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1
Module I
BUSINESS ECONOMICS
INTRODUCTION
Managerial Economics consists of that part of economic theory which helps the business manager to take
rational decisions
...

Managerial Economics integrates economic theory with business practice
...
It deals with the use of
economic concepts and principles for decision making in a business unit It is otherwise called Business
Economics or Economics of the Firm
...
The term Managerial
Economics is more in use now a-days
...
Hence it is also called Applied Economics
...
In other words, it deals with the application of economic theory to
business management
...


ii
...
(Spencer and
Siegelman)
"Business economics deals with the use of economic modes of thought to analyse business
situation”
...
Micro economics: Managerial economics :s micro economic in character
...
It does not study the problems of the entire economy
...
Normative science: Managerial economics is a normative science
...
It determines the goals of the enterprise
...

3
...
It concentrates on making economic theory more
application oriented
...

4
...
It prescribes solutions to
various business problems
...
Uses macro economics: Marco economics is also useful to business economics
...
Managerial
economics takes the help of macro-economics to understand the external conditions such as business
cycle, national income, economic policies of Government etc
...
Uses theory of firm: Managerial economics largely uses the body of economic concepts and principles
towards solving the business problems
...


2
7
...
Managerial economics analyses the problems
and give solutions just as doctor tries to give relief to the patient
...
Multi disciplinary: Managerial economics makes use of most modern tools of mathematics, statistics
and operation research
...

9
...
-Managerial economics is both a science and an art
...
It points out to the objectives and also shows the way to attain the said objectives
...
Managerial economics
answers the five fundamental problems of decision making
...
In order to solve the problems of decision- making, data are to be collected and analysed in the light
of business objectives
...

As pointed out by Joel Dean "The purpose of managerial economics is to show how economic analysis can
be used in formulating business policies"
Main Objectives
1
...

2
...

3
...

4
...

5
...

6
...

7
...
To help in demand and sales forecasting
...
To help in operation of firm by helping in planning, organising, controlling etc
...
To help in formulating business policies
...
To help in profit maximisation
...
-Thus, Business economics offers a number of benefits to business managers
...


3
SCOPE OF MANAGERIAL OR BUSINESS ECONOMICS
Managerial economics is a developing science which generates the countless problems to determine its
scope in a clear-cut way
...

1
...
The foremost aspect regarding scope is demand analysis and
forecasting
...
Since all output is meant to be sold, accurate estimates of demand help a firm in minimising its
costs of production and storage A firm must decide its total output before preparing its production
schedule and deciding on the resources to be employed
...

2
...
A firm's profitability depends much on its costs of production
...
Production process are under the charge of engineers but the business
manager works to carry out the production function analysis in order to avoid wastages of materials and
time
...
The main topics discussed under cost and
production analysis are: Cost concepts, cost-output relationships, Economies and Diseconomies of scale
and cost control
...
Pricing decisions, policies and practices
...
Since a firm's income and profit depend mainly on the price decision, the pricing policies and all
such decisions are to be taken after careful analysis of the nature of the market in which the firm operates
...

4
...
Each and every business firms are tended for earning profit, it is profit which
provides the chief measure of success of a firm in the long period
...
A successful business manager is one who can form more or
less correct estimates of costs and revenues at different levels of output
...
It is therefore, profit-planning and profit
measurement constitute the most challenging area of business economics
...
Capital management
...
Investments are made in the plant and machinery and buildings which are
very high
...
It means capital management i
...
,
planning and control of capital expenditure
...

6
...
If the stock is too much,
the capital is unnecessarily locked up in inventories At the same time if the level of inventory is low,
production will be interrupted due to non-availability of materials
...
Therefore, managerial economics will use some methods such as ABC analysis,
inventory models with a view to minimising the inventory cost
...
Linear programming and theory of games : Linear programming and theory of games have came to be
regarded as part of managerial economics recently
...
Environmental issues: There are certain issues of macroeconomics which also form apart of managerial
economics
...

9
...
They refer to regular fluctuations in economic
activities in the country
...
Thus, managerial economics comprises both micro and macro-economic theories
...


FUNDAMENTAL CONCEPTS OF APPLIED MANAGERIAL ECONOMICS
Decision making is the core of Managerial Economics
...
The following are the six fundamental concepts used in
Managerial Economics:
1
...
Opportunity cost
of anything is the cost of the next best alternative which is given up
...
It is the earnings that would be realised if the available resources were put to
some other use
...
Thus opportunity costs are measured by the sacrifices made in the decision
...
It is also called alternative cost or transfer cost
...
If the machine has only one use, it has no opportunity
cost
...
If an old building is proposed to be used for a
business, likely rent of the building is the opportunity cost
...
Devenport, an American Economist explains the concept
of opportunity cost with reference to an example
...
When the girl so drops
by the way - side one fruit and runs with the other, then the opportunity cost of the fruit she saves is the
foregone alternative of the fruit she lost
...
The concept of opportunity
cost plays an important role in managerial decisions
...
This concept helps in
the best allocation of available resources
...
Principle of incremental cost and revenue: Two important incremental concepts used in Managerial
Economics are fundamental concepts of Managerial Economics are incremental cost and incremental
revenue
...
Incremental revenue means
the change in total revenue resulting from a decision
...

Incremental principle can be used in the theories of consumption, production, pricing and distribution
...

3
...
Another principle is the principle of time perspective which is useful in
decision-making in output, prices, advertising and expansion of business
...
On the contrary, in the short-run it can afford to ignore some of
its (fixed) costs
...
The
principle of time perspective can be stated as under : A decision should take into account both the short
run and the long run effects on revenues and costs and maintain a right balance between the long run and
the short run perspectives
...
Discounting Principle
...

This is also implied by the common saying that a bird in hand is worth than two in the bush
...
1000 today to Rs
...

There are two main reasons for this : (1) the future is uncertain and it is preferable to get Rs
...
1000next year, one would do well to
receive Rs
...
100 for one year
...
1000 obtainable after one year ?
The principle of economics used in the calculation is called the discounting principle
...
Equi-marginal principle : This is one of the widely used concepts in managerial economics
...
According to this principle, an input should be
allocated in such a manner that the value added by the last unit of input is same in all uses
...
The equi-marginal principle can be applied in different areas of management
...
The objective is to allocate resources where they are most productive
...
It can be applied in any discussion of budgeting
...

The equi-marginal principle can also be applied in multiple product pricing
...
The equi-marginal principle may also be applied in allocating research expenditures
...
Optimisation : This is another important concept used managerial economics
...
The objective may be maximisation of profit or minimisation of
time or minimisation of cost
...


Financial Economics
Financial economics is the application of economic principles to financial decision making that involves the
allocation of money under conditions of uncertainty

6
1
...

2
...

This provides framework for making decisions as to how to get funds and what we should do with them
once we have them
...

Prudent decision making on how to finance different activities is very important for any firm
...
Investors allocate their funds among financial assets in order to accomplish their
objectives
...

Subject Matter
Financial economics is the branch of economics studying the interrelation of financial variables, such
as prices, interest rates and shares, as opposed to those concerning the real economy
...

It studies the following:
i
...


How risky is the asset? (identification of the asset appropriate discount rate)

iii
...
How does the market price compare to similar assets? (Relative valuation)

Financial decisions in a firm
Three broad areas of financial decision making namely, capital budgeting, capital structure, and working
capital management
...
Capital budgeting: the most imp decision that any firm has to make is to define the business or
businesses that it wants to be
...
As strategic planning calls for evaluating costs and
benefits spread out over time, it is essentially a financial decision making process
...

Considerable managerial time, attention, and energy are devoted to identify, evaluate, and implement
investment projects
...

2
...
The key issues in the capital structure decision are
i
...

Which specific instruments of equity and debt finance should the firm employ?
iii
...
Working capital management: working capital management, also referred to as short term
financial management refers to the day to day financial activities that deal with current assets(
inventories, debtors, short-term holdings of marketable securities) and current liabilities (shortterm debt)

Financial economics is comprised of three related areas
1
...

2
...
Financial managers are primarily concerned with the investment and financing decisions
within the organisations
...
Investment Management: this area is dealing with the management of individual or institutional
funds
...

Relationship of Finance to Economics
There are two important linkages between economics and finance
...

i
...


Key macro-economic factors like the growth rate of economy, the domestic savings rate, the
role of the government in economic affairs, the tax environment, the nature of external
economic relationships, the availability of funds to the corporate sector, the rate of inflation,
the real rate of interest, and the terms on which the firm can raise finances define the
environment in which the firm operates
...

While an understanding of the macro economic developments sensitises the financial manager
to the opportunities and threats in the environment, a firm grounding in micro economic
principles sharpens his analysis of decision alternatives
...
For example, the principle of marginal analysis is applicable to a number of
managerial decisions in finance
...


8

Module II
Investment
The word "investment" can be defined in many ways according to different theories and principles
...
However, the different meanings of "investment" are more
alike than dissimilar
...

According to economics, investment is the utilization of resources in order to increase income or
production output in the future
...

An investment is the commitment of funds made with an expectation of some positive returns
...


waiting for returns

ii
...


Definitions of Investment
i
...
Investment means making an addition to the stock of goods in existence
...
Joan Robinson)

ii
...
(F
...

[Real assets include land, buildings or machinery owned
...
]
In theoretical economics, investment means the purchase of capital goods- goods which are not consumed
but instead used in the future production
...
However,
in finance, investment means buying securities or other monetary or paper(financial) assets in the money
markets or capital markets
Characteristics / Nature of Investment
All investments have following characteristics
Return: an investment is characterised by the expectation of return
...
The returns may be earned in the form of dividend or interest or in the form
of capital appreciation
...
The risk varies from investment to investment
...


9
Safety: The safety of investment refers to the certainty of return of initially invested funds
...

Liquidity: An investment which is easily saleable or marketable is said to be possessing liquidity
...
It can be transacted quickly, 2
...
The price change between two successive transactions is small and negligible
...

The degree of convenience of an investment varies widely
...
On the other
hand, purchase of a property involves lot of procedural and legal issues and one has to take special pain to
maintain it
...
When you invest in national
saving certificate, you can get a tax rebate
...
CORPORATE SECURITIES
i
...
Creditorship Securities or Debt Capital
A
...
Shares are the most universal form of
raising long-term funds from the market
...
Different types of shares are issued to suit the requirements of investors
...
So different types of shares suit different types of investors
...
Equity Shares
Equity shares or ordinary shares represent the owner’s capital in a company
...
They have control over the working of the company
...
Equity shareholders are paid
dividend after paying it to the preference shareholders
...
Equity share capital cannot be redeemed during the life time of the company
...

Characteristics of Equity shares
i
...
Under the Companies Act, 1956, a company cannot purchase its own shares
...
Claims/Right to Income: Equity shareholders a claim on income left after paying dividend to preference
shareholders(Residual claim)
...
The distribution of income as
dividend to equity shareholders is left to the discretion of the Board of Directors of the Company under the
Companies Act, 1956
...

iii
...
In the
event of liquidation of a company, the assets are utilized first to meet the claims of creditors and
preference shareholders and everything left belongs to the equity shareholders
...
Right to control or Voting Rights: Equity shareholders have voting rights in the meeting of the company
and have a control over the working of the company
...
Directors are appointed in the Annual
General Meeting by majority votes
...
But often such indirect control of shareholders is weak and
ineffective because of the indifference of most of the shareholders in casting their votes
...
Pre-emptive Right: To safeguard the interest of equity shareholders and to enable them maintain their
proportional ownership, they are given Pre-emptive right by Companies Act 1956
...
Shares
so offered to existing shareholders are called Right Shares
...
Limited Liability: although equity shareholders are the real owners of the company, their liability is
limited to the value of share they have purchased
...
(Ownership
without risk)
Advantages of Equity Shares
i
...

iii
...

v
...

They can be issued without creating any charge over the assets of the company
...

Equity shareholders are the real owners of the company who have the voting rights
...


Disadvantages of Equity Shares
i
...
As equity capital cannot be redeemed, there is a danger of over capitalization
iii
...
During prosperous periods higher dividends have to be paid leading to increase in the value of shares in
the market and speculation
v
...


11

2
...
These
shares are given two preferences
...
Whenever the company has
distributable profits, the dividend is first paid on preference share capital (b) preference for the repayment
of capital at the time of liquidation of company
...
A fixed rate of dividend is paid on preference share capital
...
So they have no say in the management of the company
...
Cumulative Preference Shares: those shares have a right to claim dividend for those years also for
which there are no profits
...
Eg
...
Non-cumulative Preference Shares: No claim for arrears of dividend
c
...
Participating preference shares: the holders of these shares carry an additional right of sharing
profits of the company
...
Non-participating preference shares: the shares on which only a fixed rate of dividend is paid
f
...
Non convertible preference shares
Features of Preference shares
i
...
However, a company may issue redeemable preference shares with a
limited life after which these are supposed to be retired or paid back
...
Claims on Income: A fixed rate of dividend is payable on preference shares
...
But like equity shareholders, the holders of preference shares also
cannot legally demand payment of dividends or distribution of earnings, as it is the prerogative of the
management to decide whether to pay dividend or to reinvest its earnings
...
Claims on Assets: they have a preference in the repayment of capital at the time of liquidation of a
company
...

iv
...
So they do not have any say in the management or control
of the company
...

v
...
It
resembles equity in the sense that a) payment of dividend is not obligatory b) payable only out of
distributional profits etc
...

1
...

3
...

It provides preferential rights in regard to payment of dividends and repayment of capital at the
time of liquidation of the company
...

1
...

3
...

The market price of the preference shares fluctuate much more than that of debentures
...
No Par Stock/Shares
No par stock means shares having no face value
...
The share certificate of the company
simply states the number of shares held by its owner without mentioning any face value
...
Dividend on such shares is paid per share and not as a percentage of fixed nominal value of
shares
...


Sweat Equity

the term sweat equity means equity shares issued by a company to its employees or directors at a discount
or for consideration other than cash for providing know-how or making available rights in the nature of
intellectual property rights or value additions
...


B
...
A
debenture or a bond is an acknowledgement of a debt
...

a
...
These loans are raised by the issue of
debentures
...
A debenture holder is a creditor of the
company
...
Unlike shares, debenture or bond is a creditorship
security with a fixed rate of interest, fixed maturity period, perfect income certainty and low risk of capital
...

Types of Debentures
i
...

They have no priority as compared to other creditors
...


13
ii
...

In case of default in the payment of interest or principal amount, debenture holders can sell the assets
in order to satisfy their claims
...
In this case debentures are paid in priority to unsecured creditors
...
Bearer Debentures: These debentures are easily transferable
...
The debentures are handed over to the purchaser without any registration deed
...
Registered Debentures: Registered debentures require a procedure to be followed for their
transfer
...
Redeemable Debentures: These debentures are to be redeemed on the expiry of a certain period
...

vi
...
They are payable either on the winding up of the company or at the time of any default
on the part of the company
...
Convertible Debentures: Sometimes a company may issue convertible debentures
...
However, debentures issued at discount can be converted either into
the equivalent number of shares in proportion to the cash originally paid on the nominal value of
debentures or into the proportionately reduced number of fully paid-up shares
...

Convertible debentures may either be Fully Convertible Debentures (FCD) or Partly Convertible
Debentures(PCD)
...
PCDs are converted into equity shares
partly and the balance is not converted into equity
...


II
...
There are two varieties namely; 1
...
Tax free bonds
...

Features of PSU bonds
iii
...


iv
...


v
...


They are traded on the Stock Exchanges
...
Post Office Deposits and certificates
The investment avenues provided by post offices are generally non-marketable
...
Post offices accept savings deposits as well as fixed
deposits from the public
...
Six-year National Savings Certificates (NSC) are issued by post offices to investors
...

ii
...
No income tax benefit is
available on IVP
...
They are transferable by mere delivery
...
Kisan Vikas Patras: KVPs have a maturity period of five and half years
...
Premature encashment of KVP is permitted after two and half years of issue
...
Government Securities
Debt securities issued by Central Govt,, State govt and quasi governmental agencies are referred to as
government securities
...
Securities markets in India are commercial banks,
cooperative banks, insurance Co’s, provident funds, financial institutions
...


An investment that resembles a company debentures
...


ii
...


iii
...


V
...
Treasury Bills: It is a short term money market instrument issued by the central govt
...
Govt issues the treasury bills to bridge short term
mismatch between receipts and expenditures
...

2
...
The commercial
paper is subject to credit rating by any of the recognized credit rating agencies of India
...
maturity period is 180 days
ii
...

iii
...
Certificate of Deposits: They are essentially securitised short-term time deposits issued by banks
during period of tight liquidity, at relatively high interest rates
...
REPOS: Repos is a money market instrument, which enables collateralised short term borrowing
and lending through sale/purchase operations in debt instrument
...

5
...
Life Insurance Policies
Life Insurance Corporation offers many investment schemes to investors
...
Some of the schemes of LIC are Whole Life Policies, Convertible
Whole Life Assurance Policies etc

VII
...
These are three kinds of provident funds applicable to different sectors of employment, namely
Statutory Provident fund, Recognised Provident fund and Unrecognised Provident Fund
...
An apt decision on investment
program leads a business firm to achieve its high profit; hence a methodology to assist the management to
take correct decision on its investment proposals is a most important factor for which capital budgeting
technique would assist
...

MEANING AND NATURE OF CAPITAL BUDGETING
Capital budgeting is the process of making investment decisions in capital expenditures
...
The main characteristic of a capital expenditure is that the expenditure
is incurred at one point of time whereas benefits of the expenditure are realized at different points of time
in future
...

The following are some of the examples of capital expenditure
i
...
Research and development project cost, etc
...
Thus, capital expenditure
decisions are also called as long term investment decisions
...
It is the process of deciding whether or not to commit resources to a
particular long term project whose benefit are to be realized over a period of time, longer than one year
...

“Capital budgeting is long-term planning for making and financing proposed capital outlays”
(Charles T
...
" (Lynch)

16
From the above description, it may be concluded that the important features which distinguish capital
budgeting decision from the ordinary day today business decisions are:
1
...

2
...

3
...

4
...

5
...

NEED AND IMPORTANCE OF CAPITAL BUDGETING
The importance capital budgeting can be well understood from the fact that an unsound investing decision
may prove to be fatal to the very existence of the concern
...
Large Investment
...
But the
funds available with the firm are always limited and the demand for funds far exceeds the recourses
...

2
...
Capital expenditure involves not only large amount of funds but also
funds for long-term or more or less on permanent basis
...
e
...

3
...
The capital expenditure decisions are of irreversible nature
...

4
...
Capital budgeting decisions have a long-term and significant effect on
the profitability of a concern
...
An unwise decision may prove disastrous and fatal to the very existence of the
concern
...

5
...
The long term investment decisions are difficult to be taken
because (i) decision extends to a series of years beyond the current accounting period, (ii) uncertainties of
future and (iii) higher degree of risk
...
National Importance
...
Thus, we may say that
without using capital budgeting techniques a firm may involve itself in a losing project
...


17
CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process as it involves decisions relating to the investment of current funds
for the benefit to be achieved in future and the future is always uncertain
...
Identification of Investment Proposals
...
The proposal or the idea about potential investment opportunities may originate
from the top management or may come from the rank and file worker of any department or from any
officer of the organization
...

2
...
The committee views these Proposals from various angles to ensure
that these are in accordance with the corporate strategies or selection criterion of the firm and also do not
lead to departmental imbalances
...
Evaluation of Various Proposals: The next step in the capital budgeting process is to evaluate the
profitability of various proposals
...

4
...
But it may not be possible for the firm to invest immediately in all the acceptable
proposals due to limitation of funds
...

5
...
Proposals meeting the evaluation and
often criteria are finally approved to be included in the Capital Expenditure Budget However; proposals
involving smaller investment may be decided at the lower levels for expeditious action
...

6
...
Preparation of a capital expenditure budgeting and incorporation of a
particular proposal in the budget does not itself authorise to go ahead with the implementation of the
project
...
Further,
while implementing the project, it is better to assign responsibilities for completing the project within the
given time frame and cost limit so as to avoid unnecessary delays and cost over runs
...
Performance Review The last stage in the process of capital budgeting is the evaluation of the
performance the project
...
The unfavourable variances, if any should be looked into and
the causes of the same be identified so that corrective action may be taken in future
...
The various commonly
used methods are as follows:
I
...
Pay-back Period method or Pay out or Pay off method
...
Improvement of Traditional Approach to Payback Period Method
...
Rate of Return Method or Accounting Method
...
Time -adjusted method or discounted Methods:
iv
...

v
...

vi
...

TRADITIONAL METHODS:
1
...
This method is based on the principle that every
capital expenditure pays itself back within a certain period out of the additional earrings generated from
the capital assets
...
Under this method, various investments are ranked
according to the length of their payback period in such a manner that the investment with a shorter ay
back period is preferred to the one which has longer pay back period
...
The pay-back period can be ascertained in the following manner:
i
...

ii
...

Pay-back period= Cash Outlay of the project or Original cost of the Asset/Annual Cash Inflows
iii
...

Example: A project costs Rs
...
20,000for 8 years
...

Pay back Period = Initial Outlay of the Project/Annual Cash Inflow = 1, 00,000/20,000 = 5 years

19
Advantages of Pay-back Period method
(1) The main advantage of this method is that it is simple to understand and easy to calculate
...

(3) In this method, as a project with a shorter pay-back period is preferred to the one having a longer payback period it reduces the loss through obsolescence and is more suited to the developing countries, like
India, which are in the process of development and have quick obsolescence
...

Disadvantages of Pay-back Method
Though pay-back period method is the simplest, oldest and most frequently used method, it suffers from
the following limitations:
(1) It does not take into account the cash inflows earned after the payback period and hence the true
profitability of the projects cannot be correctly assessed
...
It treats all cash flows as equal though they occur indifferent periods
...

(3) It does not take-into consideration the cost of capital which is a very important factor in making sound
investment decisions
...

2
...
Post Pay-back Profitability Method
...
Hence, an, improvement over this method can be made by taking into
account the returns receivable beyond the pay-back period
...

ii
...
One of the limitations of the pay-back period method is that is it ignores
the life of the project beyond the pay-back period
...
This method is also known as Surplus Life over Pay-back method
...
The
method can be employed successfully where the various projects under consideration do not differ
significantly as to their size and the expected cash inflows are even throughout the life of the project
...
Discounted Pay- back Method
...
Hence, an improvement over this method can be made by employing the
discounted pay-back period method
...
The present values of all inflows are cumulated in order of
time
...
The project which gives shorter discounted payback period is accepted
...
Rate of Return Method:
This method takes in to account the earnings expected from the investment over their whole life
...
According to this
method, various projects are ranked in order of the rate of earnings or rate of return
...
This method can also
be used to make decision as to accepting or rejecting a proposal
...

The return on investment method can be used in several ways as follows:
(a) Average Rate of Return Method
...
In other
words, it establishes the relationship between average annual profits to total investments
...
In this method the total profit after tax and depreciation is divided by the total investment
(c) Return on Average Investment Method- In this method the return on average investment is
calculated
...

(d) Average Return on Average Investment Method
...
Under this method, average profit after depreciation and taxes is divided by the average
amount of investment; thus

[Average annual profits after dep & taxes/ Average investment] 100
Advantage of Rate or Return Method
i
...

ii
...

iii
...

Disadvantages of Rate of Return Method
(1) This method also like pay-back period method ignores the time value of money as the profits earned at
different points of time are given equal weight by averaging the profits
...


21
(3) It ignores the period in which the profits are earned as a 20% rate of return in 27 years may be
considered to be better than 18% rate of return for 12 years
...

(4) This method cannot be applied to a situation where investment in a project is to be made in parts
...
e
...

These methods do not take into consideration the time value of money, the fact that a rupee earned today
has more value than a rupee earned it after five years
...
These methods also called modern
methods of capital budgeting are becoming increasingly popular day by day
...
Net present value method
The net present value method is a modern method of evaluating investment proposals
...
It recognizes the fact that a rupee earned today is worth more than
the same rupee earned tomorrow
...
The following are the necessary steps to be followed for
adopting the net present value method of evaluating investment proposals
(i) First of all determine an appropriate rate of Interest that should be selected as the minimum require
rate of return called cut -off rate or discount rate
...
The discount rate should be either the
actual rate of interest in the market on long-term loans or it should reflect the opportunity cost of capital
of the investor
...
e
...
If the total investment is to be made in the initial year, the present value shall be the same as the cost
of investment
...

(iv) Calculate the present value of each project by subtracting the present value of cash inflows from the
present value of cash outflows for each project
...
e
...

(vi) To select between mutually exclusive projects, projects should be ranked in order of net present
values, i
...
the first preference should be given to the project having the maximum positive net present
value
...
An/(1+r)n

Advantages of the Net Present Value Method
•

It recognizes the time value of money and is suitable to be applied in a situation with uniform cash
outflows and uneven cash inflows or cash flows at different periods of time
...


•

It takes into consideration the objective of maximum profitability
...


•

It may not give good results while comparing projects with unequal lives as the project having higher
net present value but realized in a longer life span may not be as desirable as a project having
something lesser net present value achieved in a much shorter span of life of the asset
...


•

It is not easy to determine an appropriate discount rate
...


Internal Rate of Return Method

The internal rate of return method is also a modern technique of capital budgeting that takes into account
the time value of money
...
In the net present value
method the net present value is determined by discounting the future cash flows of a project at a
predetermined or specified rate called the cut-off rate
...
Under this method, since the discount rate
is determined internally, this method is called as the internal rate of return method
...
It can be determined with the help of the following mathematical formula
...
An/(1+r)n
Where, C = Initial Outlay at time Zero
...
An = Future net cash flows at different periods
...

The following steps are required to practice the internal rate of return method
...
Determine the future net cash flows during the entire economic life of the project
...
Determine the rate of discount at which the value of cash inflows is equal to the present value of
cash outflows
...
Accept the proposal if the internal rate of return is higher than or equal to the cost of capital or
cut off rate and reject the proposal if tie internal rate of return is lower than the cost of cut-off
rate
...
In case of alternative proposals select the proposal with the highest rate of return as long as the
rates are higher than the cost of capital or cut-off-rate
...


(iii)

The determination of cost of capital is not a pre-requisite for the use of this method and hence it
is better than net present value method where the cost of capital cannot be determined easily
...


(v)

This method is also compatible with the objective of maximum profitability and is considered to
be a more reliable technique of capital budgeting
...

(i) It is difficult to understand and is the most difficult method of evaluation of investment proposals
...
In this sense, Net
Present Value method seems to be better as it assumes that the earnings are reinvested at the rate of
firm's cost of capital
...


24
6
...
Profitability index also called as
Benefit-Cost Ratio (B/C) or 'Desirability factor' is the relationship between present value of cash inflows
and the present value of cash outflows
...
The proposal is
accepted if the profitability index is more than one and is rejected if index is less than one
...


25

Module III
Introduction to Balance Sheet
What is a Balance Sheet?
The balance sheet presents the firm's financial structure
...
Most balance sheets are produced quarterly although some farm firms use an
annual balance sheet
...

Assets are what the firm has, and liabilities are what the firm owes
...

For example, if the firm’s assets are $1 million and its liabilities are$600,000, its equity is $400,000
...
Or, assets equal liabilities plus equity
...

Assets are conventionally divided into current, intermediate and long-term assets
...
For example, if an intermediate asset is valued
at$100,000 and the firm owes $80,000 on an intermediate loan for this asset, the asset and liability would
be listed opposite each other
...
What Does a Balance Sheet Look Like?
The total assets on the left equal the total liabilities and equity on the right
...
Thus, equity is the
residual after deducting liabilities from assets

Assets
Current assets are listed first on a balance sheet
...
They include items like cash; bank accounts; investments in stocks,
bonds or mutual funds; receivables; inventories for sale in the period between the balance sheets; supplies
on hand and the value of growing crops etc
...
This is because of the importance of liquidity
...
Traditional agricultural markets are more volatile today
...

Intermediate assets include depreciable capital assets, such as machinery, vehicles, equipment, etc
...

Long-term assets are typically made up from buildings and land
...

The three asset types are, therefore, essentially separated by their liquidity
...
Some assets can be classified one way by one firm and another way by another firm
...
Still, the
classification is important
...


Liabilities
Current liabilities are debts to be paid within the period between balance sheets
...
Current
liabilities consume liquidity
...
These bills include the current portion of notes and
mortgages as well as payables, such as supplies and labour
...
They are notes and money borrowed to purchase
intermediate assets (machinery, breeding stock, equipment)
...
Eg
...


Equity
Equity is what is owned
...
The balance sheet shows
that, after subtracting liabilities from assets, the firm has $450,000 in equity
...
Observing changes and identifying trends helps to identify what good and bad
things are happening to the firm
...
They provide the knowledge, first,
to see if there is a trend; second, to determine whether the trend is good or bad; and third, to take
appropriate action
...
A doctor typically runs through a series of tests and compares
the test results with the patient's condition before the tests, rather than merely concentrating on the test
results
...
The subsequent analysis will identify what the
patient might do to accentuate the good trends and to reduce the bad trends
...
The analysis runs the business
through a series of tests and, like the doctor, needs more than one number to show the complete picture
...
Liquidity is the ability of the firm to meet debts when they
become due
...
These liabilities
include accounts payable, operating loans and the current portion of notes and mortgages
...
Current assets include items such as cash, cash equivalents,
inventory and receivables
...
If there is, the firm is
liquid
...


27
Working Capital is a useful liquidity tool
...
For example, the balance sheet shows a CA of $100,000 and CL of $50,000
...
In other words, after paying all the bills, there is still $50,000of
working capital left
...

Quick Working Capital looks at working capital more critically
...
For instance, growing crops are not as easy to sell as crops in storage
...
Nothing is as liquid as cash
...
CA - inventory - CL is a useful definition of quick working capital
...
Thus, the firm is not as liquid as the working capital of $50,000 implied
...
It is calculated by dividing current assets by current liabilities
(CA/CL
...
5, this means that there is $1
...
Or, there is $1
...
00 of the
firm's bills
...
This
ratio is found by dividing CL by total liabilities (CL/TL)
...
The current debt ratio is, therefore, $50,000/$550,000, or
...
This means that nine cents of
every dollar of debt is due in the next period
...
For an average firm with average
debt, the ratio should be no higher than10 cents
...


Solvency
Solvency is a long-run term
...
If the
firm's assets are greater than its liabilities, it is solvent
...
Equity is the single
best measure of solvency
...

A positive equity trend is a useful indicator of a firm's financial health
...
If the total debt is $550,000,and equity is $450,000
...
2
...
20 in debt
...
5 whenever possible
...
The following examples show its
importance: Suppose, for example, that a firm will get a guaranteed 20 percent return on its assets
...
8 million (that is, $4 million x 1
...
8 million)
...

The firm had no debt
...

The real benefit of borrowing money is that the firm can do things with the money that it could not do

28
otherwise
...
Borrowing money creates leverage
...
Suppose that the firm only has $1 million,
that both assets and equity are $1million and that it has no debt but likes the guaranteed 20 percent
return and decides to borrow some money to take advantage of this investment
...
The firm now has $4 million in assets and
will invest it at 20 percent
...

The $4 million increased to $4
...
But, with the
3-to-1 leverage, the firm's equity has increased from $1 million to $1
...
This is the
joy of leverage
...
67
...
Leverage is, of
course, a two-edged sword
...
So, the
final example illustrates a negative 20 percent return, starting with a leverage ratio of 3
...
But this time it lost 20 percent of
its asset value
...

Assets fell to $3
...
8 = $3
...
The firm still has $3 million in debt
...
And the leverage ratio, which started at 3, has now increased to 15 (that is, 3,000/200)
...
This is an almost impossible position from which to recover
...
High leverage brings high returns if it works but disaster if it does not
work
...


Conclusion
In conclusion, the balance sheet is the essential tool for illustrating a firm's financial structure
...

A firm cannot operate without access to balance sheets
...
A firm will gain
profoundly
...
Or the
benefits should be greater than the costs
...
Therefore the decision rule obviously is; accept only those investments or
financing proposals that enhance the wealth of shareholders ie
...

However the problem here is how this benefits and costs are to be measured and evaluated
...
This lead us to consider the
concept of Time Value of Money
...

A sum of money at present worth more than the same amount at some future time
...


Risk: One thousand rupee now is certain, whereas the same amount receivable next year is
less certain

29
ii
...


iii
...


There are mainly two methods to measure the time value of money namely; Future value and
compounding and present value and discounting
...
Future Value and compounding
Future value is the final accumulated value of a sum of money at some future time period
...
The frequency of calculation of the rate of return is called compounding
...
500 that pays annually a compounded nominal interest rate
of 5 %
...

FV1
...

I = the prevailing rate of interest
...
05)
FV2

FV3

FV4

Future Value

PV0 (1+i)2

FV1 (1+i)

500 (1+0
...
05)

PV0 (1+i)3

FV2 (1+i)

500 (1+0
...
25 (1+0
...
05)4

578
...
05)

551
...
81

607
...
05)5

607
...
05)

638
...
Present Value and Discounting
An alternative way of assessing the worth of an investment is to invert the compounding process to give
the present value of the future cash flows
...
Present value is the current
worth of future cash flows and the process of reducing cash flows to present values is called discounting
...

The NPV shows the residual amount left, when the net amount invested is deducted from the sum of
discounted cash flows over the life of the asset at a desirable rate of discount
...
At the end of one year, the total amount
received is π1 which should include the initial investment π0 plus the additional earnings equal to the
current rate of interest
...
If we
discount the earnings after one year at this rate, we will arrive at the present value of such earnings one
year hence as under

PV π1 = π1/ (1+r)
PV π2 = π2/ (1+r)2
The present value of the series of annuities received over the life of an asset can be thus calculated as:

PV = π1/ (1+r) + π2/ (1+r)2 + π3/ (1+r)3 +
...
Uncertainties can be
minimized through planning and forecasting
...


Meaning of Demand Forecasting
Future is uncertain
...
Since the demand is
uncertain, production, cost, revenue, profit etc
...
Through forecasting it is possible to
minimise the uncertainties
...
It is an
attempt to foresee the future by examining the past
...

Objectives of Demand Forecasting
i
...


ii
...


iii
...


iv
...


To determine financial requirements
...


To determine separate sales targets for all the sales territories
...


To eliminate the problem of under or over production
...


To help the proper capital budgeting
...
All methods can be broadly classified into two
...
Survey methods
Under this method surveys are conducted to collect information about the future purchase plans of
potential consumers
...
Survey methods
are used for short term forecasting
...

(a) Consumers' interview method (Consumers survey): Under this method, consumers are interviewed
directly and asked the quantity they would like to buy
...
This is done by adding up all individual demands
...
When all the consumers are interviewed,
the method is known as complete enumeration method
...
Then demand is estimated after combining the
individual forecasts (sales estimates) of the salesmen
...

(c)Experts' opinion method: This method was originally developed at Rand Corporation in 1950 by Olaf
Helmer, Dalkey and Gordon
...
This method is also known as Delphi
method
...

(d)Consumer clinics: In this method some selected buyers are given certain amounts of money and asked
to buy the products
...
In this way the consumers’ responses to price changes are observed
...
On this basis demand is estimated
...

(e) End use method: This method is based on the fact that a product generally has different uses
...
) is prepared
...
Then the demand of all end users of the product is added to get the total
demand for the product
...
Statistical Methods
Statistical methods use the past data as a guide for knowing the level of future demand
...
These methods are used for established products
...

(i)Trend projection method: Future sales are based on the past sales, because future is the grand-child of
the past and child of the present
...
This method makes use of time series (data over a period of time)
...
The trend in the time series can be estimated by using any one of
the following four methods:(a) Least-square method, (b) Free-hand method, (c) Moving average method
and (d)semi-average method
...
Under these methods the relationship between the sales (dependent variable) and other
variables (independent variables such as price of related goods, income, advertisement etc
...

Such relationship established on the basis of past data may be used to analyse the future trend
...

(iii) Extrapolation: Under this statistical method, the future demand can be extrapolated by applying
Binomial expansion method
...


33
(iv) Simultaneous equation method
...
This method is not
very popular
...
According to this
technique the events of the present can be used to predict the directions of change m the future
...

Personal income, non-agricultural placements, gross national income, prices of industrial materials,
wholesale commodity prices, industrial production, bank deposits etc
...


Methods of Demand Forecasting for New Products
Demand forecasting of new product is more difficult than forecasting for existing product
...
Hence, no historical data are available
...
For this
a research is to be conducted
...
Thus it is very difficult to forecast the demand for new
products
...
Joel Dean has suggested the following methods for forecasting demand of new
products:
1
...
The demand is forecasted on the basis of the demand of
the old product
...

2
...
g
...
Thus the demand for a new product is analysed as a substitute for some
existing goods or service
...
Opinion poll approach: Under this method the demand for a new product is estimated on the basis of
information collected from the direct interviews (survey) with consumers
...
Sales Experience approach: Under this method, the new product is offered for sale in a sample market,
i
...
by direct mail or through multiple shop or departmental shop
...

5
...
The dealers are able to know as to how the customers will
accept the new product
...
The above methods are
not mutually exclusive
...


Demand estimation
-To avoid over production
-Determine its price and promotional policies to secure optimum sales
Finding information about the current demand for a firm’s product is called demand estimation
...
“ (Evans Douglas)
It is a short term process because; the data collected for estimation is only for a short period, usually a
year or less
...
Consumer surveys
Consumer surveys involve questioning a sample of consumers about how they would respond to particular
changes in the price of the commodity, income, price of related commodities, advertising or promotional
expenditures, credit incentives, and other determinants of demand
...
Observational research
This refers to the gathering of information on consumer preferences by watching them buying and using
products
...

Some cases only consumer survey possible
...

3
...
There are certain categories of people namely, salesmen,
market consultants, and professional experts-who know the markets trends
...
Consumer clinics or market stimulation
5
...
Many methods are there
...

Alternatively, the firm could change one at a time, each of the determinants of demand under its control in
a particular market over time and record consumers’ responses
...
Virtual shopping
A novel method of studying consumer tastes and preferences
...
The consumer can see all kinds of products, he can also read its label and
check its content, price etc then he can purchase the product
...


35
7
...
Computer models will imitate human behaviour sufficiently to allow top management to
simulate or test the impact of managerial decisions before implementing those decisions in the real world
...
The factors of production and all other things which the
producer buys to carry out production are called input
...
Thus production is the activity that creates or adds utility and value
...

According to Edwood Buffa,
“Production is a process by which goods and services are created"

Production Function
Production is the process by which inputs are transformed in to outputs
...
The functional relationship between input and output is known as production function
...
In other words, it states the minimum quantities of input that are necessary to
produce a given quantity of output
...
The production function varies with the changes in technology
...
Therefore, in the modern times the output
depends not only on traditional factors of production but also on the level of technology
...
The equation is expressed as follows:
Q= f (L, K, T……………n)
Where, Q = output
L = labour
K = capital
T = level of technology
n = other inputs employed in production
...
In the short run production function the quantity of only one input varies while all other inputs
remain constant
...


Assumptions of Production Function
The production function is based on the following assumptions
...
The level of technology remains constant
...
The firm uses its inputs at maximum level of efficiency
...
It relates to a particular unit of time
...
A change in any of the variable factors produces a corresponding change in the output
...
The inputs are divisible into most viable units
...
The managerial uses of
production function are outlined as below:
1
...
Profits can be maximized only by minimizing
the cost of production
...
The
production function helps in substituting the inputs
...
It helps to determine optimum level of output: The production function helps to determine the
optimum level of output from a given quantity of input
...

3
...

4
...
It also helps in cost control and cost reduction
...


COST FUNCTION
Introduction
The word 'cost' has different meanings in different situations
...
The accounting records end up with the
balance sheet and income statements which are meant for legal, financial and tax needs of the enterprise
...
It is a historical recording which is not of very
much help to the managerial economist in his business decision-making
...
The decisionmaking concepts of cost aim at projecting what will happen in the alternative courses of action
...
These decisions
necessitate profitability calculations for which a comparison of future revenues and future expenses of
each alternative plan is needed
...

Knowledge of the cost-output relation helps the manager in cost control, profit prediction, pricing,
promotion etc
...

TC = F(Q)
Where
TC = Total cost
Q = Quantity produced
F = function

37
The production function combined with the prices of inputs determines the cost function of the firm
...

In economic theory, the short-run is defined as that period during which the physical capacity of the firm is
fixed, and during which output can be increased only by using the existing capacity more intensively
...


Short-run Cost-Output Relation
The cost concepts made use of in the cost behaviour are total cost, average cost and marginal cost
...
It is the summation of fixed and
variable costs
...
e
...
remains
fixed
...
e
...
vary with the variation in
output
AC =TC / Q
Or it is the total of average fixed cost (TFC / Q) and average variable cost(TVC/Q)Marginal cost is the
addition to the total cost due to the production of an additional unit of product
...
It can be arrived at by dividing the change in total cost by the change in total
output
...
Hence change in total cost implies change in total
variable cost only
...
Fig
...
TFC curve is a horizontal straight line
representing Rs
...
TC = TFC+TVC
...
As
TFC remains constant the gap between TVC and TC will always be the same
...


Long-Run Cost-Output Relations
Long-run is a period long enough to make all inputs variable
...
The firms are
able to expand the scale of their operation in the long-run by purchasing larger quantities of all the inputs
...
The long-run cost-output relations therefore imply the
relationship between total costs and total output
...
In the long-run a firm has a number of alternatives in regard to the scale of operations
...
Hence the
long-run average cost curve is composed of a series of short-run average cost curves
...
At any one time the firm has only one size of plant
...
Any increase in production in that period is possible only with that plant
capacity
...
But in a long period the firm can move
from one plant size to another
...


The long-run cost-output relationship is shown graphically by the LAC curve
...
In the fig
...
3 we have assumed that there are only three sizes of

39
plants-small, medium and large, S ACj refers to the average cost curve for the small plant, S AC, for the
medium size plant andSAC3 for the large size plant
...
For an output beyond OQ the firm will opt for medium size plant
...
For an output OR the firm will choose the large plant
...
The LAC curve drawn will be tangential to the three SAC curves i
...
the LAC curve touches each
SAC curve at one point
...

No point on any of the LAC curve can ever be below the LAC curve
...
The plant which
yields the lowest average cost of production will be selected
...

In the long-run the demand curve of the firm depends on the law of returns to scale
...

It implies that when production increases, per unit cost first’ decreases but ultimately increases
...
Like SAC curve LAC curve also is U shaped, but it will
be always flatter then SAC curves
...
The increasing
return is experienced on account of the economies of scale or advantages of large-scale production
Increase in scale makes possible increased division and specialization of labour and more efficient use of
machines
...


ECONOMIES OF SCALE
INTRODUCTION
In the long run when scale of production is increased firm gets economies of scale up to a point
...
Economies of scale refer to advantages of large scale production
...

Diseconomies are the disadvantages which a faces when the scale of production is expanded beyond a
certain level diseconomies may be of two types- internal and external diseconomies
...
Internal Economies and Diseconomies
We saw that returns to scale increase in the initial stages and after remaining constant for a while, they
decrease
...
The answer is that initially a
firm enjoys internal economies of scale and beyond a certain limit it suffers from internal diseconomies of
scale
...

As the firm increases its scale of operations, it becomes possible to use more specialised and efficient form
of all factors, specially capital equipment and machinery
...
Secondly, when the scale of production is increased and the amount of
labour and other factors become larger, introduction of a greater degree of division of labour or
specialisation becomes possible and as a result cost per unit declines
...
This happens because
when the firm has reached a size large enough to allow utilisation of almost all the possibilities of division
of labour and the employment of more efficient machinery, further increase in the size of the plant will
bring high long-run cost because of difficulties of management
...

(ii) Managerial economies and diseconomies: Managerial economies refer to reduction in managerial
cost
...
The production manager
can look after production, sales manager can look after sales, finance manager can look after finance
department
...
g
...

Since individual activities come under the supervision of specialists, management’s efficiency and
productivity greatly improve
...
Thus specialisation of
management enables large firms to achieve reduction in managerial costs
...
Management finds it difficult to exercise
control and bring coordination among various departments
...
All these affect the efficiency and productivity of management and the firm itself
...
This enables the firm to place a bulk order for materials and components and
enjoy lower prices for them
...
If the sales staff is not
being worked to capacity, additional output can be sold at little extra cost
...
As scale of production increases, advertising costs per unit of
output fall
...

These economies become diseconomies after an optimum scale
...

(iv) Financial economies and diseconomies: In raising finance for expansion large firm is in favourable
position
...
However, these financial costs will rise more proportionately after the optimum scale of
production
...

(v) Risk bearing economies and diseconomies: It is said that a large business with diverse and multiproduction capability is in a better position to withstand economic ups and downs, and therefore, enjoys

41
economies of risk bearing
...


II
...
They are internal in the sense that they accrue to the firm due to its own
efforts
...

External economies and diseconomies are those economies and diseconomies which accrue to firms as a
result of expansion in the output of whole industry and they are not dependent on the output level of
individual firms
...
e
...
These are available to one or more of the firms in the form of :
1
...
Expansion
of an industry results in greater demand for the various kinds of materials and capital equipment required
by it
...
This reduces their cost of
production and hence their prices
...

2
...
This will change the technical co-efficient of production and will enhance productivity of firms in
the industry and reduce their cost of production
...
Development of skilled labour : When an industry expands in an area the labour in that area is well
accustomed to do the various productive processes and learns a good deal from the experience
...

4
...
They can provide them at a lower price
to the main industry
...
This will tend to reduce the cost of production in
general
...
Better transportation and marketing facilities: The expansion of an industry resulting from entry of new
firms may make possible the development of transportation and marketing network to a great extent
which will greatly reduce cost of production of the firms
...

However, external economies may also cease if there are certain disadvantages which may neutralise the
advantages of the expansion of an industry
...
An example of external
diseconomies is the rise in some factor prices
...
This may result in pushing up the prices of such factors of production specially when they are short in
supply
...
The government may also through its locational policy
prohibit or restrict expansion of an industry at a particular place
...
It is an alternative method used to
avoid tough competition
...

PRICE LEADERSHIP
Price leadership is a feature of oligopolistic situation
...
Price leadership can be seen when most or all of the firms in an
industry decide to sell their product at a price fixed by one among them
...
These price followers simply accept the price fixed by the price leader and adjust their
output to this price
...
Its leadership may be established as a result of price-war in which it emerges as
the winner
...

Instead there will be some agreement among the various firms with regard to the price that is to be
charged
...
There may be a formal
agreement among the various firms to follow the price fixed by a leader chosen from among them
...


The price and output decisions are illustrated in the above figure
...
These two firms are producing
homogeneous products and are having equal share in the market
...
DD is the demand curve facing each firm which
is half of the total demand curve for the product
...
MC, is the
marginal cost curve of firm A and MC2 is the marginal cost curve of the firm B
...
If the price is fixed independently each firm
will fix a price at which MC=MR
...
But in
the oligopolistic market the firm B cannot make maximum profit by fixing the price as OP, The firm B is to
fix its price as OP, the price the low cost firm A has fixed
...
While A makes maximum profit, B is to be satisfied with a lower profit
...

TYPES OF PRICE LEADERSHIP
The following are the important types of price leadership
...
Price Leadership of the Dominant Firm
One firm controls a major portion of the total market supply and hence dominates the entire market
...
The dominant firm fixes the price and the
other firms simply accept this price
...
The leader fixes a price that will give it maximum profit
...
Barometric Price Leadership
In the barometric price leadership an old experienced firm, not necessarily dominant one, assumes the
role of a leader and fixes a price acceptable to all the firms in the industry
...
The leader, while fixing the price, does not look after its own interest rather it
considers the interest of all the firms in the industry
...

3
...
For this it may use both legal and illegal methods
...

FEATURES OF A PRICE LEADERSHIP FIRM
(i) The firm has a considerable share in the total market supply
...

(iii) The firm has initiative in taking timely action after considering the various factors
...

MERITS and PROBLEMS of PRICE LEADERSHIP
MERITS
(i) Price war leading to unhealthy competition among the various firms can be avoided
...

(iii) Helps to reduce uncertainty in the oligopoly market situation
...

(v) It helps to avoid government interference or any public criticism
...

PROBLEMS
(i) If the leader is not able to make a correct estimation of the reactions of his followers he may lose his
leadership
...
This price cutting may be in the form of discounts and
rebates, credit facilities, after-sales services, 'money back' guarantee, easy instalment facilities etc
...

(iii) Even when the rival firms follow the price fixed by the leader they may indulge in 'non-price
competition' to increase their sales
...
This non-price competition may be possible with the concessions

44
mentioned above
...

help this
...


PRICE DISCRIMINATION OR DISCRIMINATING MONOPOLY
Price discrimination refers to the practice of selling the same product at different prices to different
buyers
...
Robinson defines it as "charging different price for the same product or same price for
differentiated product"
...
Stigler defines price discrimination as "the scale of technically similar
products at prices which are not proportional to Marginal costs"
...
Price
discrimination is personal when a seller charges different prices for different persons
...
Price discrimination is local when the seller charges different prices for people of
different localities
...
Discrimination is according to use when the same commodity is put to different uses
...

Degrees of price discrimination
Prof
...
C
...

i
...

ii
...

iii
...

i
...
Price discrimination of the first degree is said to occur
when the monopolist is able to sell each separate unit of the output at a different price
...

At price Rs
...
9 the buyer would purchase 2
units of the good; at price of Rs
...
7 he would take 4
units of the good and so on
...
7 the buyer buys 4
units then he would Rs
...
By doing so, he gets a consumer surplus of Rs
...
This is
so because; the buyer is willing to pay Rs
...
9 for the second, Rs
...

7 for the fourth
...
34
...
28
...
34
...

ii
...

iii
...
The price charged in the sub-market need not be the lowest demand
price of that sub-market
...
The nature of the commodity should be such as to enable the monopolist to charge different prices
...
For example, doctors charge different fees for the rich and for the poor for same service
...
When the markets are separated by long distance or tariff, then price discrimination is possible
...
For example, a commodity maybe sold at Rs
...
20 in Madras
...
10 it is not profitable for the
consumers to transport the commodity from Delhi to Madras on their own
...

3
...
For example, electricity board
charges a lower price for industrial purposes and a higher price for domestic purposes
...

3
...
Different prices are
charged for different varieties although they differ only in label or name
...

4
...
If a seller is
discriminating between two markets but the buyers are ignorant that the seller is selling the product at a
lower price in another market, price discrimination is possible
...

5
...
For example, railways charge different rates for carrying coal, cotton, silk and fruit even
though the service rendered is the same for all
...
A monopolist can easily charge discriminating prices when goods are being supplied to special orders
...
It is obvious that price discrimination
can be practised only under imperfect competition
...
Under perfect competition, the seller has to take the market price as given
...
The possibility of price discrimination under perfect competition exists
only if all sellers are combined together
...

Price discrimination can occur under conditions of imperfect or monopolistic competition
...
When there is monopoly, the market
imperfection is maximum and the possibility of price discrimination is also maximum
...


METHODS OF PRICING
There are four basic pricing policies
...
Cost-based pricing policies
...
Demand - based pricing policies
...
Competition - based pricing policies
...
Value-based pricing policies
...
Cost-based pricing policy
The policy of setting price essentially on the basis of the total cost per unit is known as cost-oriented
pricing policy
...
The following are the
four methods of pricing which fall under cost-oriented pricing policy
...
Cost plus Pricing: The theory of full cost pricing has been developed by Hall and Mitch
...
They determine price on the basis
of full average cost of production AVC + AFC margin of normal profit
...
Under the method, the price is fixed to cover all costs
and a predetermined percentage of profit
...
Under this method, cost includes production cost (both
variable and fixed) and administrative and selling and distribution cost (both variable and fixed)
...

ii
...
Under this method, the cost is added with a
predetermined target rate of return on capital invested
...
This method is also known as
rate of return pricing
...
Marginal Cost Pricing: Under both full cost pricing and rate of return pricing, the prices are set on the
basis of total cost (variable cost + fixed cost)
...
In this method, fixed costs are totally excluded
...
Break even pricing: this is a form of target return pricing
...
Under break even pricing, break even analysis is used for point
...
The firm first determines the breakeven point
...
Thus, both variable cost and fixed cost are covered under this methods but it does not include any
profit
...
It helps in determining that
volume at which the company’s cost and revenue are equal
...
It shows the effects on profit of changing the amount invested in advertisement of
changing the sales compensation methods of adding a new product or of changing a marketing in focusing
channel this methods of pricing helps the marketer in a calculating output or sales to earn a desired profit
calculating margin of safety changes in price making decisions, and changes in cost and price et
...
Demand - based Pricing Policy
Under this pricing policy, demand is the basic factor
...
In short, the price is fixed according to the demand for product
...
When the demand is low, a low price is charged
...
Differential pricing: Under this method the same product is sold at different prices to different
customers, in different places and at different periods
...
Telephone authorities charge less for trunk calls at night than during
day
...

ii
...
This method reveals price-quantity mix that maximizes total profit
...

iii
...
It is based on the principle that the product or
brand should be positioned at the top of the market and must offer greater qualitative terms than similar
brands in other price segments
...
The BPL, group followed this when they
invaded the refrigerator market with a Rs
...

The other companies which follow premium pricing include Titan, Sony TV, Arial and Dove Conditioner
...
Neutral Pricing: It means offering extra value or benefits with the brand cost or price remaining
competitive
...

3
...
This policy does not
necessarily mean setting of same price
...
Actually this policy implies that the firms 'pricing decisions
is not based on cost or demand, prices are changed or maintained in line with the competitor’s prices
...

i
...
The firm adjusts its own prices to suit the general price structure in the industry
...
This method is
usually adopted by firms selling homogeneous product in a highly competitive market
...
This method is also called
acceptance pricing or market equated pricing or parity pricing
ii
...
For example, the price of a cup of tea or coffee is customarily fixed
...
The price will change only when the cost changes significantly
...
Customer prices may be maintained
even when products are changed
...
Thus, under this method, the existing price is maintained as long as possible
...
Sealed bid pricing: In all business lines when the firms bid for jobs, competition based pricing is
followed
...
The firm fixes its prices on how the competitors
price their products
...

4
...
The following are the pricing methods based
on customer value
...
Perceived - value pricing: Another method is judging demand on the basis of value perceived by the
consumers in the product
...
When a company develops a new
product it anticipates a particular position for it in the market in respect of price, quality and service, 'Then
it estimates the quality it can sell at this price
...
If it appears to be so, the company goes
ahead with translating the perception into practice, otherwise it drops the proposal
...
In the case of new
products there is no past information for ascertaining trends and consumer reaction
...
In the case of pioneer product, the
estimation of its demand is very difficult
...

In pricing a new product, generally two type are followed (a) Price Skimming
When a new product is introduced in the market, the firm fixes a price much higher than the cost of
production
...
The high price charged helps to skim the cream off the market at a time when there is no
competition this is possible because the newly introduced product reached the hands of the consumers
after a long waiting and by the time it comes to the market a heavy demand for the same has
accumulated
...
This market situation
will not continue for long
...
In the long run the number
of enthusiastic buyers who are ready to buy at a high price will decrease
...
But
gradually when more and more new producers imitated these products their price came down
...
The price skimming policy is followed as long as there is heavy
demand without any competition from a rival
...
In the long run the possibility of making huge profit by price skimming disappears
...
Under the following situations the price skimming
policy can be easily followed
...

(ii) The product is meant for the higher income group whose demand is inelastic
...

(iii) There are heavy initial promotion expenses and the firm wants to realise it from the customers before
other competitive firms-enter in
...

(b) Penetration Pricing
The price fixed is relatively a lower one
...
When the new firm enters an existing market where
there are a number of firms it has to penetrate the market and achieve an acceptance for its product
...
The penetration price may be sometimes below the cost of production
...
A few,
important of them are explained below
...
Costs and other factors
are important in pricing
...
Costly items diamond, jewellery etc
...
They demand highly priced items
...
Then in the retail shops another pricing 'odd pricing' issued
...
19
...
20; Rs
...
90 instead of Rs
...
An article priced at Rs
...
90 will have more sales than when it is priced
Rs
...

2
...
The prices
are fixed to suit local conditions
...
Manufacturers
cannot control the price
...
Certain business people reduce
the size of the product, if the cost of manufacturing increases, Sometimes, the firm changes the price by
adopting new package, size etc
...

3
...

The products, when introduced in the market have a limited period free from other manufacturers
...
Generally, the
price moves downwards are when competitors enter into the market field
...
Penetration Pricing: A low price is designed in the initial stage with a view to capture market share
...
Because of the low price, sales value increases, competition falls down
...
Geographical Pricing: The distance between the seller and the buyer is considered geographic pricing
...
The majority producing centres are located in
Bombay, Delhi, Calcutta and Madras and at the same time consuming centres are dispersed throughout
India
...

(a) F
...
B
...
(b) Zone Pricing: Under this, the company
divides the market into zones and quotes uniform prices to all buyers who buy within a zone
...
The price in one zone varies from that of another one
...
The price is quoted by adding the transport cost
...
One or more cities are
selected as points from which all shipping charges are calculated
6
...
But this price is set by the management after
considering all relevant factors
...
Usually the administered price remains unaltered for a considerable
period of time
...
Dual Pricing: under this dual pricing system, a producer is required compulsorily to sell a part of his
production to the government or its authorized agency at a substantially low price
...

8
...
This method is generally adopted by
wholesalers and retailers
...
For example, the cost of an item Rs
...
13 the Mark up is Rs
...

9
...
Pricing
decisions are made initially and remain constant for a long period
...
Many prices are not desired and the prices should not be too close to
each other or too far from each other
...

120,140, 170 etc
...

10
...
The price is not fixed
...
In certain cases, the product may be prepared on the basis of specification or design by the
buyer
...

11
...
The probable expenditure is worked out then the after
offer is made quoting the price, which is also known as contract price
...


51
12
...
When a new product moves to the market, its price is monopoly price there no problem is no
competition or no substitute
...




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