Time Value of Money

In many financial decisions cost and benefits occur at different points in time, in most of the cases costs are incurred upfront and afterwards the firms receive benefits from the projects they have invested in. I’ll try to present how to evaluate a project by taking into account the time value of money.

Example: Let’s consider you have the following opportunity to invest your money:

Cost: $1000 today.

Benefit: $1700 in one year.

Because currency is the same it might appear for someone that the cost and the benefit is directly comparable, so that the project’s net value is $1700-$1000=$700. However, this calculation ignores the fact that cost and benefit are incurred at different points in time.

In general a dollar today is more than a dollar in one year, simply because if you have a dollar now, you can invest it. For example you could deposit your dollar under in a bank account that offers a deposit rate of 5%, so in one year you will have $1.05. Even if the revenue for the case that I provided is extremely small, when the potential budget for investment increases drastically, the benefit from this investment becomes much larger. The difference between money today and money in the future that was provided in the example above is called the time value of money.

Interest rate

Be depositing our money in a bank, we can transfer them from one to another point in time with no risk. Similarly, by borrowing money from the bank we exchange money in the future for the money we receive today. This rate, by which we exchange money today with money in the future, is called interest rate. As exchange rate offers us the ability to convert from one currency to another, the interest rate offers us the ability to convert money from one to another point in time. It tells today the market price of dollar in the future. The risk-free rate,r_f, is the interest rate at which money can be borrowed or lent without incurring risk over a certain period of time.

Since it is a market price, the risk-free rate depends on the supply and demand in the savings and borrowing market. In case that we know the risk-free rate, we can use it to evaluate other decisions in which costs and benefits are positioned in different points in time without knowing investor’s preference.

When we represent the value of a cash-flow in terms of dollars today, we call it the Present Value (PV) of investment; however, if we express it in terms of dollars in future, we call it the Future Value (FV) of investment.

The Stock Market

 

As it is known shareholders want managers to maximize firm’s value, such that the return on their invested funds will be higher. We can determine the value of their investment by knowing the price of the share/stock they invested in and the number of shares that they purchased. Here we can distinguish two types of companies, private and public companies. Private companies have a limited number of shareholders and their shares/stocks are not traded publicly, therefore the value of investment can be difficult to determine; however, many companies are public companies, which means that their shares are traded on some special markets called a stock market (or stock exchange). These markets determine the price of these shares and provide liquidity to the company, because of continuous investment opportunities in the listed companies. A liquid investment is the one at which you can sell it at a price very close to the current purchasing price. This means that if, for example one invested in some stocks, then he can sell these stocks at the price that other people are currently buying these stocks in the market. Liquidity is attractive to outside investors, because it provides flexibility regarding the investment timing.

Primary & Secondary Stock Markets

When a firm issues new shares and sells them to investors, they do it on primary market. Afterwards, these shares continue to be traded between corporations and investors in the secondary market. In the latter market no action is required from corporation’s side. For example, if you would like to purchase Apple’s shares, you place an order on a stock exchange (let’s say NYSE), then you will purchase these shares from someone who held them before, not from the Apple company directly.

The largest stock market in the world is the U.S stock market called New York Stock Exchange (NYSE). Another well-known U.S stock exchange is the American Stock Exchange (AMEX), the National Association of Security Dealers Automated Quotation (NASDAQ). Other countries have at least one stock exchange, ex: Tokyo Stock Exchange (TSE) and London Stock Exchange (LSE).

NYSE

The NYSE is a physical place. On the floor of NYSE, market makers connect buyers and sellers. They make two prices for every stock they make market for: the price these market makers are willing to buy the stock (the bid price) and the price for which they are willing to sell the stock (the ask price). If a customer comes and he/she is willing to purchase some shares at this price, they will “respect” their official price (up to a given number of shares) even though there might not be another investor who is willing to take the other side of this transaction. Therefore, they can assure liquidity of the market and that they trade at the given prices. One rule of these exchange markets is that the bid and the ask prices aren’t too far apart and that the large price change occurs as a series of small changes in the price of these shares. Ask price is always higher than the bid price and this difference is called bid-ask spread. A person who is buying a stock pays the ask (the higher price) and when he/she sells the stock, he/she gets the bid. This bid-ask spread is a transaction cost that is paid in order for this trade to occur. Since the market-makers take the other side of the transactions when investors are coming, this cost is revenue for them for maintaining the market liquid and for respecting the price that they set in the market. It is also the case that some investors pay additional taxes, like commissions.

NASDAQ

This type o market doesn’t have any physical location. Investors can make these transactions by phone or internet. Therefore in this case there are more market makers that set different prices for the stocks that they trade. In contrast to NYSE, at NASDAQ these multiple markets make these investors to compete with each other. Best prices are posted in NASDAQ in the beginning and orders are filled accordingly; therefore, investors get the best price, whether they are selling or buying these stocks.

Stock market capitalization

The Anti-Combines Laws & Merger Types

   The main importance of anti-combined policy (antimonopoly policy) is ideas to prevent industrial concentration or monopolization, to achieve locative efficiency and to promote competition. Even if many economists say that these are the main aims of this policy some of them may argue that anti-combined policies aren’t so effective and their goals aren’t always achieved.
   The main important anti-monopolistic idea is that they produce less output and charge higher prices than firms from competitive market system. In pure competition firms produce output quantity where P=MC. This equation is so important because P represents benefit that society gains from extra unit of output, while MC is the cost that society is ready to pay for that extra unit. When this equation occurs (P=MC) society doesn’t gain any higher total benefit by producing one more or one less unit of output. However, a monopolist doesn’t maximize profit by equating marginal benefit (not price) with marginal cost.  In this case, there is an under allocation of resources to this monopolized products, so that economic well-being of society is less than it would be with greater competition.
   It is said that in nineteenth century the market forces in monopolized industries don’t provide sufficient control over prices to protect consumers, achieve locative efficiency and get a fair competition. So there were two methods by which a government could control these market forces:

• Regulatory agencies: In the markets where products or producing technology creates a natural monopoly, the government organizes public regulatory agencies that control economic behavior.
• Anti-combined laws: in some kinds of market systems this control took form of anti-combined or anti-monopoly legislation that prevents the growth and development of a monopoly.

Anti-combined legislation depends on corporate size and concentration. That’s why it’s important to examine all merger types.

Merger Types
   There are three basic merger types. Let’s examine and describe them carefully bellow:

1. A horizontal merger represents a merger between competitors that sell similar products in the market.
2. A vertical merger is a merger between some firms at different stages of production process.  An example can be a merger between a firm that produces glass and another that produces plastic so that they may create windows that are sound-proof. Another example is that Pepsi, which is a supplier of soft drinks, and Pizza Hut, so that they supply food and drinks for these fast-food firms.
3. A conglomerate merger may be defined as any merger that isn’t horizontal or vertical; it is a combination of firms in different industries or firms that operate in different geographical areas. This type of merger can extent the line of goods sold or combines some unrelated companies. An example of conglomerate merger is a union between Pizza Hut and some vehicle producing firms.

Technological advantage and efficiency

      Technological advance contributes enormously to economics efficiency. New and better products and processes enable the society to produce more goods at a less price, and produce a higher-valued mix of output.

 Productive efficiency
       Technological advance improves productive efficiency by increasing the productivity of inputs and by reducing the average total costs. In enables society to produce the same amount of goods and services by using fewer resources, so that it frees unused resources and produce something else from them. If society needs now more less-expensive goods, process of innovation helps to gain greater quantity of output by sacrifying fewer resources used as input. We may state that process innovation increase productive efficiency: it reduces society’s cost of whatever mix of goods and services it wants and thus it is an important factor that shifts economy’s production possibilities curve by shifting it rightwards.
Allocative efficiency
   Technological advance used at production process of various goods increase the allocative efficiency by giving society more desired mix of goods and services.  Consumers are willing to buy a new product rather than an older one only if the new one increases the total utility obtained from usage of the same quantity of scarce resources. That’s obviously that new product (and new mix of products) will create a higher total utility for society. That’s why demand for old product declines and demand for the new one increases. High economic profit gained from the new product attracts resources away from less-wanted by society uses to the production of new item.  This shifting of resources continues until marginal cost and marginal benefit equalize each other.
   However, innovation (either of product or price) may create a monopoly power in the market through patents and through other advantages of being first. When a new monopoly power results from an innovation, society may lose a part of its efficiency it otherwise would have gained from this innovation.  The reason is that monopolist may keep product’s price above marginal cost.
   Innovation may reduce or even destroy monopoly power by providing competition somewhere it didn’t previously exist. Economic efficiency is enhance after this event occurs, because this new product helps to push the prices down, close to marginal cost and minimum average total costs (ATV). Innovation that leads to greater competition in an industry reduces output-restrictions and monopoly prices.

Creative Destruction
   Innovation may even generate a creative destruction, in which creation of new products and production methods simultaneously destroys the market position of existing monopolies and old ways of doing business.
   Examples of creative destructions: movies brought new competition to theatres, which can be shown one at a time, but movies latter were challenged by television, aluminum cans and plastic bottles also displaced glass bottles in many uses, e-mail has challenged the postal service.
   Schumpeter says that an innovator will displace any monopolist that no longer delivers superior performance, but this idea is most treated as a wishful thinking nowadays. In this view, idea that creative destruction is automatic, but it neglects somehow the ability of well-established firms to provide shelter by themselves or by lobbying government to do it. This idea ignores differences between legal freedom of entry and economic reality of entering potential newcomers to concentrated industries.
   In this case dominant firm(s) may use strategies as buyouts, selective price-cutting, massive advertising to block the entry and competition from existing rivals and appearing innovative firms. Moreover, some firms may be able to persuade government to give them subsidies, tax-break, tariff-protection to strengthen their market power.
   In conclusion, while innovation increases economic efficiency; in some cases it may lead to expanding of monopoly power. Moreover, innovation may destroy monopoly power, but this process is neither automatic nor inevitable. However, technological change, innovation and efficiency doesn’t always bring monopoly power.

Market structure and R&D Incentive

 
    Does R&D incentive depend on market system? Is a highly competitive industry with thousands of small firms better suited for technological advantage than an industry that is made up of three or four large firms? Or is there another better suited market system?

Market Systems and Technological advance
Let’s describe short-comings and strengths of all four market systems as related to technological advance.
   Pure Competition
   Is there a strong incentive for a pure competitor to initiate R&D researches? A positive factor is that strong competition provides a reason for them to innovate. If a pure competitor doesn’t introduce a new-product or cost-reducing production process, then one or more of his rivals that could drive the firm away from the market. As a matter of short-run profit and long-run survival, a pure competitor is under continual pressure to improve the product and process of production, and to lower the costs through innovation. Also, in pure competitive market there a lot of firms, so there is a greater chance that this improvement in product or process may be found by more firms.
   However, on the negative side, the expected return firm R&D process may be low or even negative because entry is extremely easy the profit from innovation can quickly disappear if the new firms that entered this kind of market structure are using the same new, innovated products and product technology. Also small the fact that the firms are small-sized and get only normal profit in long run leads to several questions if the R&D program is necessary in this case.  Also it’s quite known that technological advance in pure competitive market system hasn’t come from R&D processes of individual firms but from example from government-sponsored researches (for example in agricultural industry fertilizers, new kinds of seed may be discovered by some governmental researches).
Monopolistic Competition
   Unlike firms in pure competition market, the monopolistic competition market’s firms sell differentiated products so they have a strong incentive to engage in product development. This incentive is to make their product different from these produced by competitors, because newly produced goods may create monopoly power and thus economic profit will increase.
   However in this case, like in pure competition market system there is the same negative side. Most monopolistic competitors are small sized-firms, thus their ability to secure inexpensive R&D process is limited. Moreover, monopolistic competitors find it difficult to extract large revenues from technological advantages. Economic profits are only temporary, because the entry to monopolistic competitive industry is relatively easy. In long run new entrants with similar goods reduce the revenues that came from innovation, so that the innovator gets only normal profit in future. Thus monopolistic competitors have relatively low expected rates of return.
Oligopoly
   Oligopoly has many characteristics that permit technological advantage. First of all, large size of oligopolists often helps them to finance R&D process associated with product innovation. Often oligopolists realize economic profit, a part of which is saved. This retained-funding serves as a major source of available and relatively low-cost R&D.  In addition, barriers to entry give assurance that firms will be able to maintain economic profits that these firm gains from innovation. Large volume of sales of oligopolists enables them to spread the cost of R&D equipment and teams of specialized researches over larger quantity of output. Finally, R&D activity in oligopolistics firms helps them to compensate inevitable R&D misses with R&D hits. That’s why oligopolists clearly have great incentive to innovate.
   However R&D activities may not always have positive effect. Oligopolists may not have such a great incentive to induce innovation process. An oligopolist may say that it’s little sense to purchase costly new technology and produce new products if they are currently getting high-economic profits even without them. The oligopolists want to maximize revenues by exploiting fully capital assets. Why to produce an innovative good if the firm is producing economic profits with equipment designed to produce its existing products?  There are many large firms in this kind of market system that have quite modest improvements in R&D process.
Pure Monopoly
   Generally pure monopolists have little incentive to engage in R&D, since it can continue to get economic profits because of entry barriers by maintaining to produce old good. The only incentive for pure monopolists to engage in R&D process is defensive: to reduce the risk of getting bankrupt by appearance of a new product or production process that may destroy it. If there is a possibility to discover a new product that will offer pure monopolists high revenues, they may have an incentive to find it. By doing this, monopolist will try to exploit new product or production process for continued economic profit or until it will get maximum possible profit from the capital that this firm assets. But generally, economists say that pure monopoly is conducting least innovation process.

Inverted-U Theory

   This information can lead us to discover a new theory called inverted-U theory that makes a relationship between market system and the rate of technological advantage. This theory presents R&D spending as percentage of firm’s revenue (vertical axis) and industry rate concentration (horizontal axis). Inverted-U shape curve states that R&D efforts are weak in very low concentration ratio (pure competition) and very high concentration ration (pure monopoly).
   Firms in industries with very low concentration ratio are mostly competitive ones. They are small so that financing R&D is very difficult. Entry to these industries is easy, which makes difficult to sustain economic profit from non-patented innovations. That’s why firms in these types of market systems spend little from their revenues on R&D. In Contrast,  in the part of the curve where concentration ratio in very high economic profits are very-high so innovation will not add more profit. Moreover, innovation requires costly “retooling” of big firms, which will create a great amount of lost money for whatever addition profit is. That’s why in the right part of the graph the expected rate of return from R&D is very low, and the expenditures on this process are low too. Also, lack of rivals make monopolist to spend less money from their revenues on this process.
   The optimal industry for R&D is the one in which returns from innovation spending are high and the funds to finance this process is available and inexpensive. These factors seem to describe industries in which where there a few very large firms and where concentration ratio is not so high to prohibit competition by smaller rivals. Rivalry among larger oligopolistic firms and competition between larger and smaller firms provide a strong incentive for R&D. The inverted U theory shows that loose oligopoly is the optimal structure for R&D spending.
Market Structure and Technological Advantage: Conclusion
   Other things equal, the optimal market structure for technological advantage seems to be an industry in which there is a mix of large oligopolistic firms (40 to 60 percent concentration ratio) with other smaller innovative firms.
   “Other things equal assumption” is quite important here. If a specific industry is highly technical may be more important determinant for R&D than its structure. While some concentrated industries (like electronics, machineries) spend large quantities of money on R&D and are very innovative, others (like copper, cigarettes) are not. Level of R&D depends on its technical character and technological opportunities in its market structure. Simply, it’s easier to innovate a computer industry than a copper one.
    Conclusion: The inverted-U curve is useful depiction of general relationship between R&D spending and market structure, other things equal.

 

Imitation and R&D Incentives

   We know that product and process innovation can explain us how technological advance can maximize firm’s profit, but it also it may state a potential problem in economics called imitation problem, situation in which firm’s rivals may imitate newly invented product or process, so that profit gained by firm that initiated R&D process is greatly reduced. An example can be, a firm buys a high-quality notebook from other one that has a great success in market sales and study it piece by piece and then reproduce entire new model in a computer that is an imitation of original one. This technique was used many times in our world’s market. This type of imitation is actually a legitimate one, so it is often the main path to widespread of innovation and diffusion.
   However, the dominant firm in an industry that is making big profits may let other small firms to spend great quantity of money on product and process of innovation and analyze their success and losses. This firm then quickly can become the second firm that uses these innovations if they are successful. This is called fast-second strategy, strategy by which a second firm uses innovation and R&D results of another firm, so that latter one incurs all cost of innovation and R&D expenditures.

Benefit of being first
   Fast-second strategy and imitation may raise an important question: is there any incentive to be the first firm that incurs all cost and expenditures if the competitors may imitate innovated product? Why not imitate others successful innovations and let them bear the cost of R&D and innovation process? Even this idea is a plausible there are some advantages and protections for the firms that take the lead in this innovation competition. Let’s describe some of them:

Patents
   Some technological innovations and breakthroughs may be patented. If a product or production process in patented it can’t be imitated for about two decades. The purpose of patents is to reduce imitation and to help other firm to engage in R&D with possibility of gaining of high profits. And if for example one firm clones the new innovated products of another firm then the latter one might be included in a patent-infringement lawsuit and pay back all revenues lost by the firm which patented its product.

Copyright and trademarks
   Copyrights protect publishers of books, various articles, movies, musical compositions from having their works copied. Trademarks give the exclusive opportunity to innovators to use a specific product name (Nokia, Ferrari, McDonald’s). These legal protections help innovators to increase their incentive for product innovation.

Brand Recognition
   Brand-name recognition gives innovator a major marketing advantage for several years. Consumers identify a product with the firm that first introduced and popularized it in the world’s market, for example Kellogg’s Corn Flakes, Sony’s Walkman).

Trade secrets
   Some innovations however include some trade secrets, without which imitation isn’t possible. A very popular example is Coca-Cola which has a secret formula for its drinks. Other firms have some special production technique that is known only to them. A relative advantage is learning-by doing, kind of specialization that allows them to achieve cost reductions. The innovator’s low cost may enable to continue its profits even after imitations are spread in the market.

  Time Lags
   Time lags between innovation and imitation often help innovating firms to realize high economic profits, since the firm that imitates needs some time to learn properties of new innovated good. Once imitators have learnt all these particularities of that good, it needs to design a substitute good and construct a factory that will produce it. Different entry barriers like big amount of funding, economies of scale, and price-cutting may increase the time between innovation and imitation. That’s why it may take several years before rival firms can successful imitate new product and earn some innovator’s market share. That’s why innovator will continue its profits.

Buyouts
   Another advantage of being first may be a buyout, purchase of innovating firm by a larger firm. In this case innovative entrepreneurs will get their rewards immediately in form of cash or shares from the purchasing firm, rather than waiting for uncertain future profits from their own production and efforts.

Optimal amount of Research and Development (R&D)

How do firms decide what amount of research and development to use? This depends on the amount of marginal benefit and marginal cost firm gets after R&D activity. This decision comes from one basic rule of economics: In order to get the greatest profit a firm should expand a specific activity until marginal benefit (MB) will be equal to its marginal costs (MC). If a firm sees that a R&D activity brings more marginal benefit than the marginal cost then this firm should expand its activity. However, if marginal benefit is less than marginal cost then this R&D activity should stop or shouldn’t be started. R&D spending decisions is a complex one, because it involves a possible future gain for present sacrifice. While R&D spending is immediate the expected benefits are uncertain and may occur at some possible future point in time. The MB=MC idea is still relevant for R&D decisions.

Spending in R&D
In order to obtain funds for R&D activities firms have several options:
  Bank loans– Some firms are able to finance their R&D activities by obtaining loans from banks or other type of financial institutions. The cost of using this kind of funds is the interest rate paid to the lender. The marginal cost is the Future Value (FV) of money borrowed.
Bonds– Profitable firms may borrow funds for R&D by issuing bonds and selling them. In this case, interest is the cost paid by bondholders to lenders. In this case, again, marginal cost is the interest rate paid for money borrowed.
Retained earnings– some big firms may finance their R&D activity by retaining some earnings. In this case firm retains a part of its profit rather than paying dividends to its owners. Some undistributed corporate profit, called retained earnings, can be used to finance R&D activity. The marginal cost in this case is the rate that could be earned from interest as deposits in financial institutions.
Venture capital– A small start-up firm may be able to attract venture capital to attract R&D projects. Venture capital is simply money, not real capital. Venture capital is part of household savings that is used to finance high-risk business venture in exchange of possible future share if thus ventures succeed. Marginal cost of this type of financing is the share of expected profit that business will have to pay to these people that offered this money.
Personal savings– Sometimes entrepreneurs may finance R&D activities from their own savings. In this case marginal cost is the forgone interest rate.
To sum up, we may state that whatever are the funds for R&D, the marginal cost in all the cases is forgone interest rate, i. Let’s assume that interest rate is the same for all amount of money needed. Also, let’s say that a firm call EcoMoney must pay an interest rate of 10% for the least expensive funding available to it. Let’s draw a graph called interest-rate cost-of-funds curve that denotes marginal cost of each amount of money borrowed for 10% interest rate and is shown simply by a horizontal line. Let’s make a graph and a table that depicts this situation.

With this information EcoMoney want to determine how much R&D to finance in the next year.
Expected Rate of Return
Firm’s marginal benefit from each dollar spent on R&D is it is profit (or return) gained from it. Thus R&D is expected to result in a new product or production method that will increase firm’s revenue. This return isn’t guaranteed but it is possible, so there is a risk to invest money in research and development process. Let’s suppose that after considering all risks EcoMoney constructs an expected-rate of return versus research and development cost graph and table. Expected-rate of return curve is marginal benefit of each dollar spent on R&D. This curve slope is negative because of diminishing returns from R&D expenditures. A firm will direct its initial R&D expenditures to the highest expected-rate of return activities and additional funding will be invested in activities that offer successively lower rates of returns. Thus firm increases R&D spending it uses to finance R&D activities of progressively lower rates of returns.


Optimal R&D spending
The figure bellow combines interest-rate-cost-of-funds curve and the expected rate of return curve. These two curves intersect at EcoMoney’s optimal amount of R&D, which is 35 million of dollars. This result can also be determined from the previous tables that showed amount of funding at various rates of return and interest cost of borrowing (in this case 10%). AT this point MR and MC from expenditures on R&D are equal. The firm should undertake all R&D expenditures up to 35 million of dollars, since these parameters yield higher marginal benefit and expected rate of return, r, than interest costs of borrowing money, i.
Optimal vs. affordable R&D
As we know there can be too much, or too little of a good thing. So it is with R&D and technological advance. The figures from above show that R&D expenditures make sense as long as the expected return equals or exceeds the expenditures needed to finance it. Many R&D expenditures may be affordable but also most of them aren’t worthwhile, because their marginal benefit is less than their marginal cost.
Not Guaranteed returns
    The outcome of R&D researches are expected, but not guaranteed. At the time of decision, it may look worthwhile, but they can’t predict with high accuracy future events, that’s why sometimes some R&D decisions are like an informed gamble and not as typical business decision. Invention and innovation carry with them high possibility of risk. So there may be a successful outcome or a costly disappointment.