BUS400

Professor

MIDTERM EXAM

Instructions.

1. This is your midterm exam. It has 8 questions.

2. You must complete the exam by yourself.
3. Answers to your exam are due on March 6, 2019 at 11:59 p.m. Failure to timely file
your answers to the exam will result in a 0.
4. Use the cases and the additional readings to answer the exam.

Time passes, and so will you. Good luck!

1. In the 1980s, it cost approximately $100,000 for a video game company to develop a new
game. Today, development costs average $20 million for a major title. Less than 1 in 5
games that go to market become profit-makers. Most of the sales for a game occur during its
first few months on the market. In a typical year, there are a limited number of blockbuster
hits that arrive on the market. A blockbuster is a title that sells more than 1 million copies in
a year. Electronic Arts, the leading player, had 27 titles that sold more than 1 million copies
each in 2006, by far the most of any video game publisher. The average game today is priced
at $50-60 at the retail store. The typical retailer markup was 20%. The cost of
manufacturing a game typically is about $3 per unit. The royalty fee paid to the maker of the
video game console (like Sony Play Station or Microsoft Xbox) is $8 per unit. The royalties
paid for content used in the video game range from $0-$10 per unit.1 Do you think the
number of video game publishers has increased or decreased since the 1980s? Why?

1 Arthur Thompson, “Electronic Arts in 2007: Can it Retain its Global Lead in Video
Game Software?”
2. In 2005, over 27 million people played golf in the United States. Roughly 9 million of those
individuals played golf at least eight times per year. Golfers traditionally purchased their
clubs in specialty golf shops, sometimes located on golf courses. However, in the late
1990s, golfers began to find new locations to purchase clubs. A company in Pennsylvania,
Dick’s Sporting Goods, began to grow rapidly, opening its 50th store in 1995. By 2000, it
had 100 stores located in 19 states. Golf equipment represented a key category for Dick’s.
Some golfers were also beginning to browse for used clubs on a new website called eBay,
which launched in 1995. During the 1990s, competitors in the golf club industry invested
heavily in research and development so as to generate innovations in product performance.
Technological change occurred at a rapid pace during the 1990s. While club makers used to
introduce new products every 4-5 years in the prior decade, they began to launch new
products every 12-18 months in the 1990s. Innovations in design focused on enabling the
golfer to hit the ball farther and more accurately. The industry leader, Callaway Golf,
launched this era of rapid technological innovation with the introduction of its very popular
“Big Bertha” golf club in 1991. Callaway enjoyed record sales and earnings in the 1990s,
peaking at earnings of $132 million in 1997. Other firms also enjoyed healthy sales and
profits. In the mid to late 1990s, the United States Golf Association (USGA) became
concerned about the technological changes taking place. They worried that the newest clubs
enabled pros such as Tiger Woods to drive the ball so far as to overwhelm many older golf
courses, designed decades ago when clubs were far less technologically advanced. The
technology had become so good that pro golfers in their 60s reported that they were hitting
the ball farther than they ever had in their careers. Thus, the USGA decided to impose
regulations on new club technology. They capped the allowable coefficient of restitution at
0.83; this coefficient measured the ratio of incoming to outgoing velocity. This restriction
was intended to prevent the ball from “jumping” off the club the way that it tended to do for
the Big Bertha and other comparable products. What is your evaluation of the changes
taking place in the golf club industry? What would you predict might occur to profits in this
industry moving forward?2

2 Source: John Gamble, “Competition in the Golf Equipment Industry in 2005.”

3. Costco is the nation’s leading firm in the discount warehouse retail industry. It had $58
billion in revenue in 2006, as compared $41 billion for Sam’s Club and $8 billion for B.J.’s
Wholesale. Costco’s strategy focused on offering a limited selection of goods at low prices
in a treasure-hunt shopping environment. Costco’s prices were typically only 14% above
cost, whereas the usual markup on similar items at supermarkets was 20-50%. Its product
line consisted of approximately 4,000 items, as compared to the roughly 40,000 items usually
stocked at a supermarket. Food, beverages, health and beauty aids, and cleaning supplies
represented a little more than ½ of their sales. The remainder of their sales consisted of
everything from appliances and electronics to jewelry and patio furniture. About 25% of
their product line was constantly changing. These items were often attractively priced
luxury items such as flat-screen TVs, leather sofas, Waterford crystal, or Movado watches.
The idea of a treasure hunt was that these items would often only be in the stores for a few
weeks; once they sold out, Costco would not bring in more of that same item. As Costco’s
CEO said, “It’s the type of item a customer knows they better buy because it will not be there
next time, like Waterford crystal. We try to get that sense of urgency in our customers.”
Costco’s customers were relatively affluent, often earning more than the typical discount
retail customer. Costco typically did not engage in much advertising. They did not issue a
weekly sales circular the way that many supermarkets do. Costco’s distinctive capabilities
included its well-paid, well-trained, courteous sales staff, that was very able and willing to
answer customer questions. Costco employees had much better pay and benefits than the
typical discount retailer. Its capabilities also included its very efficient supply chain, which
moved goods directly from manufacturers to its warehouse stores, or through a few cross-
docking facilities to the warehouse stores. When goods arrived at the stores, they typically
went straight to the shopping floor, never stopping in a back room storage area. Goods were
often displayed on the shopping floor on the pallets upon which they had been shipped. The
floors of the stores were often concrete. Suppose that Costco, given its tremendous success
in warehouse retailing, is considering moving into the traditional supermarket business.
Please conduct a value chain analysis of Costco. Would you advise Costco to enter the
supermarket business? Why or why not?
4. Firm A has a Return of Equity of 21.5%, while Firm B has a Return on Equity of 17.0%.
Gary Allenson, an equity analyst at Merrill Lynch, has cited these ROE numbers as
justification for his conclusion that Firm A has a competitive advantage over Firm B. Please
examine the data below, and explain whether you agree with Mr. Allenson’s conclusions:

Firm A Firm B

Revenue $ 1,300,000 $ 1,000,000

Net Profit $ 117,000 $ 110,000

Total Assets $ 1,170,000 $ 687,500

Total Equity $ 544,186 $ 647,059

5. The Best Corporation currently produces 100 units of a particular electronic device per
year. Its total costs rise with volume as shown in the table below.

Units Total Costs

90 12250
91 12275
92 12300
93 12325
94 12350
95 12375
96 12400
97 12425
98 12450
99 12475
100 12500

a. What are the Best Corporation’s total profits at a production volume of 100
units, if it charges an average price of $150 per unit?

b. What if a customer comes along and wants to buy an additional unit of the
electronic device (the 101st unit of production for this year), but it is only
willing to pay $75 for the item? Would it make economic sense to sell the
customer the electronic device for that price?
5. Suppose that firms within a particular industry have the following cost curve.
Cost/Unit

Minimum
Efficient
Scale

2,000 5,000 10,000 Units/Year

Total industry volume is roughly 750,000 units. The industry has many
players, and the top 10 firms have a combined market share of approximately 25%.
Due to major technological change looming in the near future, some analysts predict
that minimum efficient scale in three years will be roughly 500,000 units, while the
industry total volume will be growing at 15% per year over the next three years. If
you were an investment banker, would you ramp up your mergers and acquisitions
practice focused on this industry/sector based on these estimates/data?
6. Consider the following financial information for an apparel retailer pursuing a low
cost strategy.

Please answer these specific questions (and be sure to explain your responses):

a. Are SG&A expenses as a percentage of sales likely to be rising or falling at this

firm from 2004-2008?
b. Are sales per square foot and inventory turns likely to be rising or falling?
c. Are interest payments as a percentage of sales likely to be rising or falling?
d. What is your overall assessment of this firm’s recent financial performance?
7. Please read the following description of Enterprise Rent-a-Car’s founding in 1957 and the
strategy that helped it become the most successful rental car firm in the country. What
explains their competitive advantage and success?

Enterprise Rent-a-Car was founded in 1957 and became the most profitable automobile rental
company in the United States. Most of the leading rental car companies during the 1950s through
the 1980s focused on the airport rental market, meaning that they rented cars to business and
leisure travelers who arrived at the airport and needed ground transportation. Firms such as Hertz
and Avis prospered at airport locations. They paid concession fees to the airports, often working
hard to secure the most convenient on-airport locations. Their large parking lots provided the
space required to stock a wide variety of cars for travelers seeking rentals. Firms such as Hertz
and Avis were known for keeping their branches open nearly 24 hours per day to accommodate
travelers. Customers appreciated the extended hours. They also appreciated priority service
offered for frequent renters; such priority service enabled travelers to not even have to speak to an
agent when they arrived at the airport. They could go directly to their awaiting car. Enterprise
did not locate at airport locations, but instead they focused on off-airport locations. In particular,
Enterprise located their small branches near automobile repair shops, and it provided cars to
people who were inconvenienced when their car was in the shop. Enterprise even offered to pick
customers up at home if they needed a rental car. Every Wednesday, Enterprise employees
deliver pizzas and donuts to their friends at the nearby auto body shops.

The major American automakers – General Motors, Ford, and Chrysler – developed close ties
with major rental car companies such as Hertz and Avis, and eventually, Ford even acquired
Hertz and took major stakes in Avis and National Rent-a-Car. Enterprise remained independent
and family-owned throughout the years. The auto manufacturers liked controlling one or more
rental car companies, because they were an important source of sales – rental car companies
purchased as much as 10% of the cars produced by the American automakers. Automakers also
liked being able to use their volume with rental car companies to smooth out their production
runs; i.e. they would ramp up rental car production during slow times for consumer sales, and
decrease rental car production when consumer sales were high. Of course, such shifts in
production didn’t always suit the needs of the rental car companies.

In the early days, rental car firms leased their cars from the automakers, and they returned them
after several years. Enterprise became the first rental car company to purchase their autos rather
than lease them from firms such as GM and Ford. Enterprise managed to rent its cars for more
years than the typical on-airport agencies such as Hertz and Avis. Enterprise then sold the used
cars from their off-airport locations after they had rented them for several years. Enterprise’s
founder, Jack Taylor, chose to offer a haggle-free sale process for the used cars. He posted a
price on the window of each car, typically below the Kelley Blue Book’s suggested retail price
for that used car. Consumers learned that this price was a take-it-or-leave-it price, with no
bargaining involved. Finally, Enterprise has a unique way of hiring and managing its employees.
The company’s chief operating officer puts it this way: “We hire from the half of the college class
that makes the upper half possible. We want athletes, fraternity types—especially fraternity
presidents and social directors. People people.” Once they are hired, employees are trained well,
and branch managers are given a great deal of autonomy to tailor their location to the local
market.
8. Please examine the cost data below and explain whether you believe that this data suggest
high or low barriers to entry in this industry:

Firm A Firm B Firm C Firm D

Units Produced Per Year 10,000 100,000 5,000 150,000

Total Annual Production Costs $ 50,000 $ 200,000 $ 40,000 $ 150,000