Overview: Production and Cost II• Opportunity Costs in Practice – Example: Valuing a 1998 Boeing 737-700• Economies of Scale and Scope • Learning Effects 1The 1998 Boeing 737-700 Check the Airliner Price Guide 2Cost Saving From a 1998 737-700 • The User Cost of Capital UCCt = rVt + (Vt -Vt+1 ) = r ($27.4 m) + ($27.4m - $25.8m) = 9.2% ($27.4 m) + ($27.4m - $25.8m) = $ 4.11 m • Equivalently, in terms of percent depreciation, UCCt = (r + %dep’n)Vt % dep’n = (Vt -Vt+1 )/Vt = (27.4 - 25.8)/27.4 = 5.8% 3Calculating Delta’s cost of capital, r Four steps: 1. Determine Debt/Equity Structure Total Market value of Debt D: $4.7 Bn (from Moody’s or Annual Report) Market Capitalization E: $6.21 Bn (from Yahoo Finance – spring 2001) 2. Calculate Cost of Equity with CAPM (1*)re = rf +β equity ( r − rf )m + Risk ( )%16.5 free rate Risk rel. to market Market risk premium 14 . 1 %6 = % 0 . 12 Calculating Delta’s cost of capital (cont.) 3. Calculate Cost of Debt Weighted average of cost of each maturity of debt used by Delta (from Moody’s): rd = 9%. Corporate tax rate τ = 39.6%. 4. Weighted Average Cost of Capital ⎛ E ⎞ (2*)WACC= re ⎝⎜ D E ⎠⎟ + rd ⎛⎜ D ⎞⎟ ( 1−τ)+⎝ D E ⎠+ ⎛ 21.6 ⎞ ⎛%0.12 ⎜ ⎟+ %9 ⎜ 7.4 ⎞⎟( 1− %6.39 )= 2.9 %⎝ 7.4 + 21.6 ⎠ ⎝ 7.4 + 21.6 ⎠ (*) If relevant, equations (1) and (2) will be provided to you on the exam. 4Economies of Scale and Scope • Cost savings associated with ‘size’ of business • Economies of Scale – Unit cost savings at higher scales of production – (AC falls with higher Q) • Economies of Scope – Costs savings from producing multiple products – ‘Joint production economies’ 5Economies of Scale, AC and MC • Economies of Scale – AC decreases with Q, so MC < AC • Constant Costs – AC constant with Q, so MC = AC – “Scalable Business” • Diseconomies of Scale – AC increases with Q, so MC > AC Example: Software or CD’s 0 10 20 30 40 50 60 70 0 5 10 15 20 25 Output 6Example: Producing Near Full Capacity 0 10 20 30 40 50 60 70 0 5 10 15 20 25 Output Full Range: U-Shaped Average Cost 15 13 11 9 7 5 iPoiRange of Economies of Scale Range of D seconomies nt of 3 Constant of Scale Costs 1 01 2345678910 -1 Output 7A Terminology Pothole • “Returns to Scale” refers to physical properties of production – Double inputs yields more than double output – “Increasing returns to scale” • With constant input prices, same concepts as scale economies – Increasing returns = economies of scale, etc. • Other differences are not important for us Economies of Scope • Cost savings associated with the simultaneous production of several products – Unit costs are lower than if products are produced separately • Sources? •Examples 8Learning Effects • Costs savings that arise from repetition, practice or experience of ongoing production. • Sources? •Examples 9Estimation of Learning Curves AC pe r Lot • How is the effect of learning on costs quantified? – With cost data, estimate learning curves – (use consultants if necessary) • Why quantify the effect of learning on costs? – Only way to know precise benefit of today’s Ln(AC pe r Lot) production on tomorrow’s costs Empirical Learning Curves Typically Log-Log Specification Ln(AC per Lot) = α + β Ln(Cumulative Lot Number) Why? Typical Data Pattern 150 4.8 4.6 100 4.4 4.2 50 4 0 3.8 010203040 0 1 2 3 4 Lot Number (or Cumulative Production) Ln(Lot Number (or Cum. Prod.)) 10Learning Curve ‘Strategy’ • Overproduce Now for Lower Costs in Future • Needs to be undertaken with care – In the 1980’s, some people thought overproduction of this kind always made sense 11Learning Curve ‘Strategy’: Assumptions • Demand: – Will be sufficient to absorb higher output • Learning: – Learning will occur, or can be managed – No “Technological risk” – Competitors cannot “free ride” on your learning – No forgetting Take Away Points • User cost of capital is an important component of economic costs. It consists of economic depreciation and the opportunity cost of capital. • Scale and learning effects are important sources of competitive advantage and entry barriers. • Scale effects refer to movements along the AC curve, learning effects are shifts of the AC curve
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