Considerations on FINANCIAL INDECES

enrico-furia1

 

 

di Enrico Furia


 

Summary

A) Cost/Benefit Analysis

B) The Relationship between Profit and Utility

C) Game Theory: Zero-sum Games and Non-zero-sum Games

D) Chaos Theory: from Chaos to Attractors

 

 

 

 

 

 

MARGINAL ANALYSIS (see Neoclassical Economics)

MARGINAL COST

MAGINAL COST OF FUNDS SCHEDULE

MARGINAL COST PRICING

MARGINAL DISUTILITY

MARGINAL EFFICIENCY OF CAPITAL

MARGINAL EFFICIENCY OF CAPITAL SCHEDULE

MARGINAL EFFICIENCY OF INVESTMENT

MARGINAL EFFICIENCY OF INVESTMENT SCHEDULE

MARGINAL PER CAPITA REINVESTMENT QUOTIENT CRITERION

MARGINAL PHYSICAL PRODUCT

MARGINAL PRODUCT

MARGINAL PROPENSITY TO WITHDRAW

MARGINAL RATE OF SUBSTITUTION

MARGINAL RATE OF TRANSFORMATION

MARGINAL REVENUE

MARGINAL REVENUE PRODUCT

MARGINAL UTILITY

MARGINAL UTILITY OF INCOME, OR MARGINAL UTILITY OF MONEY

NET PRESENT VALUE

CASH FLOW

WORKING CAPITAL

WORKING CAPITAL RATIO

RATE OF RETURN

RETURN ON INVESTMENT

RETURN ON ASSET

RETURN ON EQUITY

RETURN ON SALES

RETURN ON EMPLOYMENT

 

 

MARGINAL ANALYSIS 

Marginal Analysis is a body of economic theory which uses the general approach methods and techniques of the original nineteenth century marginalist economists, or neo-classical economists.

The term neo-classical derives from the view that the originator of the so-called ‘marginalist revolution’ were extending and improving on the basic foundations of the classical economists such as D. Ricardo and J.S. Mill. 

The founders of the neo-classical system, J.M. Clark, F.Y. Edgeworth, I: Fisher, A. Marshall, V. Pareto, L. Walras and K. Wicksell used marginal analysis (the concept of marginal utility and marginal productivity) to analyse the pricing of goods, services and factors of production in competitive markets. They emphasised that the market prices of goods and factors were related to their scarcity. In particular they studied the possibility of a set of market prices which ensured the quality of supply and demand in all markets. The idea of a perfectly competitive economy in equilibrium, which may be attributed especially to Walras, is central to the neo-classical scheme.

The macroeconomic approach to describing the economy is a distinguishing characteristic of this neo-classical theory. Prices of commodities, derived from individual rational maximising behaviour in markets, distinguishes this approach from both classical economics and Keynesian economics.

While classical economics was concerned with long run developments of economies as a whole, and in particular the relationship between the distribution of the economic surplus and the pattern of development, neo-classical value theory became essentially a theory of the allocation of scarce resources in a static economy. In common with many classical theorists the nineteenth century classical economists accepted that there exist market forces which tend to maintain full employment

This contrasts sharply with the Keynesian view that involuntary unemployment may exist even in spite of market forces. Modern neo-classical economics may be said to incorporate most of the central ideas of its founders.

 

 

MARGINAL COST

It is the extra cost of producing an extra unit of output. Algebraically it is written

ΔC

MC = ——

ΔX

where Δ means ‘a small change in’, C is total cost and X is output. In the short run the marginal cost curve slopes upwards due to the operation of the law of diminishing returns. Note also that marginal cost cannot be affected by the level of fixed costs. Quite simply, if an extra unit of output is produced, fixed costs do not change and hence extra fixed costs must be zero. It follows that marginal cost is determined by variable costs only. In the long run marginal costs may rise, fall or stay constant depending on the presence of economies or diseconomies of scale.

 

 

MAGINAL COST OF FUNDS SCHEDULE

It is the schedule detailing the true cost of financial capital to the enterprise. In an imperfect capital market the true cost will exceed the interest rate. Firms can raise money to finance investment from many sources and the cost of finance will vary with the source. The least expensive source of finance may be the firms retained profits or its depreciation fund. More expensive will be a right issue or new issue of equities or borrowing on fixed interest.

 

 

MARGINAL COST PRICING

Marginal Cost pricing is a practise pursued by private firms or public corporations in which price is made equal to marginal cost. Giving continuous revenue and cost curves, this imply setting price at the point at which the demand curve cuts the marginal cost curve. The market conditions prevailing in perfect competition ensure marginal cost pricing since average and marginal revenue are the same. Hence the requirement for profit-maximisation, that marginal cost be equal to the marginal revenue, means that price equals marginal cost. Under imperfect competition, however, profits will not be maximised with price equal to marginal cost since average revenue will exceed marginal revenue. Hence marginal cost pricing under imperfect competition will only come about through some format of regulation or taxation. In the public sector, nationalised industries are recommended to use marginal cost pricing, the rational being that it maximises economic welfare.

 

 

MARGINAL DISUTILITY

Marginal disutility is the extra non-utility  resulting from a small change in some variable.

 

 

MARGINAL EFFICIENCY OF CAPITAL

It is that unique rate of discount which would make the present value of the expected net returns from a capital asset just equal to its supply price when there is no rise in the supply price of the asset. The term originates with Keynes and is sometimes known incorrectly as the internal rate of return. This latter concept is distinct in that it takes specific account of the fact that the supply price of capital assets will rise in the short run as all firms simultaneously seek to increase the size of their capital stock.

 

 

MARGINAL EFFICIENCY OF CAPITAL SCHEDULE

The schedule detailing the long-run equilibrium relationship between the desired capital stock and the interest rate. At all points along this schedule the marginal efficiency of capital is just equal to the interest rate. The schedule is downward sloping reflecting diminishing returns to capital stock.

At the firm level this schedule is sometimes considered to represent the demand curve for capital.

However, it cannot do so for the concept of the marginal efficiency of capital takes no account of the rising supply price of capital assets the firm will encounter in the short run.

 

 

MARGINAL EFFICIENCY OF INVESTMENT

Also known as the Internal Rate of Return.

That rate of discount which would make the present value of the expected net returns from the capital asset just equal to its supply price where it is recognised that this price will rise in the short run.

 

 

MARGINAL EFFICIENCY OF INVESTMENT SCHEDULE

It is the demand curve for investment.

The schedule detailing the relationship between the marginal efficiency of the investment and the interest rate. Investment will be carried on until this point in the short run while in the long run the equilibrium of the capital stock is given by the point of equality of the marginal efficiency of capital and the interest rate. In contrast to the marginal efficiency of capital schedule this schedule describes a flow and not a stock relationship.

 

 

MARGINAL PER CAPITA REINVESTMENT QUOTIENT CRITERION

It is an investment criterion with the objective of maximising income per head at future date. It states that the best allocation of resources will be achieved by equating the marginal per capita reinvestment quotient of capital in each of its uses. It is assumed that profits are reinvested and wages consumed. Gross productivity per worker minus consumption per worker determines the gross amounts per worker available for reinvestment. The criterion thus favours projects where profits are high. The development objective underling the criterion has been criticised as being unrealistic. Governments are likely to wish consumption to increase in near future as main objective. The use of the criterion will not give priority to increasing employment which may well be considered a main objective.

 

 

MARGINAL PHYSICAL PRODUCT

This is defined as the addiction to total output resulting from the employment of an additional unit of labour, and may be derived from the production function, holding other factors fixed. The marginal physical product schedule may be regarded as the demand curve for labour. Labour is employed up to the point at which the payment to the last unit is equal to the output product produced by the last unit. It is more conventional by means of simple change in scale to convert marginal physical product into value of marginal physical product namely by multiplying the former by product price (See marginal revenue product). If there is a rise or fall in the wage, then the number of units of labour employed will fall or rise according to the slope of the marginal physical product/value of marginal physical product schedule. In the long run, labour demand will still be determined by labour’s marginal physical product although in a more complex fashion, A wage rise, for example, will have a negative substitution effect as the firm substitutes cheaper capital for the more expensive labour, thereby reducing the quantity of labour demanded. There will also be a negative scale effect as a wage increase leads to a higher marginal cost of production which in turn reduces the firm’s optimal output and hence derived demand for labour. The two effects reinforce each other to lead to an unambiguously inverse relationship between wages and the firm’s demand for labour. This demand curve is more elastic than the short run demand.

 

 

MARGINAL PRODUCT

The extra output obtained by employing one extra unit of a given input (factor of production). Thus the term should be qualified with respect to which input is in question –e.g. the marginal product of labour, the marginal product of capital, etc,.

 

 

MARGINAL PROPENSITY TO WITHDRAW

The change in withdrawals (W) as a result of one additional unit of income (Y), which may be written as

ΔW

MPW = ——

ΔY

 

It is the proportion of any extra unit of income that is not passed on in the circular flow of income.

 

 

MARGINAL RATE OF SUBSTITUTION

In consumer demand theory the marginal rate of substitution refers to demand of one good, say Y, that is required to compensate the consumer for giving up an amount of another good, say X, such that the consumer has the same level of welfare (utility) as before. In indifference curve analysis it is, in fact, the slope of the indifference curve which, in terms, is equal to the ratio of the marginal utilities of the two goods in question, i.e.

MU x

MRS x, y    = ——

MU y

The terms derives from J.R. Hicks’ Value and Capital (Oxford University Press, 1939).

Other writers prefer different terminology and the MRS is sometimes referred to as the personal rate of substitution, or the rate of commodity substitution.

 

 

MARGINAL RATE OF TRANSFORMATION

The numerical value of the slope of the production possibility frontier. The marginal rate of transforming good A into good B is the fall in the rate of output of good A which permits an additional units of good B to be produced. It is equal to the ratio of the marginal cost of good B to the marginal cost of good A.

 

 

MARGINAL REVENUE

Is the change in total revenue arising from the sale of an additional unit of output. In perfect competition marginal revenue will equal price because the firm faces an infinitely elastic demand curve, i.e. it can sell any amount of output at the prevailing market price. Within market structures such as imperfect competition, the firm faces a downward sloping demand curve and thus in order to sell an additional unit of output, it must reduce the price on all the output it sells. Marginal revenue will then be equal to the new price minus the fall in revenue on those units which would otherwise have sold at the higher price. Marginal revenue is an important concept in the analysis of the firm. A necessary condition of profit maximising equilibrium is that marginal revenue be equal to marginal cost.

 

 

MARGINAL REVENUE PRODUCT

The marginal physical product multiplied by the marginal revenue from the sale of the extra unit of output from the employment of the extra unit of input. Under perfect competition price equals marginal revenue, so that we can write

 

MRP = MPP.P

 

Where MPP is marginal physical product and P is price. Under imperfect competition, however, price does not equal marginal revenue and it is necessary to modify the equation to

 

MRP = MPP.MR

 

Where MR is the marginal revenue associated with the sale of the extra units of output.

 

 

MARGINAL UTILITY

Its the extra utility obtained from an extra unit of any good.

Mathematically expressed as

ΔU

MU = ——–

ΔX

 

where U is utility, X is the amount of a good, and ‘Δ’ is a ‘small change in’.

 

 

MARGINAL UTILITY OF INCOME, OR MARGINAL UTILITY OF MONEY

Indicates the rate at which an individual’s utility increases as his personal budget (income) is expanded by unit (£1, $1, etc.). When consumers maximise utility it will be the case that the marginal utility of each good purchased will equal its price multiplied by the marginal utility of money. Strictly speaking, the term is better defined as the marginal utility of income since money as money has particular attributes which affect the utility it may provide to someone holding it.

Marshall assumed the marginal utility of money is constant –i.e. did not change as the price of goods in an individual’s shopping basket’ changed.  This was held to be reasonable as long as the items in question formed a small proportion of the consumer’s budget. Otherwise it is not.

 

 

NET PRESENT VALUE

Is the sum that results when the discounted value of the expected cost of an investment are deducted from the discounted value of the expected returns. That is, if the discount rate is r, the return in year is R1, the return in year 1 is C1 and so on, then the net present value is given by the formula:

 

t = T     R t – C  t

NPV =  Σ ——-

t = 0    (1 + r)t

 

If the NPV is positive the project in question is potentially worth undertaking. The precise rule for acceptance or rejection, however, will depend on the method of ranking all available options which have positive net present values and this can require the use of programming techniques. In macroeconomics, the net present value approach can be found in the classical approach to investment appraisal originated by Irving Fisher. In contrast, Keynes adopted the marginal efficiency of capital  approach which essentially begins in the same way but does not require the adoption of a discount rate for the purposes of discounting. Rather it asks what rate of discount will equate the two discounted streams of returns and costs. The result then has to be compared with some rate of interest. (See Marginal Efficiency of Investment).

 

 

CASH FLOW

It is the sum of retained earnings and depreciation provision made by firms. As such it is the source of internally generated long term funds available to the company.

In other words it is the in and out flow of money payments made and received from the firm in a determined period, which can be used for investments, after having deducted all the business costs.

 

 

PAYBACK RATIO 

This is the ratio of total capital investment to cash flow.

This calculation can be defined in real terms as the number of years it takes the cash flow from the product to repay the total capital investment (total capital project expenditures plus deferred business development costs plus total assets transferred to the product) and the incremental net working capital.

 

 

WORKING CAPITAL

It generally refers to the amount of current assets which is financed from long-term sources of finance. Gross working capital is alternatively defined as the sum of all current assets while net working capital is the amount by which current assets exceed current liabilities. The size of working capital is an indicator of the liquidity and solvency of a company, particularly when related to other financial indicators in the form of financial ratios.

 

 

WORKING CAPITAL RATIO

This is found by dividing current liabilities into current assets. It is the measure of a firm’s liquidity. If the ratio exceeds unity, the company can meet its current liabilities in full as they fall due. The ratio may frequently be misleading, however, as the constituent figures are taken from the balance sheet of the company. The data on the latter are only past values and do not represent the present. Neither is information presented about the timing of receipts and payments (See Quick Asset Ratio).

 

QUICK ASSET RATIO

This is the ratio of liquid assets to current liabilities. Liquid assets are cash, most term investments which can be quickly realised and account receivable where an allowance is made for bad debts. Stock is not included as it may not be readily realisable. This concept is a refinement on the working capital ratio but still does not present an entirely up-to-date picture of the current situation.

It also ignores the inflows and outflows of cash which are of great importance to the liquidity of a company.

 

RATE OF RETURN

A general concept referring to the earnings from the investment of capital, where the earnings are expressed as a proportion of the outlay. The term is applied to a wide variety of situations in economics. It can refer to the earnings from the investment of physical capital, money capital and also the return to investment in human capital.

The term is most frequently applied to the rewards from capital expenditure by business. The definition employed unfortunately varies among users. Accountants and businessmen have traditionally had a different definition compared to economists, but there is now a tendency for the economist’s definition to become more widely accepted. The traditional approach of businessmen and accountants is to define the term as the ratio of profit to capital employed. Profits have been defined in various way for this purpose, but the most sensible is net profit after taxation and depreciation. Profits can refer to the initial year’s profits or to the average over the lifetime of the project. The initial year’s profits may be quite unrepresentative and average profit is clearly more sensible. Capital has been defined as either the initial capital expenditure on a project including working capital, or average capital employed over the project’s lifetime. The latter definition is superior. The profits figure expressed as a percentage of the capital figure gives the rate of return on capital employed. It is compared with the firm’s cost of capital.

Economists do not find the above concept very helpful in assessing the rewards to capital investment. The approach does not take into account the timing of the cash flows. A project, which generates a given total income a number of years earlier than a second project, is obviously more attractive: the funds can be reinvested to earn further income. For this reason economists prefer the concept known as the ‘internal rate of return’. This concept explicitly takes into account the timing of the cash flows from a project. It is the discounted rate which makes the net present value of a project equal to zero. It is conventionally known as the solution for r in the following equation:

 

i = n

C =   ∑    V   i

i = 1   (1+r)2

 

 

where C refers to the initial capital expenditure in the initial time period and V refers to the net cash flow from the project in any year of its life. If the solution for r is 10 per cent this indicates that the capital expenditure can be recovered and a 10 per cent return on the outstanding balance of the capital attained over its lifetime. The internal rate of return is compared with the company’s cost of capital in order to determine whether a proposed project should be accepted or not. This method of appraising projects also has some drawbacks. It does not give an indication of the amount of wealth generated from a project. (This is better indicate by use of the net present value method). Further, there are sometimes multiple rates of return. These may occur when there is more than one change of sign in the pattern of net cash flows over the lifetime of the project. The internal rate of return is sometime known as the discounted cash flow yield and the investor’s yield. The calculated rate of return is not a precise measure of the return to capital in a business, as it is not really possible to separate out the returns to each factor of production (See Net Present value).

 

 

RETURN ON INVESTMENT

It is computed as follows:

Average Net Income after Taxes

R.O.I. = ————————————————————————————————–

[(Capital expenditures, plus assets transferred, plus residual asset value): 2]

plus average working capital.

 

 

RETURN ON ASSET

It is to be calculated as shown below:

 

Net Income after Taxes for the Period Annualised x 100

R.O.A. = ——————————————————————-

Total Assets at the End of the Period

 

 

RETURN ON EQUITY

It is a financial return of a company and corresponds to the following ratio:

 

Average Net Income after Taxes

—————————————

Net Working Capital

 

 

EARNINGS PER SHARE

This is a measure of the total earnings of a company in its ordinary share capital and is calculated by dividing net income by the number of ordinary shares. Net income represents gross income less deductions for depreciation, interest payments, the earnings of preference shares and corporation tax liability.

Earning per share is in most cases higher than dividends per share, because the firm in general chooses to distribute only a part of these (distributed profits), which are that part of net profit released by the firm in the form of dividend payments to the owners of equity capital.

Dividend is a payment to shareholders in a company, either in the form of cash or shares. A cash dividend is a payment made out of profits after corporation tax and after interest to debenture holders has been paid. Dividends to preference shareholders are also paid before payments to ordinary shareholders. Thus the risk born by the latter is greater. Dividends are traditionally expressed as a percentage of the nominal value of the ordinary share capital, and in recent years (more sensibly) as an absolute amount per share. Share dividends (or script or bonus issue) involve no direct cash payment. The shareholder can obtain cash by selling the shares on the stock exchange. Shares in companies are quoted ‘cum dividend’ meaning that the purchase of the share carries with it the right to the next dividend, or ‘ex dividend’ meaning that the purchase does not carry the right to the next dividend.

 

Dividend Cover indicates the ratio of earnings per ordinary shares to gross dividend per share.

The higher the figure the greater is the number of times that the most recent reported earnings exceeds the most recently paid dividend. The definition of earnings in calculating this ratio is made complicated by the imputation form of corporation tax where advance corporation tax (ACT) sometimes cannot be fully offset against corporation tax. The concept of ‘maximum’ earnings is employed, which, if there is no excess ACT, means earnings on a ‘nil dividend’ basis grossed up by the rate of imputation credit (which equals the standard rate of income tax). Where excess ACT exists the figure employed is the dividend grossed up by the imputation credit plus retained earnings.

 

Dividend Pay-out Ratio is the proportion of total profits accounted for by dividend payments.

 

Dividend Yield is the dividend per share as a percentage of the market price per share. Where dividends are declared as a percentage of the nominal value of the share the formula is

 

Dividend percentage x nominal share value

—————————————————– x 100

100 x market price of share

 

The dividend yield shows the percentage return available to an investor at current market prices. Dividends are paid out of profits after payment of corporation tax. From the point of view of a company raising new equity, the dividend yield is a main component of the cost that has to be paid for such capital.

 

di Enrico Furia

 


 

Enrico Furia
Enrico Furiahttps://www.aneddoticamagazine.com
Multilingual executive with experience in international finance, foreign investment, business development, negotiations, product planning, strategic planning, ICT, energy, academic and vocational teaching. Strategist with proven success in pinpointing profitable opportunities while realizing corporate objectives Established solid business relationship, maintaining a large network of international contacts. Motivational leader and team builder experienced in cross cultural teaching, management, and people development. Hands-on manager with sound technical skills and global perspective of potential markets Multifaceted financial advisor on information systems, project management, energy, banking, and investment analysis. Posts

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