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Tuesday, December 29, 2009


Free trade area is a designated group of countries that have agreed to eliminate tariffs, quotas and preferences on most (if not all) goods and services traded between them. It can be considered the second stage of economic integration. Countries choose this kind of economic integration form if their economical structures are complementary. If they are competitive, they will choose customs union.
Unlike a customs union, members of a free trade area do not have the same policies with respect to non-members, meaning different quotas and customs. To avoid evasion (through re-exportation) the countries use the system of certification of origin most commonly called rules of origin, where there is a requirement for the minimum extent of local material inputs and local transformations adding value to the goods. Goods that don't cover these minimum requirements are not entitled for the special treatment envisioned in the free trade area provisions.
Cumulation is the relationship between different FTAs regarding the rules of origin — sometimes different FTAs supplement each other, in other cases there is no cross-cumulation between the FTAs. A free trade area is a result of a free trade agreement (a form of trade pact) between two or more countries. Free trade areas and agreements (FTAs) are cascadable to some degree — if some countries sign agreement to form free trade area and choose to negotiate together (either as a trade bloc or as a forum of individual members of their FTA) another free trade agreement with some external country (or countries) — then the new FTA will consist of the old FTA plus the new country (or countries).
Within an industrialized country there are usually few if any significant barriers to the easy exchange of goods and services between parts of that country. For example, there are usually no trade tariffs or import quotas; there are usually no delays as goods pass from one part of the country to another (other than those that distance imposes); there are usually no differences of taxation and regulation. Between countries, on the other hand, many of these barriers to the easy exchange of goods often do occur. It is commonplace for there to be import duties of one kind or another (as goods enter a country) and the levels of sales tax and regulation often vary by country.
The aim of a free trade area is to so reduce barriers to easy exchange that trade can grow as a result of specialisation, division of labour, and most importantly via (the theory and practice of) comparative advantage. The theory of comparative advantage argues that in an unrestricted marketplace (in equilibrium) each source of production will tend to specialize in that activity where it has comparative (rather than absolute) advantage. The theory argues that the net result will be an increase in income and ultimately wealth and well-being for everyone in the free trade area. However the theory refers only to aggregate wealth and says nothing about the distribution of wealth. In fact there may be significant losers, in particular among the recently protected industries with a comparative disadvantage. The proponent of free trade can, however, retort that the gains of the gainers exceed the losses of the losers.



















Monday, December 28, 2009

The kinked demand curve

The kinked demand curve theory is an economic theory regarding oligopoly and monopolistic competition. When it was created, the idea fundamentally challenged classical economic tenets such as efficient markets and rapidly-changing prices, ideas that underly basic supply and demand models. Kinked demand was an initial attempt to explain sticky prices.
Kinked" demand curves have in common with traditional demand curves that they are downward-sloping. They are distinguished by a hypothesized convex bend with a discontinuity at the bend - the "kink." Therefore, the first derivative at that point is undefined and leads to a jump discontinuity in the marginal revenue curve.
Classical economic theory assumes that a profit-maximizing producer with some market power (either due to oligopoly or monopolistic competition) will set marginal costs equal to marginal revenue. This idea can be envisioned graphically by the intersection of an upward-sloping marginal cost curve and a downward-sloping marginal revenue curve (because the more one sells, the lower the price must be, so the less a producer earns per unit). In classical theory, any change in the marginal cost structure (how much it costs to make each additional unit) or the marginal revenue structure (how much people will pay for each additional unit) will be immediately reflected in a new price and/or quantity sold of the item. This result does not occur if a "kink" exists. Because of this jump discontinuity in the marginal revenue curve, marginal costs could change without necessarily changing the price or quantity.
The motivation behind this kink is the idea that in an oligopolistic or monopolistically competitive market, firms will not raise their prices because even a small price increase will lose many customers. However, even a large price decrease will gain only a few customers because such an action will begin a price war with other firms. The curve is therefore more price-elastic for price increases and less so for price decreases.

The two seminal papers on kinked demand were written nearly simultaneously in 1939 on both sides of the Atlantic. Paul Sweezy of Harvard College published "Demand Under Conditions of Oligopoly." Sweezy argued that an ordinary demand curve does apply to oligopoly markets and promotes a kinked demand curve.
From Queen's College in Oxford, Robert L. Hall and Charles J. Hitch wrote "Price Theory and Business Behavior," presenting similar ideas but including more rigorous empirical testing, including a business survey of 39 respondents in the manufacturing industry.
Hall and Hitch further present a hypothesis for the initial setting of prices; this explains why the "kink" in the curve is located where it is. They base this on a notion of "full cost" - marginal cost of each unit plus a percent of overhead costs or fixed costs with an additional percent added for profit. They emphasize the importance of industry tradition in history in determining this initial price, noting further, "An overwhelming majority of the entrepreneurs thought that a price based on full average cost…was the ‘right’ price, the one which ‘ought’ to be charged


Others such as George Stigler have argued against kinked demand. His primary opposition is summarized in a Working Paper out of the Stanford University Economics Department by seminal authors Elmore, Kautz, Walls et al.
New classical economists, led by Chicago’s George Stigler, worked to discredit the kinked demand models. Stigler first argues that the kinked demand models are not useful, as Hall and Hitch’s model only explains observed phenomenon and is not predictive. He further explains that the kinked demand analysis only suggests why prices remain sticky and does not describe the mechanism that establishes the kink and how the kink can reform once prices change. Stigler also asserts that the model is unnecessary because Chicago theory already included allowances for short-run sticky prices due to collusion, menu costs, and regulatory or bureaucratic inefficiencies in markets

Friday, December 18, 2009


Window dressing is presenting company accounts in a manner which enhances the financial position of the company. It is a form of creative accounting involving the manipulation of figures to flatter the financial position of the business. It is also defined as: ‘A form of accounting, which while complying with all the regulations, nevertheless, gives a biased impression of the company’s performance.’ Though it is not illegal, it is considered by many financial pundits as unethical.

Reasons for Window Dressing:

*Enhance Liquidity position of the Co. – hiding a deteriorating liquidity position, and
*Showcase stable Profitability of a company –
*Massaging profit figures with methods such as income smoothing or profit smoothing *Reduce Liability for Taxation
*Ward-off takeover bids
*Encourage Investors
*Re-assure Lenders of Finance
*To influence share price
*Hide poor management decisions
*Satisfy the demand of major investors concerning the desired level of return
*Achieve the sales or profit target, thereby ensuring that management bonuses are paid

Methods used for Window Dressing:

Income Smoothing: It redistributes income statement credits and charges among different time periods. The prime objective is to moderate income variability over the years by shifting income from good years to bad years. An example is reducing a Discretionary Cost (e.g., advertising expense, research and development expense) in the current year to improve current period earnings. In the next year, the discretionary cost will be increased. Ambiguity in Capitalizing and Revenue expenditure – E.g. Computer software with useful life of 3 years. As revenue expenditure it is treated as negative item on P&L account. As capitalizing expenditure, it is treated as an asset in balance sheet, with yearly depreciation in the P&L.

Changing depreciation policy - Increasing expected life of asset reduces depreciation provision in P&L account, hence, increasing net profits. Also, net book value in balance sheet will be higher for a longer period, thereby, increasing firm’s asset value.

Changing stock valuation policy - Change in method of stock valuation policy (LIFO, FIFO or AVCO) can lead to increase in value of closing stock, boosting up the profits. For example, in a rising price scenario, usage of FIFO method helps in increasing closing stock inventory valuation, thereby reducing the COGS, and hence inflating the earnings. Similarly, in a falling price scenario, LIFO valuation method for inventory is more favourable.

Sale and Lease Back– This involves selling fixed assets to a third party and then paying a sum of money per year to lease it back. Thus, the business retains the use of the asset but no longer owns it.

Off-Balance Sheet Financing – Conversion of capital lease to operating lease so that the asset no longer features in the assets or liabilities of the balance sheet which automatically improves ratios such as Total Asset Turnover Ratio (TATO), Return on Assets, Equity Multiplier, etc. The costs saved are the interest expense on debt availed to finance the capital lease and depreciation. Also, the debt-raising capacity of the company increases as the liabilities component tones down. Naturally, earnings are inflated under this method. In the later years of use of asset, the company may revert back to capital lease financing since the with net block having reduced considerably, the deprecation by WDV method will also be very less, thereby providing an opportunity to inflate earnings. Also, it provides the addition benefit of saving on tax.

Including intangible assets - If intangible assets like goodwill are not depreciated the firm can maintain value of its assets giving a misleading view.

Bringing sales forward – Sales show up in the P&L account when the order is received and not at the point of transfer of ownership rights as mentioned in the notes to accounts of the Co. under the heading of ‘Revenue Realisation’.Encouraging customers to place orders earlier than planned increases the sales revenue figure in P&L account. This brings sales forward from next year to this year.

Extraordinary Items- Extraordinary items are revenues or costs that occur, but not as a result of normal business activity. These events are unusual and unlikely to be repeated They should be highlighted in accounts, and inserted after the calculation of Profit before Interest and Taxation. To include these in normal revenues will again exaggerate business profits.

Economics A-Z (G,H,I,M)

Gains from trade The addition to output and consumption resulting from specialization in production and free trade with other economic units including persons, regions, or countries.

General Agreement on Tariffs and Trade (GATT) An international body set up in 1947 to probe into the ways and means of reducing tariffs on internationally traded goods and services. Between 1947 and 1962, GATT held seven conferences but met with only moderate success. Its major success was achieved in 1967 during the so-called Kennedy Round of talks when tariffs on primary commodities were drastically slashed and then in 1994 with the signing of the Uruguay Round agreement. Replaced in 1995 by World Trade Organization (WTO).

Giffen goods The term Giffen goods refers to inferior goods which experience a rise in demand when prices rise and a fall in demand when the prices decrease. This is remarkable because Giffen goods break the law of demand.

A theoretical concept, Giffen goods are named after its conceptualizer, Sir Robert Giffen, as is pointed out in the book 'Principles of Economics' by Alfred Marshall. There is limited proof of the existence of real Giffen goods. However, the presence of Giffen goods have been argued by many economists.

The concept implies that potential consumers of the goods believe that if the price is higher the quality of those goods are higher. Marketing-led pricing studies often find this to be the case, although this typically only applies

Global warming Theory that world climate is slowly warming as a result of both MDC and LDC industrial and agricultural activities.

Gross domestic product (GDP): Gross Domestic Product: The total of goods and services produced by a nation over a given period, usually 1 year. Gross Domestic Product measures the total output from all the resources located in a country, wherever the owners of the resources live.

Gross national product (GNP) is the value of all final goods and services produced within a nation in a given year, plus income earned by its citizens abroad, minus income earned by foreigners from domestic production. The Fact book, following current practice, uses GDP rather than GNP to measure national production. However, the user must realize that in certain countries net remittances from citizens working abroad may be important to national well being. GNP equals GDP plus net property income from abroad.

Globalisation or Globalization: The process whereby trade is now being conducted on ever widening geographical boundaries. Countries now trade across continents and companies also trade all over the world.

Human capital Productive investments embodied in human persons. These include skills, abilities, ideals, and health resulting from expenditures on education, on-the-job training programs, and medical care.

Imperfect competition: A market situation or structure in which producers have some degree of control over the price of their product. Examples include monopoly and oligopoly. See also perfect competition.

Imperfect market A market where the theoretical assumptions of perfect competition are violated by the existence of, for example, a small number of buyers and sellers, barriers to entry, nonhomogeneity of products, and incomplete information. The three imperfect markets commonly analyzed in economic theory are monopoly, oligopoly, and monopolistic competition.

Import substitution A deliberate effort to replace major consumer imports by promoting the emergence and expansion of domestic industries such as textiles, shoes, and household appliances. Import substitution requires the imposition of protective tariffs and quotas to get the new industry started.

Income inequality The existence of disproportionate distribution of total national income among households whereby the share going to rich persons in a country is far greater than that going to poorer persons (a situation common to most LDCs). This is largely due to differences in the amount of income derived from ownership of property and to a lesser extent the result of differences in earned income. Inequality of personal incomes can be reduced by progressive income taxes and wealth taxes. This is measured by the Gini coefficient.

Index of industrial production: A quantity index that is designed to measure changes in the physical volume or production levels of industrial goods over time.

Inflation is the percentage increase in the prices of goods and services.

Indirect tax: A tax you do not pay directly, but which is passed on to you by an increase in your expenses. For instance, a company might have to pay a fuel tax. The company pays the tax but can increase the cost of its products so consumers are actually paying the tax indirectly by paying more for the merchandise.

Interdependence Interrelationship between economic and noneconomic variables. Also, in international affairs, the situation in which one nation's welfare depends to varying degrees on the decisions and policies of another nation, and vice versa. See also dependence.

International commodity agreement
Formal agreement by sellers of a common internationally traded commodity (coffee, sugar) to coordinate supply to maintain price stability.

International Labor Organization (ILO) One of the functional organizations of the United Nations, based in Geneva, Switzerland, whose central task is to look into problems of world labor supply, its training, utilization, domestic and international distribution, etc. Its aim in this endeavor is to increase world output through maximum utilization of available human resources and thus improve levels of living.

International Monetary Fund (IMF) An autonomous international financial institution that originated in the Bretton Woods Conference of 1944. Its main purpose is to regulate the international monetary exchange system, which also stems from that conference but has since been modified. In particular, one of the central tasks of the IMF is to control fluctuations in exchange rates of world currencies in a bid to alleviate severe balance of payments problems.

International poverty line An arbitrary international real income measure, usually expressed in constant dollars (e.g., $270), used as a basis for estimating the proportion of the world's population that exists at bare levels of subsistence.

Land reform A deliberate attempt to reorganize and transform existing agrarian systems with the intention of improving the distribution of agricultural incomes and thus fostering rural development. Among its many forms, land reform may entail provision of secured tenure rights to the individual farmer, transfer of land ownership away from small classes of powerful landowners to tenants who actually till the land, appropriation of land estates for establishing small new settlement farms, or instituting land improvements and irrigation schemes.

Macroeconomic stabilization Policies designed to eliminate macroeconomic instability.

Macroeconomics: The branch of economics that considers the relationships among broad economic aggregates such as national income, total volumes of saving, investment, consumption expenditure, employment, and money supply. It is also concerned with determinants of the magnitudes of these aggregates and their rates of change over time.

Market. In marketing terms, market is an organization or a group of customers who are engaged in the buying and selling of a particular product. They possess the necessary finances to buy the product and are allowed by the rules and regulations of the state to do so. The magnitude or size of a market is not fixed. The market for a particular product can be expanded by reducing its price. The market for a particular item may also be expanded by revamping some of the existing rules and regulations. This would lead to a greater number of people buying that particular product.

Market economy: A free private-enterprise economy governed by consumer sovereignty, a price system, and the forces of supply and demand.

Market failure: A phenomenon that results from the existence of market imperfections (e.g., monopoly power, lack of factor mobility, significant externalities, lack of knowledge) that weaken the functioning of a free-market economy--it fails to realize its theoretical beneficial results. Market failure often provides the justification for government interference with the working of the free market.

Market-friendly approach: World Bank notion that successful development policy requires governments to create an environment in which markets can operate efficiently and to intervene selectively in the economy in areas where the market is inefficient (e.g., social and economic infrastructure, investment coordination, economic "safety net").

Market mechanism: The system whereby prices of stocks & shares, commodities or services freely rise or fall when the buyer's demand for them rises or falls or the seller's supply of them decreases or increases.

Market prices: Prices established by demand and supply in a free-market economy.

Merchandise exports and imports: All international changes in ownership of merchandise passing across the customs borders of the trading countries. Exports are valued f.o.b. (free on board). Imports are valued c.i.f. (cost, insurance, and freight).

Merchandise trade balance: Balance on commodity exports and imports.

Microeconomics: The branch of economics concerned with individual decision units--firms and households--and the way in which their decisions interact to determine relative prices of goods and factors of production and how much of these will be bought and sold. The market is the central concept in microeconomics.

Middle-income countries (MICs): LDCs with per capita income above $785 and below $9,655 in 1997 according to World Bank measures.

Mixed economic systems: Economic systems that are a mixture of both capitalist and socialist economies. Most developing countries have mixed systems. Their essential feature is the coexistence of substantial private and public activity within a single economy.

Monetary policy: The regulation of the money supply and interest rates by a central bank in order to control inflation and stabilize currency. If the economy is heating up, the central bank (such as RBI in India) can withdraw money from the banking system, raise the reserve requirement or raise the discount rate to make it cool down. If growth is slowing, it can reverse the process - increase the money supply, lower the reserve requirement and decrease the discount rate. The monetary policy influences interest rates and money supply.

Money supply: the total stock of money in the economy; currency held by the public plus money in accounts in banks. It consists primarily currency in circulation and deposits in savings and checking accounts. Too much money in relation to the output of goods tends to push interest rates down and push inflation up; too little money tends to push rates up and prices down, causing unemployment and idle plant capacity. The central bank manages the money supply by raising and lowering the reserves banks are required to hold and the discount rate at which they can borrow money from the central bank. The central bank also trades government securities (called repurchase agreements) to take money out of the system or put it in. There are various measures of money supply, including M1, M2, M3 and L; these are referred to as monetary aggregates.

Monopoly: A market situation in which a product that does not have close substitutes is being produced and sold by a single seller. See also monopsony.

Multi-Fiber Arrangement (MFA) A set of nontariff bilateral quotas established by developed countries on imports of cotton, wool, and synthetic textiles and clothing from individual LDCs

Multinational corporation (MNC) An international or transnational corporation with headquarters in one country but branch offices in a wide range of both developed and developing countries. Examples include General Motors, Coca-Cola, Firestone, Philips, Volkswagen, British Petroleum, Exxon, and ITT. Firms become multinational corporations when they perceive advantages to establishing production and other activities in foreign locations. Firms globalize their activities both to supply their home-country market more cheaply and to serve foreign markets more directly. Keeping foreign activities within the corporate structure lets firms avoid the costs inherent in arm's-length dealings with separate entities while utilizing their own firm-specific knowledge such as advanced production techniques.

Saturday, December 12, 2009

Economics A-Z (D,E,F)

Death rate: numbers of people dying per thousand population.

Deflation: Deflation is a reduction in the level of national income and output, usually accompanied by a fall in the general price level.

What is depreciation/ Developed country is an economically advanced country whose economy is characterized by a large industrial and service sector and high levels of income per head.

Developing country, less developed country, underdeveloped country or third world country: a country characterized by low levels of GDP and per capita income; typically dominated by agriculture and mineral products and majority of the population lives near subsistence levels.

Dumping occurs when goods are exported at a price less than their normal value, generally meaning they are exported for less than they are sold in the domestic market or third country markets, or at less than production cost.

Direct investment: Foreign capital inflow in the form of investment by foreign-based companies into domestic based companies. Portfolio investment is foreign capital inflow by foreign investors into shares and financial securities. It is the ownership and management of production and/or marketing facilities in a foreign country.

Direct tax: A tax that you pay directly, as opposed to indirect taxes, such as tariffs and business taxes. The income tax is a direct tax, as are property taxes. See also Indirect Tax.

Double taxation: Corporate earnings taxed at both the corporate level and again as a stockholder dividend

Economic growth: Quantitative measure of the change in size/volume of economic activity, usually calculated in terms of gross national product (GNP) or gross domestic product(GDP).

Duopoly: A market structure in which two producers of a commodity compete with each other.

Econometrics: The application of statistical and mathematical methods in the field of economics to test and quantify economic theories and the solutions to economic problems.

Economic development: The process of improving the quality of human life through increasing per capita income, reducing poverty, and enhancing individual economic opportunities. It is also sometimes defined to include better education, improved health and nutrition, conservation of natural resources, a cleaner environment, and a richer cultural life.

Economic growth: An increase in the nation's capacity to produce goods and services.

Economic infrastructure: The underlying amount of physical and financial capital embodied in roads, railways, waterways, airways, and other forms of transportation and communication plus water supplies, financial institutions, electricity, and public services such as health and education. The level of infrastructural development in a country is a crucial factor determining the pace and diversity of economic development.

Economic integration: The merging to various degrees of the economies and economic policies of two or more countries in a given region. See also common market, customs union, free-trade area, trade creation, and trade diversion.

Economic policy: A statement of objectives and the methods of achieving these objectives (policy instruments) by government, political party, business concern, etc. Some examples of government economic objectives are maintaining full employment, achieving a high rate of economic growth, reducing income inequalities and regional development inequalities, and maintaining price stability. Policy instruments include fiscal policy, monetary and financial policy, and legislative controls (e.g., price and wage control, rent control).

Economies of Scale.refers to the efficiency gained in a production process as the rate of production is increased. By sharing the costs of production; operating costs, and cost per unit produced, are decreased over time.

Elasticity of demand: The degree to which consumer demand for a product or service responds to a change in price, wage or other independent variable. When there is no perceptible response, demand is said to be inelastic.

Excess capacity: Volume or capacity over and above that which is needed to meet peak planned or expected demand.

Excess demand: the situation in which the quantity demanded at a given price exceeds the quantity supplied. Opposite: excess supply

Exchange control: A governmental policy designed to restrict the outflow of domestic currency and prevent a worsened balance of payments position by controlling the amount of foreign exchange that can be obtained or held by domestic citizens. Often results from overvalued exchange rates

Exchange rate: The price of one currency stated in terms of another currency, when exchanged.

Export incentives: Public subsidies, tax rebates, and other kinds of financial and nonfinancial measures designed to promote a greater level of economic activity in export industries.

Exports: The value of all goods and nonfactor services sold to the rest of the world; they include merchandise, freight, insurance, travel, and other nonfactor services. The value of factor services (such as investment receipts and workers' remittances from abroad) is excluded from this measure. See also merchandise exports and imports.

Externalities: A cost or benefit not accounted for in the price of goods or services. Often "externality" refers to the cost of pollution and other environmental impacts.

Fiscal deficit is the gap between the government's total spending and the sum of its revenue receipts and non-debt capital receipts. The fiscal deficit represents the total amount of borrowed funds required by the government to completely meet its expenditure

Fiscal policy is the use of government expenditure and taxation to try to influence the level of economic activity. An expansionary (or reflationary) fiscal policy could mean: cutting levels of direct or indirect tax increasing government expenditure The effect of these policies would be to encourage more spending and boost the economy. A contractionary (or deflationary) fiscal policy could be: increasing taxation - either direct or indirect cutting government expenditure These policies would reduce the level of demand in the economy and help to reduce inflation

Fixed costs: A cost incurred in the general operations of the business that is not directly attributable to the costs of producing goods and services. These "Fixed" or "Indirect" costs of doing business will be incurred whether or not any sales are made during the period, thus the designation "Fixed", as opposed to "Variable".

Fixed exchange rate: The exchange value of a national currency fixed in relation to another (usually the U.S. dollar), not free to fluctuate on the international money market.

Foreign aid The international transfer of public funds in the form of loans or grants either directly from one government to another (bilateral assistance) or indirectly through the vehicle of a multilateral assistance agency like the World Bank. See also tied aid, private foreign investment, and nongovernmental organizations.

Foreign direct investment (FDI): Overseas investments by private multinational corporations.

Foreign exchange reserves: The stock of liquid assets denominated in foreign currencies held by a government's monetary authorities (typically, the finance ministry or central bank). Reserves enable the monetary authorities to intervene in foreign exchange markets to affect the exchange value of their domestic currency in the market. Reserves are invested in low-risk and liquid assets, often in foreign government securities.

Free trade: Free trade in which goods can be imported and exported without any barriers in the forms of tariffs, quotas, or other restrictions. Free trade has often been described as an engine of growth because it encourages countries to specialize in activities in which they have comparative advantages, thereby increasing their respective production efficiencies and hence their total output of goods and services.

Free-trade area A form of economic integration in which there exists free internal trade among member countries but each member is free to levy different external tariffs against non-member nations.

Free-market exchange rate Rate determined solely by international supply and demand for domestic currency expressed in terms of, say, U.S. dollars.

Fringe benefit: A benefit in addition to salary offered to employees such as use of company's car, house, lunch coupons, health care subscriptions etc.

Thursday, December 10, 2009

Economics A-Z

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Absolute advantage: A country has an absolute advantage if its output per unit of input of all goods and services produced is higher than that of another country.

Accelerator Principle - the growth in output that would induce a continuation in net investment.

Ad valorem tax:(in Latin: to the value added) - a tax based on the value (or assessed value) of property. Ad valorem tax can also be levied on imported items.

Aggregate demand is the sum of all demand in an economy. This can be computed by adding the expenditure on consumer goods and services, investment, and not exports (total exports minus total imports).

Aggregate supply is the total value of the goods and services produced in a country, plus the value of imported goods less the value of exports.

Alternative minimum tax: An IRS mechanism created to ensure that high-income individuals, corporations, trusts, and estates pay at least some minimum amount of tax, regardless of deductions, credits or exemptions. Alternative minimum tax operates by adding certain tax-preference items back into adjusted gross income. While it was once only important for a small number of high-income individuals who made extensive use of tax shelters and deductions, more and more people are being affected by it. The AMT is triggered when there are large numbers of personal exemptions on state and local taxes paid, large numbers of miscellaneous itemized deductions or medical expenses, or by Incentive Stock Option (ISO) plans.

Asset: Anything of monetary value that is owned by a person. Assets include real property, personal property, and enforceable claims against others (including bank accounts, stocks, mutual funds, and so on).

Average propensity to consume is the proportion of income the average family spends on goods and services.

Average propensity to save is the proportion of income the average family saves (does not spend on consumption).

Average total cost is the sum of all the production costs divided by the number of units produced. See also average cost.

Balance of Payment is the summation of imports and exports made between one countries and the other countries that it trades with.

Balance of trade: The difference in value over a period of time between a country's imports and exports.

Barter system: System where there is an exchange of goods without involving money.

Base year: In the construction of an index, the year from which the weights assigned to the different components of the index is drawn. It is conventional to set the value of an index in its base year equal to 100.
Bear: An investor with a pessimistic market outlook; an investor who expects prices to fall and so sells now in order to buy later at a lower price. A Bear Market is one which is trending downwards or losing value.

Bid price: The highest price an investor is willing to pay for a stock.

Bill of exchange: A written, dated, and signed three-party instrument containing an unconditional order by a drawer that directs a drawee to pay a definite sum of money to a payee on demand or at a specified future date. Also known as a draft. It is the most commonly used financial instrument in international trade.

Birth rate: The number of births in a year per 1,000 population.

Bond: A certificate of debt (usually interest-bearing or discounted) that is issued by a government or corporation in order to raise money; the bond issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal. Bonds guide.

Boom: A state of economic prosperity, as in boom times.

Break even: This is a term used to describe a point at which revenues equal costs (fixed and variable).

Bretton Woods: An international monetary system operating from 1946-1973. The value of the dollar was fixed in terms of gold, and every other country held its currency at a fixed exchange rate against the dollar; when trade deficits occurred, the central bank of the deficit country financed the deficit with its reserves of international currencies. The Bretton Woods system collapsed in 1971 when the US abandoned the gold standard.

Budget: A summary of intended expenditures along with proposals for how to meet them. A budget can provide guidelines for managing future investments and expenses.

The budget deficit is the amount by which government spending exceeds government revenues during a specified period of time usually a year.

Bull: An investor with an optimistic market outlook; an investor who expects prices to rise and so buys now for resale later. A Bull Market is one in which prices are rising.

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c.i.f., abbrev: Cost, Insurance and Freight: Export term in which the price quoted by the exporter includes the costs of ocean transportation to the port of destination and insurance coverage.

Call money: Price paid by an investor for a call option. There is no fixed rate for call money. It depends on the type of stock, its performance prior to the purchase of the call option, and the period of the contract. It is an interest bearing band deposits that can be withdrawn on 24 hours notice.

Capital: Wealth in the form of money or property owned by a person or business and human resources of economic value. Capital is the contribution to productive activity made by investment is physical capital (machinery, factories, tools and equipments) and human capital (eg general education, health). Capital is one of the three main factors of production other two are labour and natural resources.

Capital account; Part of a nation's balance of payments that includes purchases and sales of assets, such as stocks, bonds, and land. A nation has a capital account surplus when receipts from asset sales exceed payments for the country's purchases of foreign assets. The sum of the capital and current accounts is the overall balance of payments.

Capital budget: A plan of proposed capital outlays and the means of financing them for the current fiscal period. It is usually a part of the current budget. If a Capital Program is in operation, it will be the first year thereof. A Capital Program is sometimes referred to as a Capital Budget.

Capital Asset Pricing Model: A way to show the prices of securities and other risk-free assets.

Capital gains tax: Tax paid on the gain realized upon the sale of an asset. See capital gains tax for examples of tax regimes in various countries. It is a tax on profits from the sale of capital assets, such as shares. A capital loss can be used to offset a capital gain, reducing any tax you would otherwise have to pay.

Cartel: An organization of producers seeking to limit or eliminate competition among its members, most often by agreeing to restrict output to keep prices higher than would occur under competitive conditions. Cartels are inherently unstable because of the potential for producers to defect from the agreement and capture larger markets by selling at lower prices.

Census: Official gathering of information about the population in a particular area. Government departments use the data collected in planning for the future in such areas as health, education, transport, and housing..

Central bank: Major financial institution responsible for issuing currency, managing foreign reserves, implementing monetary policy, and providing banking services to the government and commercial banks.

Centrally planned economy: A planned economic system in which the production, pricing, and distribution of goods and services are determined by the government rather than market forces. Also referred to as a "non market economy." Former Soviet Union, China, and most other communist nations are examples of centrally planed economy Classical economics: The economics of Adam Smith, David Ricardo, Thomas Malthus, and later followers such as John Stuart Mill. The theory concentrated on the functioning of a market economy, spelling out a rudimentary explanation of consumer and producer behaviour in particular markets and postulating that in the long term the economy would tend to operate at full employment because increases in supply would create corresponding increases in demand.

Closed economy: A closed economy is one in which there are no foreign trade transactions or any other form of economic contacts with the rest of the world.

Collateral security: Additional security a borrower supplies to obtain a loan.

Commercial Policy: encompassing instruments of trade protection employed by countries to foster industrial promotion, export diversification, employment creation, and other desired development-oriented strategies. They include tariffs, quotas, and subsidies.

Comparative advantage: The ability to produce a good at a lower cost, relative to other goods, compared to another country. With perfect competition and undistorted markets, countries tend to export goods in which they have a Comparative Advantage and hence make gains from trading

Compound interest: Interest paid on the original principal and on interest accrued from time it became due.

Consumer Surplus is the difference between the price a consumer pays and what they were prepared to pay.

Conditionality: The requirement imposed by the International Monetary Fund that a borrowing country undertake fiscal, monetary, and international commercial reforms as a condition to receiving a loan for balance of payments difficulties.

Copyright: A legal right (usually of the author or composer or publisher of a work) to exclusive publication production, sale, distribution of some work. What is protected by the copyright is the "expression," not the idea. Notice that taking another's idea is plagiarism, so copyrights are not the equivalent of legal prohibition of plagiarism.

Correlation coefficient: Denoted as "r", a measure of the linear relationship between two variables. The absolute value of "r" provides an indication of the strength of the relationship. The value of "r" varies between positive 1 and negative 1, with -1 or 1 indicating a perfect linear relationship, and r = 0 indicating no relationship. The sign of the correlation coefficient indicates whether the slope of the line is positive or negative when the two variables are plotted in a scatter plot.

Cost benefit analysis: A technique that assesses projects through a comparison between their costs and benefits, including social costs and benefits for an entire region or country. Depending on the project objectives and its the expected outputs, three types of CBA are generally recognised: financial; economic; and social. Generally cost-benefit analyses are comparative, i.e. they are used to compare alternative proposals. Cost-benefit analysis compares the costs and benefits of the situation with and without the project; the costs and benefits are considered over the life of the project.

Countervailing duties: duties (tariffs) that are imposed by a country to counteract subsidies provided to a foreign producer

Current account: Part of a nation's balance of payments which includes the value of all goods and services imported and exported, as well as the payment and receipt of dividends and interest. A nation has a current account surplus if exports exceed imports plus net transfers to foreigners. The sum of the current and capital accounts is the overall balance of payments.

Cross elasticity of demand: The change in the quantity demanded of one product or service impacting the change in demand for another product or service. E.g. percentage change in the quantity demanded of a good divided by the percentage change in the price of another good (a substitute or complement)

Crowding out: The possible tendency for government spending on goods and services to put upward pressure on interest rates, thereby discouraging private investment spending.

Currency appreciation: An increase in the value of one currency relative to another currency. Appreciation occurs when, because of a change in exchange rates; a unit of one currency buys more units of another currency. Opposite is the case with currency depreciation.

Currency board: Form of central bank that issues domestic currency for foreign exchange at fixed rates.

Currency substitution: The use of foreign currency (e.g., U.S. dollars) as a medium of exchange in place of or along with the local currency (e.g., Rupees).

Customs duty: Duty levied on the imports of certain goods. Includes excise equivalents Unlike tariffs customs duties are used mainly as a means to raise revenue for the government rather than protecting domestic producers from foreign competition.

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Friday, November 6, 2009

Net Present Value Analysis

Use the following 5-step process in net present value analysis:
Step 1. Select the discount rate.
Step 2. Identify the costs/benefits to be considered in analysis.
Step 3. Establish the timing of the costs/benefits.
Step 4. Calculate net present value of each alternative.
Step 5. Select the offer with the best net present value.
This section will demonstrate the use of that 5-step process in two lease-purchase decision examples using nominal discount rates. You should follow the same steps for any net present value analysis whether you are using nominal discount rates or real discount rates.
Lease-Purchase Decision Example 1. Assume that you want to determine which of the following proposals will result in the lowest total cost of acquisition?
Offeror A: Proposes to lease the asset for 3 years. The annual lease payments are Rs10,000 per year. The first payment will be due at the beginning of the lease, the remaining two payments are due at the beginning of Years 2 and 3.
Offeror B: Proposes to sell the asset for Rs29,000. It has a 3-year useful life. Salvage value at the end of the 3-year period, will be Rs2,000.
Step 1. Select the discount rate. The term of the lease analysis is three years, so we will use the nominal discount rate for three years, 5.4 percent.
Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below: (Parentheses indicate a cash outflow.)


Offer-Related Expenditures/Receipts
t Offer A Offer B
0 (Rs10,000) (Rs29,000)
1 (Rs10,000) -0-
2 (Rs10,000) -0-
3 -0- Rs2,000
Step 4. Calculate net present value. The tables below summarize the net present value calculations applied to each alternative.
Net present value of Offer A
t Cash Flow DF PV
0 (Rs10,000) 1.0000 (Rs10,000)
1 (Rs10,000) 0.9470 (Rs9,470)
2 (Rs10,000) 0.8968 (Rs8,968)
Net Present Value (Rs28,438)
Note the following points in the net present value calculations above:
o There are no cash inflows associated with Offer A, only outflows.
o Payments due now are not discounted.
o Offeror A payments due at the beginning of Years 2 and 3 are treated as if they are due at the end of Years 1 and 2.
o You could have calculated the net present value of Offer A using the Sum of Discount Factors (Appendix A-1) for the payments due at the beginning of Years 2 and 3. Remember that payments due now are not discounted and payments due at the beginning of Years 2 and 3 are treated as if they are due at the end of Years 1 and 2. The calculations would be:

Net present value of Offer B
t Cash Flow DF PV
0 (Rs29,000) 1.0000 (Rs29,000)
3 Rs2,000 0.8492 Rs 1,698
Net Present Value (Rs27,302)
Note the following points in the net present value calculations above:
o Offer B salvage value is treated as a cash inflow at the end of Year 3.
o Payments due now are not discounted.
Step 5. Select the offer with the best net present value. In this example, we would select Offer B, the offer with the smallest negative net present value.
Lease-Purchase Decision Example 2. Assume that we want to determine which of the following proposals will result in the lowest acquisition cost?
Offeror A—Proposes to lease the asset for 3 years. The monthly lease payments are Rs1,500; that is, the total amount for each year is Rs18,000. These payments are spaced evenly over the year, so the use of a MYDF would be appropriate.
Offeror B—Proposes to sell the asset for Rs56,000. It has a 3-year useful life. At the end of the 3-year period it will have a Rs3,000 salvage value.
Step 1. Select the discount rate. The term of the analysis is three years, so we will use the nominal discount rate for three years, 5.6 percent.
Steps 2 and 3. Identify and establish the timing of the costs/benefits to be considered in analysis. The expenditures and receipts associated with the two offers and their timing are delineated in the table below:
Offer Expenditures/Receipts
t Offer A Offer B
0 -0- (Rs56,000)
1 (Rs18,000) -0-
2 (Rs18,000) -0-
3 (Rs18,000) Rs3,000
Step 4. Calculate net present value. The tables below summarize the net present value calculations applied to each alternative.

Net present value of Offer A
t Cash Flow DF PV
1 (Rs18,000) 0.9731 (Rs17,516)
2 (Rs18,000) 0.9215 (Rs16,587)
3 (Rs18,000) 0.8727 (Rs15,709)
Net Present Value (Rs49,812)
NOTE the following points in the net present value calculations above:
o There are no cash inflows associated with Offer A, only outflows.
o Offeror A payments are due monthly, so we used the nominal rate, mid-year factors from Table.
o You could also calculate the net present value of Offer A using the Sum of Discount Factors in Table. That calculation would produce a slightly different answer due to rounding differences.

Net present value of Offer B
t Cash Flow DF PV
0 (Rs56,000) 1.0000 (Rs56,000)
3 Rs3,000 0.8492 Rs2,548
Net Present Value (Rs53,452)
Note the following points in the net present value calculations above:
o Offer B salvage value is treated as a cash inflow at the end of Year 3.
o Payments due now are not discounted.
Step 5. Select the offer with the best net present value. In this example, we would select Offer A, the offer with the smallest negative net present value.
9.6 - Identifying Issues And Concerns
Questions to Consider in Analysis. As you perform price/cost analysis, consider the issues and concerns identified in this section, whenever you use net present value analysis.
• Is net present value analysis used when appropriate?
Net present value analysis should be used in any analysis supporting Government decisions to initiate, renew, or expand programs or projects which would result in a series of measurable benefits or costs extending for three or more years into the future.
• Are the dollar estimates for expenditures and receipts reasonable?
The base for all present value calculations is estimated future cash flows. The rationale for those estimates must be documented and supported just like any cost estimate. This includes estimates of costs that will be included in the contract or lease agreement and estimates of other cash flows that are not included. All may be used in present value calculations.
• Are the times projected for expenditures and receipts reasonable?
Discount factors depend on the discount rate and the timing of the cash flow. The timing of any cash flow not documented in the contract or lease agreement must be clearly supported. The offeror is responsible for estimating and defending cash flow estimates included in the proposal. Government technical personnel have that responsibility for estimated costs related to item ownership.
• Are the proper discount rates used in the net present value calculations?
Unless precluded by agency policy, discount rates should be taken. If they are not, the rationale must be documented.
• The rate selected should be based on the number of time periods included in the analysis. If the period of the analysis does not match any of the discount rate periods, linear interpolation should be used to estimate a rate for that period of time.
o Nominal discount rates should be used for any analysis not based on constant year dollars. Real discount rates should be used for any analysis that is based on constant year dollars.
• Are the proper discount factors used in analysis?
The discount factor should be calculated considering the timing of the cash flow.
o End-of-year discount factors should be used for cash flows at the beginning or end of the year.
o Mid-year discount factors should be used for cash flows in the middle of the year or regularly throughout the year (e.g., monthly or quarterly).
• Are discount factors properly calculated from the discount rate?
End-of-year or mid-year discount rates should be calculated following the procedures.
• Have all cash flows been considered?
Net present value analysis must consider all relevant cash flows throughout the decision life cycle.

Monday, October 26, 2009


It is difficult to infer organizational performance from one or two simple numbers. Nevertheless, in practice a number of different ratios are often calculated in strategic planning endeavors and, taken as a whole and with some caution, these ratios do provide some information about the relative performance of an organization. In particular, a careful analysis of a combination of these ratios may help you to distinguish between firms that will eventually fail and those that will continue to survive. Evidence suggests that, as early as five years before a firm fails, one may be able to detect trouble from the value of these financial ratios.1

In this note, the basic financial ratios are reviewed, and some of the caveats associated with using them are highlighted. The ratios tend to be most meaningful when they are used to compare organizations within the same broad industry, or when they are used to make inferences about changes in a particular organization's structure over time.


In order to survive, firms must be able to meet their short-term obligations—pay their creditors and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm's financial health. Two measures of liquidity are in common:

Current ratio = current assets / current liabilities

Quick ratio = (cash + marketable securities + net receivables) / current liabilities

The main difference between the current ratio and the quick ratio is that the latter does not include inventories, while the former does.

Which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is a more conservative standard. If the quick ratio is greater than one, there would seem to be no danger that the firm would not be able to meet its current obligations. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical.

A number of problems with inventory valuation can contaminate the current ratio. An obvious accounting problem occurs because organizations value inventories using either of two methods, last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their old costs. If the organization has a substantial quantity of inventory, some of it may be carried at relatively low cost, assuming some inflation in overall prices. On the other hand, if there has been technical progress in a market and prices have been falling, the LIFO method will lead to an overvalued inventory. Under the FIFO method of inventory valuation, inventories are valued at close to their current replacement cost. Clearly, if we have firms that differ in their accounting methods, and hold substantial inventories, comparisons of current ratios will not be very helpful in measuring their relative strength, unless accounting differences are adjusted for in the computations.

A second problem with including inventories in the current ratio derives from the difference between the inventory's accounting value, however calculated, and its economic value. A simple example is a firm subject to business-cycle fluctuations. For a firm of this sort, inventories will typically build during a downturn. The posted market price for the inventoried product will often not fall very much during this period; nevertheless, the firm finds it cannot sell very much of its inventoried product at the so-called market price. The growing inventory is carried at the posted price, but there really is no way that the firm could liquidate that inventory in order to meet current obligations. Thus, including inventories in current assets will tend to understate the precarious financial position of firms suffering inventory buildup during downturns.

Might we then conclude that the quick ratio is always to be preferred? Probably not. If we ignore inventories, firms with readily marketable inventories, appropriately valued, will be undeservedly penalized. Clearly, some judicious further investigation of the marketability of the inventories would be helpful.

Low values for the current or quick ratios suggest that a firm may have difficulty meeting current obligations. Low values, however, are not always fatal. If an organization has good long-term prospects, it may be able to enter the capital market and borrow against those prospects to meet current obligations. The nature of the business itself might also allow it to operate with a current ratio less than one. For example, in an operation like McDonald's, inventory turns over much more rapidly than the accounts payable become due. This timing difference can also allow a firm to operate with a low current ratio. Finally, to the extent that the current and quick ratios are helpful indexes of a firm's financial health, they act strictly as signals of trouble at extreme rates. Some liquidity is useful for an organization, but a very high current ratio might suggest that the firm is sitting around with a lot of cash because it lacks the managerial acumen to put those resources to work. Very low liquidity, on the other hand, is also problematic.


Firms are financed by some combination o£ debt and equity. The right capital structure will depend on tax policy—high corporate rates favor debt, high personal tax rates favor equity—on bankruptcy costs, and on overall corporate risk. In particular, if we are concerned about bankruptcy possibilities, the long-run solvency or leverage of the firm may be important. There are two commonly used measures of leverage, the debt-to-assets ratio and the debt-equity ratio;

Debt-to-asset ratio = total liabilities / total assets

Debt-equity ratio = long-term debt / shareholder's equity

As with liquidity measures, problems in measurement and interpretation also occur in leverage measures. The central problem is that assets and equity are typically measured in terms of the carrying (book) value in the firm's financial statements. This figure, however, often has very little to do with the market value of the firm, or the value that creditors could receive were the firm liquidated.

Debt-to-equity ratios vary considerably across industries, in large measure due to other characteristics of the industry and its environment. A utility, for example, which is a stable business, can comfortably operate with a relatively high debt-equity ratio. A more cyclical business, like manufacturing of recreational vehicles, typically needs a lower D/E—a reminder that cross-industry comparisons of these ratios is typically not very helpful.

Often, analysts look at the debt-equity ratio to determine the ability of an organization to generate new funds from the capital market. An organization with considerable debt is often thought to have little new-financing capacity. Of course, the overall financing capacity of an organization probably has as much to do with the quality of the new product the organization wishes to pursue as with its financial structure. Nevertheless, given the threat of bankruptcy and the attendant costs, a very high debt-equity ratio may make future financing difficult. It has been argued, for example, that railroads in the 1970s found it hard to find funds for new investments in piggybacking, a large technical improvement in railroading, because the threat of bankruptcy from prior poor investments was so high.


There are two measures of profitability common in the financial community, return on assets (ROA) and return on equity (ROE).

ROA = net income / total average assets

ROE = net income / total stockholders equity

Assets and equity, as used in these two common indexes, are both measured in terms of book value. Thus, if assets were acquired some time ago at a low price, the current performance of the organization may be overstated by the use of historically valued denominators. As a result, the accounting returns for any investment generally do not correlate well with the true economic internal rate of return for that investment.

Difficulties with using either ROA and ROE as a performance measure can be seen in merger transactions. Suppose we have an organization that has been earning a net income of $500 on assets with a book value of $1000, for a hefty ROA of 50 percent. That organization is now acquired by a second firm, which then moves the new assets onto its books at the acquisition price, assuming the acquisition is treated using the purchase method of accounting. Of course, the acquisition price will be considerably above the $1,000 book value of assets, for the potential acquirer will have to pay handsomely for the privilege of earning $500 on a regular basis. Suppose the acquirer pays $2,000 for the assets. After the acquisition, it will appear that the returns of the acquired firm have fallen. The firm continues to earn $500, but the asset base is now $2,000, so the ROA is reduced to 25 percent. Indeed, the ROA may be less as a result of other factors, such as increased depreciation of the newly acquired assets. Yet in fact nothing has happened to the earnings of the firm. All that has changed is its accounting, not its performance.

Another fundamental problem with ROA and ROE measures comes from the tendency of analysts to focus on performance in single years, years that may be idiosyncratic. At a minimum, one should examine these ratios averaging over a number of years to isolate idiosyncratic returns and try to find patterns in the data.


Several ratios are calculated not from the income statements and balance sheets of organizations, but from data associated with their stock market performance. The three most common ratios are earnings per share (EPS), the price-earnings ratio (P/E), and the dividend-yield ratio:

EPS = (net income - preferred dividends) /

common shares outstanding

P/E = market price per share / earnings per share

Dividend yield = annual dividends / price per share

EPS is one of the most widely used statistics. Indeed, it is required to be given in the income statements of publicly traded firms. As we can see, the ratio tells us how much the firm has earned per share of stock outstanding. As it turns out, this is not generally a very helpful statistic. It says nothing about how many assets a firm used to generate those earnings, and hence nothing about profitability. Nor does it tell us how much the individual stockholder has paid per share for the rights over that annual earning. Further, accounting practices in the calculation of earnings may distort these ratios. And finally, the treatment of inventories is again problematic.

The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily newspapers. A high P/E tends to indicate that investors believe the future prospects of the firm are better than its current performance. They are in some sense paying more per share than the firm's current earnings warrant. Again, earnings are treated differently in different accounting practices.

Finally, from the perspective of some stockholders at least, dividend policy may be important. The dividend-yield ratio tells us how much of its earnings the firm pays out in dividends versus reinvestment. Rapidly growing firms in new areas tend to have low dividend-yield ratios; more mature firms tend to have higher ratios.


In this note, we have briefly reviewed a variety of ratios commonly used in strategic planning. All of these ratios are subject to manipulation through opportunistic accounting practices. Nevertheless, taken as a group and used judiciously, they may help to identify firms or business units in particular trouble. Finding profitable new ventures requires rather more work.

Monday, September 14, 2009


What Does Hedge Mean?

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations.

Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).


The process of closing out positions that were originally put in place to act as a hedge in one's portfolio. De-hedging involves going back into the marketplace and closing out hedged positions, which were previously taken to limit an investor's risk of price fluctuations in relation to their underlying asset.

De-hedging is done when holders of an underlying asset have a bullish outlook on their investment. Therefore, the investor would prefer to remove their hedged position to gain exposure to the expected upward price fluctuations of their investment.

For example, a hedged investor in gold who feels the price of their asset is about to go up would buy back any gold futures contracts they had sold in the futures market. By doing this, the investor will have positioned themselves to reap the rewards of an increase in the price of gold if their bullish prediction on gold is correct.


1. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.

2. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged.

1. Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.

2. The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk


An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).

Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.


The accounting treatment of call options prima facie will depend upon the intention with which the options are purchased: for hedging or speculation (nonhedging).

If the position is taken as a hedge against some other position, then the relevant accounting standards will be applicable and there are certain conditions that are to be fulfilled for the same.

Only long calls and long puts are eligible for hedge accounting, as written calls or puts limit the profitability while exposing the investor to unlimited risks and as such are not eligible for hedge accounting.

The standards require that the potential for gains should be at least equal to the potential for losses; this is known as a symmetrical risk-reward situation. For a written option the risk-reward is asymmetrical; hence, written options per se do not qualify for hedge accounting.

However, a combination of written options and certain other derivative instruments that results in a symmetrical risk-reward may qualify for hedge accounting.

To qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential.

Written options based on symmetry of the gain and loss potential of the combined hedged position qualify for hedge accounting as per the accounting standard.

If a written option is designated as hedging a recognized asset or liability, the combination of the hedged item and the written option provides at least as much potential for gains (as a result of a favorable change in the fair value of the combined instruments) as it does exposure to losses from an unfavorable change in their combined fair value.

Hedge accounting is not permitted for covered calls. This prohibition is also specifically mentioned in the standard itself.

It is permissible to separate the intrinsic value and time value of an option contract, designate as the hedging instrument only the change in intrinsic value of an option, and exclude change in its time value.

The accounting standards permit an entity to apply hedge accounting for a delta-neutral hedging strategy and other dynamic hedging strategies under which the quantity of the hedging instrument is constantly adjusted in order to maintain a desired hedge ratio.

Tuesday, August 18, 2009

Loanable Funds Theory of Interest

According to the Loanable Funds Theory of Interest, the rate of interest is calculated on the basis of demand and supply of loanable funds present in the capital market. The concept formulated by Knut Wicksell, the well-known Swedish economist, is among the most important economic theories.

Basic Tenet of the Loanable Funds Theory of Interest The Loanable Funds Theory of Interest advocates that both savings and investments are responsible for the determination of the rates of interest in the long run. On the other hand, short-term interest
rates are calculated on the basis of the financial conditions of a particular economy.

The determination of the interest rates in case of the Loanable Funds Theory of the Rate of Interest, depends essentially on the availability of loan amounts. The availability of such loan amounts is based on certain factors like the net increase in currency deposits, the amount of savings made, willingness to enhance cash balances and opportunities for the formation of fresh capitals.

In an attempt to develop the macro-economic theory, John Maynard Keynes studied minutely, The Demand supply interaction of Loanable funds

According to the loanable funds theory of interest the nominal rate of interest is determined by the interaction between the demand and supply of loanable funds. Keeping the same level of supply, an increase in the demand for loanable funds would lead to an increase in the interest rate and the vice versa is true. Conversely an increase in the supply of loanable funds would result in fall in the rate of interest. If both the demand and supply of the loanable funds change, the resultant interest rate would depend much on the magnitude and direction of movement of the demand and supply of the loanable funds.

Now, the demand for loanable funds is basically derived from the demand from the final goods and services. These final goods and services are again generated from the use of capital that is financed by the loanable funds. The demand for loanable funds is also generated from the government.

The Loanable Funds Theory of the Rate of Interest has similarity with the Liquidity-Preference Theory of Interest in the sense that both of them identify the significance of the cash balance preferences and the role played by the banking sector to ensure security of the investment funds.

Thursday, July 16, 2009

What is sum of the years digits depreciation?

Sum of the year's digits depreciation is a method of calculating the depreciation of an asset over the years. Sum of the year's digits falls under the category of accelerated depreciation methods, as opposed to straight-line depreciation.

Accelerated depreciation methods are considered to be more conservative calculations of depreciation and also more accurate methods of depreciation calculation. Accelerated depreciation calculation methods assume and rest on the idea that an asset will lose value more quickly at the beginning of its useful life as opposed to losing value at a steady rate throughout its depreciable life. Another method of calculating depreciation that falls under accelerated depreciation is double-declining balance depreciation, or just plain declining balance depreciation.

Here's a simple way to describe how sum of the years digits works.

1. Take the expected life of the asset (make sure that it is in years). Count from the top number back to one. Then add all of the numbers together. So if you purchase a piece of machinery that is expected to last for 12 years, you would do the following:
12 years useful life = 12 + 11 + 10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1 Sum of the years = 78

2. To calculate the depreciation of an asset for each year of its useful life, you take the year of its useful life and set it as a percentage of the sum of the years.
This means that in the first year of your machine's life, it would end up being depreciated 12/78 in value. This fraction comes out to 15.38%. So the asset loses 15.38% of its value in the first year. The second year, the machine will be depreciated 11/78, or 14.10% of its value. In the third year, your machine will depreciate 10/78 in value, or 12.82% of its value. And so on and so forth.

3. Let's look at an example. Let's simply use the machine from up above. Let's say that this particular machine cost you $17,000. It has a salvage value of $900. Its useful life is 12 years. We have already calculated the sum of the years for the machine, and it comes out to 78.

We have already calculated that in the first year of use, the machine is going to depreciate by 15.38%. This means that in the first year of use, you will see depreciation expenses of $2467.18 (after subtracting the salvage value from the historical cost). In the second year, the machine has depreciation expenses of 14.10%. This means that you will see depreciation expenses of $2270.10. In the third year, the value will depreciate by 12.82%. Your depreciation expenses will end up being $2064.02.

That was the simple way of describing sum of years digits depreciation. Here's the more technical and complicated way of describing its formula.

Sum of years digits can also be described as a historical depreciation method. Its accelerated is in between straight line depreciation and declining balance depreciation. Here is the formula that is used to determine sum of years digits depreciation.
N = depreciable life of an asset
B = cost basis
S = salvage value
D(t) = depreciation charge for year t
Sum = (N(N + 1))/2
D(t) = (N - t + 1) x ((B - S)/Sum)

Sum of the years digits depreciation is a way of calculating depreciation that will allocate the cost of whatever asset you have over its useful life. A simpler way of describing the formula than that above is to simply say that the numerator of the fraction is the number of years left to be depreciation out of the useful life of the asset. The denominator is the sum of the years digits, determined with the formula: ( N (N + 1) ) / 2 where N is the years of the depreciable life

The sum of the years’ digits, often referred to as SYD, is a form of accelerated depreciation. (A more common form of accelerated depreciation is the declining balance method used in tax depreciation.) The sum of the years’ digits method will result in greater depreciation in the earlier years of an asset’s useful life and less in the later years. However, the total amount of depreciation over an asset’s useful life should be the same regardless of the depreciation method used. The difference is in the timing of the total depreciation.

To illustrate the sum of the years’ digits method of depreciation, let’s assume that a plant asset is purchased at a cost of $160,000. The asset is expected to have a useful life of 5 years and then be sold for $10,000. This means that the asset’s depreciable amount will be $150,000 to be expensed over its useful life of 5 years.

Next the digits in the years of the asset’s useful life are summed: 1 + 2 + 3 + 4 + 5 = 15. In the first year of the asset’s life, 5/15 of the depreciable amount (5/15 of $150,000) or $50,000 will be debited to Depreciation Expense and $50,000 will be credited to Accumulated Depreciation. In the second year of the asset’s life, $40,000 (4/15 of $150,000) will be the depreciation amount. In the third year, $30,000 (3/15 of $150,000) will be the depreciation. The fourth year will be $20,000 (2/15 of $150,000) and the fifth year will be $10,000 (1/15 of $150,000). As indicated earlier, the total depreciation during the asset’s useful life needs to sum to the depreciable cost (in this case $150,000) regardless of the depreciation method used.

Instead of adding the individual digits in the years of the asset’s useful life, the following formula can be used: n(n+1) divided by 2. In this formula, n = the useful life in years. Let’s use the formula to check our calculation above. When the useful life is 5 years, the formula will be 5(5+1)/2 = 5(6)/2 = 30/2 = 15. If the useful life is 10 years, the formula will show 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the first year of the asset having a 10 year useful life, the depreciation will be 10/55 of the asset’s depreciable cost. The second year will be 9/55 of the asset’s depreciable cost. In the tenth year, the depreciation will be 1/55 of the asset’s depreciable cost.


Tuesday, July 7, 2009

Flexible Budget

budget is a plan for the future. Hence, budgets are planning tools, and they are usually prepared prior to the start of the period being budgeted. However, the comparison of the budget to actual results provides valuable information about performance. Therefore, budgets are both planning tools and performance evaluation tools.

Usually, the single most important input in the budget is some measure of anticipated output. For a factory, this measure of output is the number of units of each product produced. For a retailer, it might be the number of units of each product sold. For a hospital, it is the number of patient days (the number of patient admissions multiplied by the average length of stay).

The static budget is the budget that is based on this projected level of output, prior to the start of the period. In other words, the static budget is the “original” budget. The static budget variance is the difference between any line-item in this original budget and the corresponding line-item from the statement of actual results. Often, the line-item of most interest is the “bottom line”: total cost of production for the factory and other cost centers; net income for profit centers.

The flexible budget is a performance evaluation tool. It cannot be prepared before the end of the period. A flexible budget adjusts the static budget for the actual level of output. The flexible budget asks the question: “If I had known at the beginning of the period what my output volume (units produced or units sold) would be, what would my budget have looked like?” The motivation for the flexible budget is to compare apples to apples. If the factory actually produced 10,000 units, then management should compare actual factory costs for 10,000 units to what the factory should have spent to make 10,000 units, not to what the factory should have spent to make 9,000 units or 11,000 units or any other production level.

The flexible budget variance is the difference between any line-item in the flexible budget and the corresponding line-item from the statement of actual results.

The following steps are used to prepare a flexible budget:

1. Determine the budgeted variable cost per unit of output. Also determine the budgeted sales price per unit of output, if the entity to which the budget applies generates revenue (e.g., the retailer or the hospital).

2. Determine the budgeted level of fixed costs.

3. Determine the actual volume of output achieved (e.g., units produced for a factory, units sold for a retailer, patient days for a hospital).

4. Build the flexible budget based on the budgeted cost information from steps 1 and 2, and the actual volume of output from step 3.

Flexible budgets are prepared at the end of the period, when actual output is known. However, the same steps described above for creating the flexible budget can be used prior to the start of the period to anticipate costs and revenues for any projected level of output, where the projected level of output is incorporated at step 3. If these steps are applied to various anticipated levels of output, the analysis is called pro forma analysis. Pro forma analysis is useful for planning purposes. For example, if next year’s sales are double this year’s sales, what will be the company’s cash, materials, and labor requirements in order to meet production needs?

A flexible budget can help managers to make more valid comparisons. It is designed to show the expected revenue and the allowed expenditure for the actual number of units produced and sold. Comparing this flexible budget with the actual expenditure and revenue it is possible to distinguish genuine efficiencies. The question is: how to prepare a flexible budget? This post provide a simple overview of how a flexible budget is prepared.

Before a flexible budget can be produced, managers must identify which costs are fixed and which are variable. The allowed expenditure on variable costs can then be increased or decreased as the level of activity changes. “Fixed costs” are those costs which will not increase or decrease over a given range of activity. The allowance for these items will therefore remain constant. Let us continue with the example…

Management have identified that the following budgeted costs are fixed:

Direct labor = $8,400
Overheads = $53,000

It is now possible to identify the expected variable cost per unit produced and sold:

Now that managers are aware of the fixed costs and the variable costs per unit it is possible to ‘flex’ the original budget to produce a budget cost allowance for 1,000 units produced and sold.

The budget cost allowance for each item is calculated as follows:

Cost allowance = budgeted fixed cost + (number of units produced and sold x variable cost per unit)

For the costs which are wholly fixed or wholly variable the calculation of the budget cost allowance is fairly straightforward. The remaining costs are semi-variable, which means that they are partly fixed and partly variable.

The budget cost allowance for direct labor is calculated as follows:

Cost allowance for direct labor = $8,400 + (1,000 units x $4) = $12,400
The budgeted sales price per unit is $120,000 / 1,200 = $100 per unit.

If it is assumed that sales revenues follow a linear variable pattern (because the sales price remains constant) the full flexible budget can now be produced.

To make sure that you followed it, let’s do further example.

Following the example of the calculation of the budget cost allowance for direct labor, calculate a revised budget cost allowance for all costs for an activity of 1,000 units and produce a revised variance statement for April.

Firstly, we need to compute the cost allowance for the overhead. Here we go:

Cost allowance for overhead = $53,000 + (1,000 units x $7) = $60,000

Next, we can make “flexible budget comparison” for April as below:

This revised analysis shows that in fact the profit was $7,610 higher than would have been expected from a sales volume of 1,000 units.
The largest variance is a $10,000 favorable variance on sales revenue. This has arisen because a higher price was charged than budgeted.

Could the higher sales price have been the cause of the shortfall in sales volume?

Although the answer to this question is not available from this information, without a flexed budget comparison it was not possible to tell that a different selling price had been charged. This is an example of variances which may be interrelated – a favorable variance on sales price may have caused an adverse variance on sales volume.
The cost variances in the flexible budget comparison are mainly adverse. These overspendings were not revealed when a fixed budget was used and managers may have been under the false impression that costs were being adequately controlled. You may be wondering what has happened to the remainder of the $6,990 adverse profit variance shown in our original budget comparison at the beginning of this example. This could be analyzed as follows:

Difference in budgeted profit -

causedby volume shortfall ($26,200 - $11,600) = ($14,600)
Profit variance from flexible budget comparison = $7,610
Total profit shortfall, per original budget comparison = ($6,990)

This shows clearly that the adverse variance was caused by the volume shortfall, and not by differences in the expected cost and revenues from the sales that were made.

Using Flexible Budgets for Planning

Although flexible budgets can be useful for control purposes they are not particularly useful for planning. The original budget must contain a single target level of activity so that managers can plan such factors as the resource requirements and the product pricing policy. This would not be possible if they were faced with a range of possible activity levels.

Tuesday, June 30, 2009

Opportunity cost

Opportunity cost or economic opportunity loss is the value of the next best alternative forgone as the result of making a decision. Opportunity cost analysis is an important part of a company's decision-making processes but is not treated as an actual cost in any financial statement. The next best thing that a person can engage in is referred to as the opportunity cost of doing the best thing and ignoring the next best thing to be done.

Opportunity cost is a key concept in economics because it implies the choice between desirable, yet mutually exclusive results. It is a calculating factor used in mixed markets which favour social change in favour of purely individualistic economics. It has been described as expressing "the basic relationship between scarcity and choice." The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, swag, pleasure or any other benefit that provides utility should also be considered opportunity costs.

The concept of an opportunity cost was first developed by John Stuart Mill.

A person who invests $10,000 in a stock denies herself or himself the interest that could have accrued by leaving the $10,000 in a bank account instead. The opportunity cost of the decision to invest in stock is the value of the interest.

A person who sells stock for $10,000 denies himself or herself the opportunity to sell the stock for a higher price in the future, inheriting an opportunity cost equal to future price minus sale price.

An organization that invests $1 million in acquiring a new asset instead of spending that money on maintaining its existing asset portfolio incurs the increased risk of failure of its existing assets. The opportunity cost of the decision to acquire a new asset is the financial security that comes from the organization's spending the money on maintaining its existing asset portfolio.

If a city decides to build a hospital on vacant land it owns, the opportunity cost is the value of the benefits forgone of the next best thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sports center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, since those uses tend to be mutually exclusive. Also included in the opportunity cost would be what investments or purchases the private sector would have voluntarily made if it had not been taxed to build the hospital. The total opportunity costs of such an action can never be known with certainty, and are sometimes called "hidden costs" or "hidden losses" as what has been prevented from being produced cannot be seen or known. Even the possibility of inaction is a lost opportunity. In this example, to preserve the scenery as-is for neighboring areas, perhaps including areas that it itself owns.

Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value. For example, a person who desires to watch each of two television programs being broadcast simultaneously, and does not have the means to make a recording of one, can watch only one of the desired programs. Therefore, the opportunity cost of watching Dallas could be enjoying Dynasty. In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the diner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals. A family might decide to use a short period of vacation time to visit Disneyland rather than doing household improvements. The opportunity cost of having happy children could therefore be a remodelled bathroom
The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetory cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all. The unseen opportunity costs then become the implicit hidden costs of that course of action.

Note that opportunity cost is not the sum of the available alternatives when those alternatives are, in turn, mutually exclusive to each other. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money which could have been made from selling the land, as use for any one of those purposes would preclude the possibility to implement any of the others.

However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money.

In some cases it may be possible to have more of everything by making different choices; for instance, when an economy is within its production possibility frontier. In microeconomic models this is unusual, because individuals are assumed to maximise utility, but it is a feature of Keynesian macroeconomics. In these circumstances opportunity cost is a less useful concept.

The first step to making good decisions is to think about the trade-offs involved. This primer explains how measuring opportunity cost can help you find the trade-off that lurks within every decision.

Let's begin by analyzing a typical decision carefully, just as a coach might videotape a tennis player's stroke and then study it frame by frame.

Suppose that Jim is about to purchase a CD of his favorite singer. Let's see what goes on in his mind as he makes his decision.

Jim first looks at the songs and thinks about the hours of pleasure he would get listening to them. In economic terms, he determines the benefit he expects to get from the CD. Next, he glances at the price tag to see how much it costs -- $15. Jim determines that the CD's benefit exceeds its cost, so he decides to buy it.

To make his decision, Jim followed a simple rule: Do something if its benefit outweighs its cost. To see if Jim's rule is a good one, let's try it out on another problem. Suppose a woman is walking along down the street when she sees a dime on the sidewalk. Should she pick it up?

Yes, you may be thinking. If she picks up the dime, she gets a benefit of 10 cents. On the other hand, it doesn't cost her anything to pick it up. The benefit clearly outweighs the cost.

But what if the woman is Madonna, and she's hurrying to a recording studio where a symphony orchestra is waiting to perform with her. Do you still think she should stop and pick up the dime?

It's clearly not worth her time. Perhaps Jim's rule needs to be modified, say to this: Do something if its benefit outweighs its cost unless you're a famous singer. Or a movie star, or President of the United States, or a brain surgeon.

But there's a simpler way. We can greatly improve Jim's decision-making rule by adding just one word. Here's the rule for deciding whether it's in your own best interest to do something:

Do something if its benefit outweighs its opportunity cost.

When asked how much something costs, people usually answer by giving its price, or money cost. Economists usually measure cost differently, using what they call opportunity cost, defined as the value of the next best alternative opportunity that is given up in order to do something.

Here's how to calculate it. When considering a choice, ask yourself three questions:

1. What alternative opportunities are there?
2. Which is the best of these alternative opportunities?
3. What would I gain if I selected my best alternative opportunity instead of the choice I'm considering?

The answer to the third question is the opportunity cost of the choice.

To find out the opportunity cost to Madonna of picking up the dime, we need to come up with her alternative opportunities and select the best one. Let's assume that Madonna's best alternative to picking up the dime would be to leave it on the sidewalk and arrive at the recording studio 30 seconds sooner.

The value of those 30 extra seconds at the recording studio is the opportunity cost to her of picking up the dime. She should compare the benefit she'd get from picking up the dime (10 cents) with its opportunity cost (arriving 30 seconds sooner at the recording studio) to decide what to do.

When we compare the opportunity cost of picking up the dime with the benefit, we can see that it doesn't make sense for Madonna to retrieve it. Her time would be better spent at the recording studio. Perhaps a child─whose time isn't worth as much─will come along later and decide to pick up the dime.

Opportunity cost and trade-offs

Let's have Jim decide again whether to buy the CD, this time using opportunity cost instead of money cost. As before, he should first consider the benefit he'd get from the CD, and look at its price tag. But before making a decision, Jim should consider alternative opportunities -- other things that he could do with the $15. Suppose his best alternative is to buy a pair of $15 sunglasses. The value to him of the sunglasses represents the opportunity cost of the CD.

As he decides whether to buy the CD, he should compare its benefit with its opportunity cost -- the sunglasses. If the benefit (the value to Jim of the CD) outweighs the opportunity cost (the value to Jim of the sunglasses), then he should buy the CD. If the benefit is less than the opportunity cost, then he shouldn't buy it.

In other words, thinking about the opportunity cost of buying a CD expresses the problem as a choice between the CD and the sunglasses. This is precisely why opportunity cost is such a powerful decision-making tool. It shows a decision for what it really is -- a trade-off between your two best alternatives.

As another example, consider a government proposal to build a new dam. Here's how a poor decision-maker might view the problem:

"If we build a dam, we'll have better flood control and cheaper electricity. If we don't, then we'll experience occasional flooding, and electricity will be more expensive."

Here the choice seems to be between having a dam and not having a dam. When put that way, it's tempting to choose to build the dam. Cheaper electricity and flood control are better than expensive electricity and floods.

Here's another way of presenting the problem:

"If we build the dam, it will provide us with flood control and cheaper electricity, but it will cost us $100 million."

This decision-maker recognizes that something must be given up to build a dam. There's a trade-off. This is better, but still not the best way to view a decision. When we think of the cost in dollars, the trade-off we're facing is often unclear. It's hard for most people to imagine how much $100 million is, and we don't know whether the money could be put to better use elsewhere.

Here's how an economist would view the problem:

"If we build the dam, we'll have flood control and cheaper electricity. But the $100 million to build the dam could be used instead to build two new high schools."

Here, the benefit of the dam is compared with its opportunity cost: new high schools. Expressed that way, the cost of the dam becomes much more concrete. Besides, it's not really money that we're sacrificing when we build a dam, but rather resources -- workers, machines, cement, and land -- that could be used elsewhere. If money were the only thing we sacrificed, there would be no trade-offs; our government could buy us everything we wanted simply by printing more money, preferably in very large denominations.

Using opportunity cost -- an example

Ernesto is trying to decide whether to attend college and has determined the money cost of attending college for one year.

Money Cost of a Year of College

Tuition: $1,000
Books and school supplies: 2,000
Room and board: 10,000
Transportation: 1,000
Miscellaneous expenses: 3,000

Total money cost: $17,000

This tells Ernesto how much money he'll need to come up with if he decides to go to college.

But in order to decide whether to go to college, Ernesto should figure out its opportunity cost. The first step is for Ernesto to determine the best alternative to going to college. Let's say that it's working full time at the local Drive-In. The opportunity cost of going to college, then, is the value of what he would gain if he worked instead of going to college.

If Ernesto worked, he wouldn’t have to pay for tuition, books, or school supplies. He also would earn $10,000 during the year that she worked. The opportunity cost of a year of college, therefore, is:

Opportunity Cost of a Year of College

Tuition: $ 1,000
Books and school supplies: 2,000
Foregone wages from working: 10,000

Total opportunity cost: $13,000

This tells Ernesto how much he'd have to spend on other things if he decided not to go to college.

You may be wondering why we didn't include room and board, transportation, entertainment, and miscellaneous expenses in the opportunity cost calculation. Wouldn't Ernesto have these expenses at college?

Yes, he would, but he also would face these costs if he decided to work. Remember, opportunity cost includes only the value of what one would gain under the next best alternative opportunity. Ernesto can't get out of paying for room and board, transportation, and entertainment by working. These expenses, therefore, should not be included in the opportunity cost of going to college.

The opportunity cost of going to college -- $13,000 -- tells Ernesto what he would gain if he chose not to go to college. When deciding whether to go to college, he should weigh that cost against the benefits of college, like higher future earnings, new friends, and a better understanding of our world.

Sunk Costs

Just as Eskimos have lots of words to describe snow, economists have lots of words to describe cost. This section introduces sunk costs.

Sunk costs are costs that must be paid whether or not you do something. They're of special interest to us because we don't want to include them when calculating opportunity cost. Unfortunately, sunk costs are like invasive weeds; it's often hard to yank them out of a problem.

To see why sunk costs should be ignored, let's go back to Sheila, who has had her car for a week now. She has just returned home from school and she's trying to decide whether to go out and see a movie.

To figure out the opportunity cost of seeing a movie, Sheila first determines her best alternative opportunity. Let's assume that it's to stay home and do homework. Next, she lists all the things that she would gain if she stayed home and did homework instead of watching a movie.

Opportunity Cost of Going to a Movie

Time to do homework: 3 hours
Gas and parking: $1.50
Admission to the theater: $2.00

Opportunity Cost: 3 hours and $3.50

Notice that Sheila correctly includes gas and parking in her opportunity cost calculations. But what about all the other costs associated with owning a car, like insurance and registration fees? Shouldn't she include them as part of the opportunity cost of going to a movie?

The answer is no. If Sheila stayed home, she'd still have to pay the same insurance and registration fees. She can't reduce these costs by staying home.

Insurance and registration fees are examples of sunk costs. Sunk costs can't be recovered by choosing the best alternative opportunity. That's why economists use the following rule when calculating the opportunity cost of something:

Ignore sunk costs.

Now suppose that Sheila decides to go to the movie and her little brother asks to come along. He will pay for his own admission. What is the opportunity cost to Sheila of bringing him?

The answer is nothing at all. Since Sheila has already decided to go to the movie theater, the expense of driving there has become a sunk cost -- she will incur that expense whether or not her brother comes. She doesn't sacrifice anything by bringing him along, unless, of course, he's obnoxious.


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