.

b. 5 firms in the industry

In case there are 5 firms in the industry, QT = total products supplied by all five firms

QT = 1000 – P  P = 1000 – QT  P = – QT + 1000

We also have MR has the same constant and intercept with demand curve but slope is

double. So,  MR = 1000 – 2QT

Firms operate where MR = MC

MR = 1000 – 2QT = 50  1000 – 2QT = 50

 QT = 475 units

Output of each firm: Qi = 475/5 = 95 units

The Price they set:

P = 1000 – QT = 1000 – 475 = 525$

Profit of each firm = (P*Qi) – (ACi*Qi ) = (525 – 50)*95 = 45,125$

In conclusion, if there are five firms in the industry and they collude to set price, the price

they will set P = $525, the output of each firm Qi = 95 units, and the profit of each firm will

be π = $45,125.

QUESTION 6 (DONE)
A firm has two plants with the following marginal cost functions:

MC1 = 20 + 2Q1
MC2 = 10 + 5Q2
Where MC1 is marginal cost in the first plant, MC2 is marginal cost in the second plant. If a firm
is minimizing its cost and if it is producing 5 units of output in the first plant, how many units of
output is it producing in the second plant? Explain 

Your response should be at least 75 words in length.

According to the question, we have:

MC1 = 20 + 2Q1

MC2 = 10 + 5Q2

We have profit max = π max when MR = MC1 and MR = MC2. Therefore, MC1 = MC2

When a firm is minimizing its cost and if it is producing 5 units of output in the first

plant, Q1 = 5  Replace Q1 = 5 into MC1 = 20 + 2Q1

MC1 = 20 + 2x5 = 30
 MC1 is fixed = 30

When the firm is minimizing cost, which means that MC2 have to be less than MC1 

MC2<MC1 or MC2 = 10 + 5Q2 =30

Q2 = (30 -10)/5 = 4 units

In conclusion, if a firm is minimizing its cost and if it is producing 5 units of output in the

first plant, output producing in the second plant should be Q2 = 4 units. The reason is that the

firm reaches profit max when MR = MC1 and MR=MC2  MC1 = MC2 and the minimum

cost of this firm is fix = 30 when Q1 = 5 units.

QUESTION 7
The Petram Company has estimated expected cash flows for 1996 to be as follows:

Probability Cash flow

.10 $120,000
.15 140,000
.50 150,000
.15 180,000
.10 210,000

Calculate the following: 

a. expected value
b. standard deviation
c. coefficient of variation
d. the probability that the cash flow will be less than $100,000

Your response should be at least 75 words in length.

a. Expected value

We have the formula to calculate expected value as below:

 n
R = ∑ Rixpi
i=1

R = expected value

pi = probability of case i

n = number of possible outcomes

Ri = value in case i

Therefore, R = 120,000x0.1 + 140,000x0.15 + 150,000x0.5 + 180,000x0.15 + 210,000x0.1

 R = $156,000

In sum, the expected value of Petram Company basing on estimated expected cash flows for

1996 is $156,000.

b. Standard deviation reflects the variation of possible outcomes from the average.

We have the formula to calculate standard deviation as below:

n
σ= √ ∑ ( Ri−R ) 2 xpi
i=1

Therefore, σ =

2 2 2

√ ( 120,000−156,000 ) x 0.1+ ( 140,000−156,000 ) x 0.15+ ( 150,000−156,000 ) x 0.5

¿+(180,000−156,000)2 x 0.15+(210,000−156,000)2 x 0.1

 σ = 23,748.68

In conclusion, the standard deviation of this project is σ = 23,748.68

c. Coefficient of variation a measure of risk relative to expected value

CV= σ/R
σ = standard deviation

R = expected value

Therefore, CV = 23,748.68/156,000

CV = 0.1522

In conclusion, CV is used to compare standard deviations or projects with unequal

expected values. The project should have CV as low as possible. The CV of this project is

0.1522. If we have to compare two project A and B, we should choose the project with CV

lower than the other.

d. The probability that the cash flow will be less than $100,000

Firstly, we have the following formula:

Z=X-R/ σ

Where Z: number of standard deviations from the mean

X: variable in which we are interested

R: expected value

σ = standard deviation

Thus, Z100,000= 100,000 – 156,000/23,748.68

 Z100,000= -2.36

With Z100,000= -2.36, we search table A.2 Areas Under the Normal Curve, page 598 (Keat

&Young, 2017). When we search 2.36, we have 0.4909. But this table only apply for right

zone, we have to take 0.5 – 0.4909 = 0.0091 = Z100,000 (for the left zone)

 Z100,000= 0.0091 = 0.91%

 In conclusion, the probability that the cash flow of the project will be less than $100,000

is 0.91%, less than 1%

QUESTION 8 (DONE)
Solomon, Inc., is a rapidly growing chain of commercial banks in north central states. A security
analyst's report issued by a national brokerage firm indicates that debt yielding 15%, comprises
25% of Northwest's overall capital structure. Furthermore, both earnings and dividends are
expected to grow at a rate of 25% per year. 

Currently, common stock in the company is priced at $25, and is not expected to pay dividends
during the coming year. This yield compares favorably with the 10% return currently available
on risk-free securities and the 16% average for all common stocks, given the company's
estimated beta of 2.5. 

Calculate Solomon’s component cost of equity using both the capital asset pricing model and the
dividend yield plus expected growth model. 

Your response should be at least 75 words in length.

Firstly, we should understand the capital asset pricing model (CAPM) is a model that

describes the relationship between risk and expected return and that is used in the pricing of

risky securities. From (Capital Asset Pricing Model – CAPM) theory, we have as below:

Cost of Equity = Risk free rate + β*(Market return rate – risk free rate)

Including Cost of capital as below:

Assets = Debt (25%) + Equity (75%)

According to case figures, we have debt yielding = 15%; g = 25%; P = $25; D1=0; risk free

rate = 10%, market return on stock = 16% and β = 2.5

1. Using CAPM to calculate as below:

Using CAPM, therefore, Cost of equity = Risk free rate + β*(Market return rate – risk free

rate)  Cost of equity = 10% + 2.5(16% - 10%)

 Cost of equity = 11.5%

Also have, cost of capital = Debt (25%) + Equity (75%)

 Cost of capital = (0.25x15%) + (0.75x11.5%) = 0.0375 + 0.08625

 Cost of capital = 0.1238 = 12.38%

2. Using the dividend yield plus expected growth model 

Using dividend yield and expected growth model, in theory we have:

D1
Cost of equity capital = ke = + g, however, in this case D1 = 0 (not expected to pay
P0

dividends during the coming year)

 ke = 0/25 + 25% = 25%

 ke = g = 25%

In conclusion, we found out that the Solomon’s component cost of equity using capital

asset pricing model = 12.38% is different from one using the dividend yield plus expected

growth model = 25%. The reason for the difference in the rate of component cost of equity

using capital asset pricing model and one using the dividend yield plus expected growth

model is that two models are just use for forecast and estimate only. The investors will base

on the model they get used to and trust more to forecast the rate they expect.