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Class Reading

• NB- Lecture notes alone are not sufficient

• It is very important that students complete the reading set in each lecture’s reading list

• Very difficult to catch up on reading if you fall behind, do a bit every day to keep up

• Remember you get out what you put in!

• Week 1 Reading:• Book: CIMA (certificate 4) Fundamentals of Business Economics

– Chapter 1A (pg 1-8)– Chapter 1B (pg 9-36)– Chapter 2 (pg 37-60)

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Fundamentals of Business EconomicsWeek 1

INTRODUCTION

• Economics studies the ways society decides what to produce, how to produce it, who to produce it for and how to apportion it.

• Key economic assumptions:– Producers will seek to maximise profits– Consumers will seek to maximise their benefits (utility)– Governments will seek to maximise the welfare of their populations

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• Microeconomics is the study of individual economic units: households and firms

• Macroeconomics is the study of the aggregated effect of the economic units: national economy, international economy

• Scarcity is the excess of human wants over what can actually be produced. A scarce resource is one at which quantity demanded at a nil price would exceed available supply

• Factors of production: Land is rewarded with rent, Labour is rewarded with wages, Capital with interest and Enterprise with profit

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Production Possibility Curve (PPC)

-Simple e.g. that looks at the possibilities of production-see pg 6 of CIMA book-two products A & B, resources are limited-point C is inefficient-point D lies outside the PPC curve-to reach point D, current resources must be increased or production methods improved (new tech)

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Opportunity Cost is the cost of one use of resources rather than another

Test yourself: Quiz page 8

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Economic Systems and Organisations

• Countries have mixed economies with private sector (private individuals or institutions) and public sector (owned by the state)

Private sector:• Two types- Profit seekers(businesses), Non profit (charities)• The economy is mostly driven by profit seeking

organisations of the private sector2 Types: Private companies (LTD) Public Companies (PLC)• Companies who's shares are sold on stock market are

“quoted companies”, not all companies are quoted

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Public Sector:• Two types: Public service; hospitals, schools, gardai State owned industries; ESB

Primary, Secondary & Tertiary Sector• Primary: sector that produces raw materials (agriculture)• Secondary: industries that process raw materials

(manufacturing)• Tertiary: Service Sector

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The Firm“any organisation that carries on a business”

• Profit maximisation usually assumed the only goal of org’s• Not the only assumption: org exists to create a customer

Agency theory• Where the management of a business is separated from the

ownership by the employment of professional managers to run the business. Agency theory looks at how agents may be expected to behave and they can be motivate their principals interests

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• Corporate governance (CG) is the system by which companies and other organisations are directed and controlled

• Orgs are governed and controlled to serve some external purpose and act responsibly in the way it conducts its affairs (external accountability!)

• Shareholders own a company but the responsibility of how the company is run is the responsibility of the board of directors (see CIMA page 16)

• Stakeholders are groups in society with interest in the activities of the organisation, e.g. National governments, international bodies

• 3 significant reports on CG: Cadbury, Hampel & Greenbury

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• Failures of CG:– Domination by single individual– Lack of board involvement– Lack of internal auditing– Lack of supervision– Lack of independent scrutiny– Lack of contact with shareholders– Emphasis on short term profit– Misleading accounts and information

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Shareholders’ Interest• Investors invest in companies by buying their shares.

Companies are expected to maximise the wealth of their shareholders by generating profit

• Shareholder owns shares in a company. Number of shares represent proportional ownership of profits, loses and assets in the company

• Any ownership interest is know as “equity”, e.g. if your house is worth more than your mortgage, the difference is your equity

• Bonds on the other hand are formal loans to companies

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Return on Investment (ROI) (page 23)

Measuring shareholder wealth:• Shareholders need objective measures of company

performance to make investment decisions/= divided by*= multiplied by1. Return on Capital Employed (ROCE)ROCE=Profit before interest & tax/capital employed* 100

• ROCE measures company success using the money invested in it to generate return, usually between 0% & 50%, the higher the better, unusual over 50%

• See example pg 2513

Earnings per Share (EPS)EPS=Profit after tax & preference dividends/equity shares in

issue

• Measures how well for its equity shareholders

Price earnings (P/E) ratioP/E=market price/earnings per share

• Looks into the future• Reflects shareholder opinion about company prospects• High P/E indicates shareholders are content with low

current return from the share

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• Cost of capital is the minimum acceptable return on an investment

Free cash flow Valuation (page 28) (^=to power of)• When companies do not pay dividends models based on

their earning may be used, discounting free cash flows• Discount value= nominal value/(1+r)^t where r is the

discount rate and t is the time when the inflow is received, see simple example top page 28

• Present value obtained by adding all the discounted cash flows together

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• Free Cash Flow to the Firm (FCFF) is the after tax cash generated by the business and available for distribution to the debt and equity holders

• FCFF= profit before interest & tax (PBIT) + depreciation – tax -capital expenditure

• Free Cash flow to Equity (FCFE) represents the potential income that could be distributed to the equity holders of a company

• FCFE= FCFF- interest payments to debt holders, see e.g. bottom page 28

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Discounting free cash flows (exam Q)Upharsin plc have forecast the company’s expected earnings:Time $Year 1 7,530,000Year 2 7,980,000Year 3 8,240,000• Company has 2,400,000 ordinary shares in issue, equity

shareholders require rate of return if 17%, what should the co’s current market value and share price be?

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• SolutionYear Cash flow(CF) discount factors PV

$ 17% $1 7,530,000 .855 6,438,150

7,980,000 .731 5,833,3808,240,000 .624 5,141,760

+=17,413,290 The current market value is 17,413,290. Dividing this figure by 2,400,00 will give us the current ordinary share price= $7.26

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• See questions on page 31 and 32• Test yourself: Quiz page 34

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Theory of Costs (reading page 38- 59)Costs of Production• Looks at how individual firms look to grow in order to

benefit from cost saving and efficiencies• Profit is equal to total revenue minus total cost of any level

of output• When some factors of production are fixed a company’s

output decision can be examined in the short run (SR)• When all are varied, examined in the long run (LR)• Factors of production: Land;its cost (rent), Labour; its cost

(wages), Capital; its cost (Interest), Enterprise; its cost (normal profit)

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• Fixed costs (FC): fixed because the availability of the factors of production is restricted

• Variable costs (VC) variable because the supply of skilled labour, machinery and buildings can be decreased or increased in the LR

• See definitions of costs page 39• Marginal costs (MC) extra cost of producing one more unit

of output• Average cost = Total cost (TC)/output

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Elements of cost: See page 40 in Book

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Costs

AFC AVC

AC

MC

Costs

AFC

Average costs, marginal costs & diminishing returnsAC and MC:• When AC is rising, MC will always be higher than the AC• When the AC is falling MC will always lie below it• When AC curve is horizontal, MC is equal to it

• A firm’s short run average cost (SRAC) curve is u-shaped, due to diminishing returns beyond a certain output level

• The law of diminishing returns says that if one or more of the factors of production are fixed, but the input of another is increased, the extra output generated by each extra unit of input will eventually begin to fall, e.g. Add more staff in a factory, difficult to coordinate work as queues form at machines, see page 45

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Economies of Scale and Long Run Costs• Once all the factors of production become variable, a firms

SRAC curve can be shifted and a firm’s minimum achievable average cost at any level can be depicted by a long run average cost (LRAC) curve

• In long run, no fixed costs• Firm can change its scale of production significantly because

costs are variable• LR output decisions are concerned with economies of scale• Output= proportion of inputs, then constant returns to scale• Output> proportion of inputs, then economies of scale• Output< proportion of inputs, then diseconomies of scale• NB, see page 47, 48, 49

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Firm’s Short Run average cost curve is U-Shaped

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AC

Output

Cost

• Growth of firms may occur through building up resources or mergers and takeover, economies of scale in action

• Diseconomies occur when firm gets beyond ideal size, the problems inherent with managing a large firm, pg 51

• The minimum efficient scale of production which is necessary for a firm to achieve the full potential economies of scale

• In SR a firm will carry on producing provided its total revenue exceed total variable costs

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Long Run Costs

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Output

CostSRAC1

Minimum efficient scale

Economies of scale

Constant returns to scale

Diseconomies of scale

SRAC3

SRAC2

SRAC4

Growth of Firms; page 54/55• Two types of growth: (1) organic (build up resources), (2)

growth through mergers and takeovers

• Vertical Integration:– Two firms operating at different stages of the production and selling

process

• Horizontal expansion or Integration:– When two firms in the same business merge– Tends to create monopolies

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• Market concentration is the extent to which supply to a market is provided by a small number of firms

• See example bottom page 55

Advantages of small firms:• Small firms do not suffer to the same extent that large

firms, not the same costs• More challenges to expansion• Manager/employee relations more likely to be co-operative• See full list page 56

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• Test yourself: Quiz page 58

• Remember to keep up with your reading!

• See exam syllabus for this weeks work on the next page, you should be able to think and answer questions in these areas

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Key Points to Know for Assessment

• distinguish the goals of profit seeking organisations, not-for-profit organisations and governmental organisations;

• compute the point of profit maximisation for a single product firm in the short run;

• distinguish the likely behaviour of a firm’s unit costs in the short run and long run;

• illustrate the effects of long run cost behaviour on prices, the size of the organisation and the number of competitors in the industry;

• explain shareholder wealth, the variables affecting shareholder wealth, and its application in management decision making;

• distinguish between the potential objectives of management and those of shareholders, and the effects of this principal-agent problem on decisions concerning price, output and growth of the firm.

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• describe the main mechanisms to improve corporate governance in profit seeking organisations.

• identify stakeholders and their likely impact on the goals of not-for-profit organisations and the decisions of the management of not-for-profit organisations

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