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ENTREPRENEURIAL FINANCEFourth Edition

Chapter 1Financial and Economic Concepts

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Opportunity Costs

The highest value that is surrendered when a decision to invest funds is made.

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Choices Available for Funds

Expected financial returns of investment opportunity

Investment opportunity Expected annual rate of return (%)

Purchase stock 11

Purchase home 9

Purchase bonds 6

Place cash in saving account

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Buy a new car -15

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Examples of Opportunity Cost

Decide to purchase car

Opportunity cost = Stock

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However, if you decided to purchase stock rather than the car

Opportunity cost = Home

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Income, Expenditures, and Taxes

Gross income is all of the money received from all sources during the year.› Wages› Tips› Interest earned on savings and bonds› Income from rental property› Profits to entrepreneurs

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Basic Income Calculations

Gross income - taxes = Disposable income› For most of us, disposable income is take-home pay.

Disposable income - Fixed expenses = Discretionary income› Fixed expenses are contractual obligations like rent, utilities,

insurance, and car payments.› Discretionary income is cash that we can spend or save.

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Taxes

Progressive taxes: larger percentage of tax paid as income increases.

Regressive taxes: smaller percentage of tax paid as income increases.

Proportional taxes: percentage of tax paid remains the same at all levels of income.

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Example of Progressive Tax

100 x dollarsin Income

dollarsin payment Tax PercentageTax

Formula for tax percentage paid:

15% 100 x $20,000

$3,000 percentageTax

28% 100 x $60,000

$16,000 percentageTax

Income tax is progressive:

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Example of Regressive Tax

5% 100x $20,000

$1,000 percentageTax

4.17% 100x $60,000

$2,500 percentageTax

Sales tax is regressive – it’s higher for those who consume more as a percentage of their incomes:› Income = $20,000; savings = 0; sales tax = 5%› Sales tax paid = $20,000 x 0.05 = 1,000

› Income = $60,000; savings = $10,000; sales tax = 5%› Sales tax paid = $50,000 x 0.05 = $2,500

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Example of Proportional Tax

The tax we pay into Medicare is a proportional tax (percentage of tax paid remains the same at all levels of income)

Formula for tax percentage paid:› Medicare tax is 1.45%› Annual income $30,000› Medicare tax = $30,000 x 0.0145 = $435› Annual income $500,000› Medicare tax=$500,000 x 0.0145 = $7,250

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Factors Affecting Interest Rates

The supply of money saved is primarily the total money that is placed in demand deposit (checking) accounts, savings accounts, and money market mutual funds. › Appear in a bank’s liabilities on balance sheet

The demand for borrowed funds is all of the money that is demanded in our economy at a given price. › Appear in a bank’s assets on balance sheet

Assets Liabilities

Equity

Charge rates of 6% to 20%

Pay rates of 0 % to 3%

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Federal Reserve Policy› The Federal Reserve is the central bank of the United States. › The Fed tries to control interest rates – and therefore the rate of

inflation or deflation – by purchases and sales of bonds› And by setting the overnight lending fee between banks (i.e., the

“federal fund rate”)

Factors Affecting Interest Rates (continued)

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More on opportunity costs

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Opportunity cost defined

The cost of any activity measured in terms of the best alternative forgone.

It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices.

In economics› It’s "the basic relationship between scarcity and choice.”› The notion of opportunity cost plays a crucial part in ensuring that scarce

resources are used efficiently.› Opportunity costs are not restricted to monetary or financial costs: the real

cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs

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Opportunity costs in consumption

Opportunity cost is assessed in not only monetary or material terms, but also in terms of anything which is of value

E.g., In a restaurant situation, the opportunity cost of eating steak could be trying the salmon. For the dinner, the opportunity cost of ordering both meals could be twofold - the extra $20 to buy the second meal, and his reputation with his peers, as he may be thought gluttonous or extravagant for ordering two meals.

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Opportunity costs in production

Explicit costs are opportunity costs that involve direct monetary payment by producers.

The opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them.

For instance, a firm spends $100 on electrical power consumed, the opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production.

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Opportunity costs in production

Implicit costs are the opportunity costs that involve only factors of production that a producer already owns.

They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent out to other firms.

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Evaluation

Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, or the explicit accounting or monetary cost is low, then, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all.

The unseen opportunity costs then become the implicit hidden costs of that course of action.

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“This time it’s personal” (Part 1)

You graduate from the University with a dual-major BS degree in marketing and chemical engineering.› You can work for Procter & Gamble for $70,000 starting salary, or› Start your own marketing consulting business for personal care

product manufacturers with starting salary of $0, but potential salary of $150,000

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“This time it’s personal” (Part 2)

You took the P&G job and have been working for them for five years. You have a salary of $85,000 and a wealth of understanding of the personal care products industry.› You can continue to work for Procter & Gamble for $85,000

salary with annual 4% raises, or› Start your own marketing consulting business for personal care

product manufacturers with starting salary of $0, but potential salary of $500,000

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“This time it’s personal” (Part 3)

Three years later you are still working for P&G and have been working for them for eight years. You have a salary of $95,000, but heard that the company may sell off your unit to a company known for its ruthless cost cutting.› Stick with the unit and lobby the acquiring company to keep your

$95,000 salary (probably no chance of a raise, though), or› Start your own marketing consulting business for personal care

product manufacturers with starting salary of $0, but potential salary of $500,000