Fixed Cost, Structure of Return and the Size of Economy

Small size economy

• Fixed cost: 1

• Variable cost: 80% of output

• Value per unit output: 1

• Size of output: 10

• Profit: – (1-0.8)*10-1= 1

large size economy

• Fixed cost: 100

• Variable cost: 50% of output

• Value per unit output: 10

• Size of output: 30

• Profit: – 10*(1-0.5)*30-100 = 50

• Which economy you prefer?

• Problems of large size economy.– high fixed cost– large amount resource support– Complex social structures and social policies

• In this course, we will discuss in greater detail

Fixed cost

• Some high fixed cost projects are self financed

• However, many projects require billions of dollar initial capital– Oil sand projects– Mining projects– Pipelines

• External financing

Methods of external financing

• Debt financing and equity financing– Debt financing: fixed interest payment, higher

fixed cost, maintaining more control, more risky

– Equity financing: dividend distribution more flexible, lower fixed cost, maintaining less control, less risky

•

• Debt financing – Public debt: Issuing cost as fixed cost, generally lower

interest payment, more information release– Bank financing: No issuing cost, generally higher

interest payment, less information release

• Tradeoffs between bank financing and public debt– If the size of debt issuing is large, which method you

would prefer?

Fixed cost and other factors

• Market size

• Duration

• Discount rate

• Uncertainty

• Other factors?

Fixed cost and market size

• Suppose you are opening a restaurant and there are two potential sites:

• The central site costs $10 000/ month and has a marginal cost of 40%.

• The remote site costs $4 000/ month and has a marginal cost of 60%.

• What is the potential profit of each site if you generate a revenue of $20 000? $40 000?

• What site would you choose under each circumstance?

Fixed cost and duration of project

A company has a choice to select one of the two projects. The first project requires an initial spending of 10 million dollars. The project will generate 3 million dollar profit each year. The second project requires an initial spending of 20 million dollars. The project will generate 5 million dollar profit each year. The discount rate is 5% per year. If two projects last for 5 years, which project you will choose? If two projects last for 10 years, which project you will choose? The criterion of selection is NPV of a project.

Answers

• 5 years– Project 1: 2.99– Project 2: 1.65

• 10 years– Project 1: 17.99– Project 2: 26.65

Discussion

• NPV is often used as the criterion in evaluation projects.

• When NPV is a good criterion and when other criteria would be better?

Fixed cost and discount rate

A company has a choice to select one of the two projects. The first project requires an initial spending of 10 million dollars. The project will generate 2 million dollar profit each year. The second project requires an initial spending of 20 million dollars. The project will generate 3.5 million dollar profit each year. Both projects last for 10 years. If the discount rate is 5% per year, which project you will choose? If the discount rate is 12% per year, which project you will choose? The criterion of selection is NPV of a project.

Answers

• 12% discount rate– Project 1: 1.3– Project 2: -0.22

• 5% discount rate– Project 1: 5.44– Project 2: 7.02

Fixed cost and uncertainty

• Someone proposes a project to you. He claims that the profit from the project will increase 10% per year for the next hundred years.

• You might think his projection should be heavily discounted. That’s right.

• Uncertainty is often reflected in discount rate.• But why central banks seem to be able to adjust

discount rate freely? We will leave the systematic discussion to the section on interest rate policies.

Other factors?

• Liquidity, fixed cost and discount rate• If you can not sell a project easily and have to

operate the project yourself during its entire life, what kinds of fixed cost and discount rate you will choose?

• If you can sell a project easily, what kinds of fixed cost and discount rate you will choose?

• MBS and financial crisis. • Other factors?

other applications

• The requirement for fixed cost is universal for all organisms and organizations.

• The idea can be applied to many other areas.

Selective advantages of different pathogens

• Virus, bacteria and protists and common pathogens with different sizes.

• In human organizations of different wealth levels, types of diseases are often different.

• In wealthy social organizations, diseases are often caused by viruses while in poor social organizations, serious diseases are often caused by protists. Why the difference?

• Protists are larger and require more investments. In environments where pathogens are vigorously attacked and couldn’t survive for a long time, large investments do not payoff. In wealthy social systems, people are well nourished and medical care is well funded, large pathogens, such as protists, do not perform well; small pathogens, such as virus, live a very short time and can mutate very fast, are more successful. Aids is caused by viruses, RNA coded viruses which mutate very fast.

• In poor social environments, where people are poorly nourished and their immune systems are weak, large pathogens have a better chance to recoup their investments. Hence diseases such as malaria, which is caused by protists, are common in poor countries but not in rich countries.

Nuclear weapons and terrorists

• Since the birth of nuclear weapons, there has been constant worry for terrorists to acquire nuclear weapons. But it has not happened so far. Why?

• To acquire nuclear weapons would need high level of investment both financially and organizationally. This makes terrorist groups easy target. Therefore, terrorist groups prefer low cost, low profile activities.