Supply and Demand

1. A firm's current profits are $1,000,000. These profits are expected to grow indefinitely at a constant annual rate of 3.5 percent. If the firm's opportunity cost of funds is 5.5 percent, determine the value of the firm:

Instructions: Round your responses to 2 decimal places.

a. The instant before it pays out current profits as dividends. $ million

b. The instant after it pays out current profits as dividends.

$ million
(page 18)
Explanation:
a. The value of the firm before it pays out current dividends is:

PVfirm = $1,000,000((1 + 0.06) / (0.06 - 0.04) = $52.75 million

b. The value of the firm immediately after paying the dividend is:

PVEx-Dividend firm= $1,000,000((1 + 0.04) / (0.06 - 0.04) = $51.75 millio

2, What is the value of a preferred stock that pays a perpetual dividend of $215 at the end of each year when the interest rate is 8 percent?

Instruction: Round your response to the nearest dollar.

$
The dividend divided by the interest rate explanation: The present value of the perpetual stream of cash flows. This is given by PVPerpetuity = CF / i = $215 / 0.08 = $2,688.

3. Jaynet spends $20,000 per year on painting supplies and storage space. She recently received two job offers from a famous marketing firm – one offer was for $105,000 per year, and the other was for $85,000. However, she turned both jobs down to continue a painting career. If Jaynet sells 35 paintings per year at a price of $6,000 each:

a. What are her accounting profits?

$

b. What are her economic profits?

$

Explanation:
a. Her accounting profits are $190,000. These are computed as the difference between revenues ($210,000) and explicit costs ($20,000).

b. By working as a painter, Jaynet gives up the $105,000 she could have earned under her next best alternative. This implicit cost of $105,000