Managerial Economics Problem

 

Question1

The City of Kiel issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt municipal bonds 10 years ago. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. Note that the combined costs associated with calling the existing bonds and paying for the flotation cost of the new issue represent the total initial outlay for the refinancing. Calculate this initial cost.

 

A. Calculate the total semi-annual savings associated with the refinancing.

 

B. What is the NPV of the refunding? Not that cities pay no income taxes, hence, taxes are not relevant in this analysis.

  

Question 2

The Leisure Products co. ( LP) manufactures lawn & patio furniture. Most of its output is sold to do it yourself warehouse stores (e.g., True Value & JC Penny), who then distribute the products under their respective brand names. LP is not involved in direct retail sales. Last year the firm had sales of $35 million.
One of LP’S divisions manufactures folding (aluminum & vinyl) chair. Sales of the chairs are highly seasonal, with 80% of the sales volume concentrated in the January-June period. Production is normally concentrated in the September-May period. Approximately 75% of the hourly workforce (unskilled & semiskilled workers) is laid off (or takes paid vacation time ) during the June-August period of reduced output. The remainder of the workforce, consisting of salaried plant management (line managers & supervisors), maintenance, & clerical staff, are retained during this slow period. Maintenance personnel, for example, perform major overhauls of the machinery during the slow summer period. LP planned to produce and sell 500,000 of these chairs during the coming year at a projected selling price of $7.15 per chair. The cost per unit was estimated as follows: Direct labor $2.25 Materials 2.30 Plant overhead* 1.15 Admin & 0.80 Selling expense ____ Total $6.50 *These costs are allocated to each unit of output based on the projected annual production of 500,000 chairs. A 10% markup ($0.65) was added to the cost per unit in arriving at the firm’s selling price of $7.15 (plus shipping). In May, LP received an inquiry from Southeast Department Stores concerning the possible purchase of folding chairs for delivery in August. Southeast indicated that they would place an order for 30,000 chairs if the price did not exceed $5.50 each ( plus shipping). The chairs could be produced during the slow period using the firm’s existing equipment and workforce. No overtime wages would have to be paid to the workforce in fulfilling the order. Adequate materials were on hand (or could be purchased at prevailing market prices) to complete the order. LP management was considering whether to accept the order. The firm’s chief accountant felt that the firm should not accept the order because the price per chair was less than the total cost and contributed nothing to the firm’s profits. The firm’s chief economist argued that the firm should accept the order if the incremental revenue would exceed the incremental cost. The following cost accounting definitions may be helpful in making this decision: • Direct labor: Labor costs incurred in converting the raw material into the finished product. • Material: Raw materials that enter into and become part of the final product. • Plant overhead: All costs other than direct labor and materials that associated with the product, including wages and salaries paid to employees who do not work directly on the product but who services are related to the production process (line managers, maintenance, and janitorial personnel); heat; light; power; supplies; depreciation; taxes; and insurance on the assets employed in the production process. • Selling and distribution costs: Costs incurred in making sales (e.g., billing and salespeople’s compensation), storing the product, and shipping the product to the customer. (In this case the customer pays all shipping costs.) • Administrative costs: Items not listed in the preceding categories, including general and executive office costs, research, development, engineering costs, and miscellaneous items. Questions 1. Calculate the incremental, or marginal, cost per chair to LP of accepting the order from Southeast. 2. What assumptions did you make in calculating the incremental cost in Question 1? What additional information would be helpful in making these calculations? 3. Based on your answers to Question 1 and 2, should LP accept the Southeast order? 4. What additional considerations might lead LP to reject the order?