Managerial Economics & Business Strategy

ECON 3551-01 Spring 2017 Project Tasks: - Read the book “Mission in a Bottle” (see syllabus) about the founding and growth of Honest Tea. - Details of the analytical work to be done follow below. Your task is to value Honest Tea at the time of its negotiations to be acquired by Coke. - By Sunday, June 11, 11.59 pm, submit via Blackboard: 1) A write-up, at least three pages in length, explaining your modeling choices and the computed valuations in three scenarios. 2) A spreadsheet that contains accompanying work. Scoring: - A project that meets the basic expectations well gets 10 points. - There is the possibility of (unlimited) extra credit for going beyond, e.g. with particularly well-motivated modeling choices, exploration of more challenging or further scenarios, research of relevant real-world data and facts … Collaboration: - You can work with each other and give each other help, but in the end each student’s project should have different numbers and be independently written up. I will not hesitate to assign zeros to evidently copied work, and to file dishonesty reports. - Be gracious in acknowledging help, and cite references and data sources (but you do not need to have any). In your project, you will propose a valuation of Honest Tea, at the time that it entered negotiations to be acquired by Coca Cola. A simple formula for valuing a company is గ ௥ , where ߨ is the expected annual profit in a typical year, and r is a typical rate of return on an asset that involves risks similar to investing in the company. (If you’re curious, you can find some details on where this formula comes from below, in section A1.) You can make a reasonable guess about r (kudos if you justify it by looking at actual interest rate or stock market return data, but a guess is fine). So your main task will be to come up with an estimate of ߨ . Since profit is revenue minus cost, and revenue derives from demand, what you need then are the demand function and the cost function. For example, if demand is ܳ = ܽ − ܾܲ and cost is ܥܳ݀ + ܳܿ = ଶ + ݂, then ߨ − ܳ ∙ ܲ = ܥ = ቀ ௔ ௕ − ଵ ௕ ቁܳ ଶ − ܿܳ − ݀ܳଶ − ݂. The first order of business is therefore to specify a demand function and a cost function (with real numbers, not letters). Explain in your report (i) the interpretation of the main parameters (for example, how the coefficient on price in the demand function relates to price elasticity) and (ii) how you can justify the values you chose for the parameters (if possible, based on information you have about Honest Tea). Do this for both the demand and the cost function. Be explicit on what you’re assuming about the industry structure that Honest Tea competes in (monopoly? competitive? monopolistic? oligopolistic?), and the technology of producing tea (economies of scale?). The characteristics of iced tea as a product (income effects? are there important complements or substitutes? does advertising matter?). Be sure that your functions are actually consistent with this discussion. Finally, estimate maximum profit ߨ in a spreadsheet, and the implied value of the company, గ ௥ . Call this your baseline estimate. Next, perform a sensitivity analysis, by looking at a risk (of lower profitability) and a potential opportunity (for higher profitability). In the risk scenario, consider one or more parameter changes that would be harmful to Honest Tea (such as a long-term income reduction, competitor price cut, new taste trends, higher resource costs, etc.), and explain why you believe it’s a plausible threat Honest Tea must be concerned about. Recalculate profit and the company value as a worst-case estimate. Finally, highlight an opportunity for Honest Tea. Some possibilities are an investment in a cost-reducing technology or an increase in quality, an advertising campaign, an additional product line, a new incentive scheme that increases executive performance, or a strategic move that creates an entry barriers and thereby modifies the industry structure. You might want to demonstrate on another Excel worksheet how this project works, and how it influences a parameter in your demand or cost function. Recalculate profit and the company value as a best-case estimate. There are no strict formatting requirements you need to adhere to in your write-up or spreadsheet. In section A2, below, you can find a summary of the spreadsheets for each chapter, and the formulas in them. A1. Present Value of a Profit Stream Why is a company that makes profits of ߨ each year worth approximately గ ௥ ? To understand this formula, you first need to know about the concept of time value of money. How much is $1 received a year from now worth today? In other words, if you could choose between $x today and $1 next year, what does x need to be so that you would be indifferent? If you invest $x for one year, you would have (1+r) ∙ $x next year, where r is the rate of return on investments. You will be indifferent between getting $x today and getting $1 next year if (1+r) ∙ $x = $1, i.e. if ݔ= ଵ ଵା௥ . More generally, you’re indifferent between $x today and $ߨ in the following period if (1+r) ∙ $x = $ߨ ,i.e. if ݔ= ଵ ଵା௥ .ߨ How about receiving $ߨ two years from now? You can earn (1+r) ∙ $x after one year, then reinvest it, and have (1+r) ∙ (1+r) ∙ $x = (1+r)2 ∙ $x after two years. In general, $ߨ in t years is worth $x today, so that (1+r)t ∙ $x = $ߨ .This means ݔ= ଵ ሺଵା௥ሻ ೟ . Suppose now a company expects to earn $ߨ each year, starting at the end of the current year, and continuing as far as we can tell forever. In today’s money that stream would be worth: ܸܲ = 1 ݎ + 1 + ߨ 1 ሺ1 + ݎሻ ⋯ + ߨ ଶ Now we’ll perform a mathematical trick, in order to simplify this expression. If you compare (1+r) ∙ PV to PV, you will notice that the difference between the two is just ߨ .