Category Archives: Management Science

Making the hard decision of pricing easier: A blueprint comparing different pricing strategies

Pricing is an important decision involving both qualitative and quantitative considerations. 🧭

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From start-ups to strong incumbents, many companies still struggle to find the market clearing price-contrary to what you were taught in your microeconomics class, such a price does not exist in real life 😉

Given current inflationary environment and incessant decline in the purchasing power, this decision is now harder than it has ever been.

Whether your company follows a value-based, cost-based, or a hybrid pricing model, there are still some guidelines working in the pricing universe.

For example, you should know how to set relative prices for the following product pairs: razor and blades, video game hardware and software, printers and cartridges.

In this article, I lay out the fundamentals of different pricing strategies and which strategy makes sense for your company. Comparing different pricing strategies and the rationale behind, I also share examples of different pricing strategies from real-world companies and that particular pricing strategy is suitable for that specific company. The content can be utilized as a blueprint or guide concerning your efforts to determine the price of your services and products.

Solution to Management Science Series #196: Financial accounting as a forensic tool: This time, investigating restructuring projects

Financial accounting as a forensic tool: This time, investigating restructuring projects

Many analysts and investors have a hard time, grasping the reasons behind why companies, especially those that are publicly traded, announce bigger layoff plans than is financially warranted.

Laying off employees is almost always one of the first acts companies undertake in their restructuring efforts. Nonetheless, these restructuring projects may be utilized to smooth earnings. Do you know how? Try to solve the following example:

Assume that the automaker Alliance planned to lay off 200 people and published the developments accordingly. The company offers $60,000 severance package for each person who is going to be laid off.

In fact, laying off only 100 people would have sufficed; however, the company chose to announce a bigger number, i.e. 200 people, and stated the relevant accounts as if it had laid off 200 people.

Why would it do so? How will this restructuring charge affect current period’s operating profit?

How would the operating profit change if the company were to restate the relevant accounts and release the related reserve accounts to reflect the real number associated with these layoffs, i.e. 100 people rather than initially stated 200 people, in the following quarters?

Solution to Management Science Series #195: Valuing Options to Expand

Casca is a video games company based in Midland. It has created many of the most well-known IPs in the video game industry.

Financial analysts of Casca estimate that Casca has a total value of $2.3B according to their DCF models. These IPs and franchises are highly valuable and Casca aims to create new video game franchises for the foreseeable future.

Developing these video game franchises also allows Casca to enter toy and merchandising industry, establishing a new adjacent business activity. Casca could initiate and expand this business activity over the next 4 years.

Current cost of this business activity is estimated to be $1B. Expected cash flows are after-tax $120M per year for 18 years. Cost of capital for toy companies is estimated to be 17%. Casca analysts investigated annualized standard deviations in firm value for publicly-traded toy companies.

With appropriate risk and company-specific adjustments, Casca thinks that the appropriate volatility value for this project is around 27%. Should Casca expand into toy business?

Solution to Management Science Series #194: Valuing Oil Reserves

Ace Chemicals has claims on oil reserves amounting to 5 billion barrels in the South Arkham Sea. Ace’s rights to develop these reserves will expire in 30 years.

Currently, developing these reserves will cost Ace $20 per barrel. Use Crude Oil WTI Futures as a proxy for the current market price of oil. Production costs per barrel is estimated to be $40 per barrel.

Use appropriate risk-free rate for this project. Also, how would your model consider the volatility of this project?

Factor in the cost of delay of the project in your model and decide whether Ace should start developing reserves now or rather wait.

Solution to Management Science Series #193: Valuing Patents/Licenses by Using Options

Toy company called Shippuden made a license agreement with the video games company called ‘SUGA’. The license would allow Shippuden to produce the toys including figures and playsets of the IP owned by SUGA for the next 10 years. Shippuden will produce and market the toys.

Financial analysts of Shippuden completed the DCF analysis and it was estimated that future cash flows for this licensing project would amount to $6.7 billion. It is also estimated that current cost of developing the products and starting production would be around $7.2 billion.

This is a new project for Shippuden and it has not been involved in such projects before. So, its analysts adjusted the risk of the project accordingly and the standard deviation of returns on such projects is estimated conservatively at 53%.

Should Shippuden collaborate with SUGA immediately on this licensing project?

How valuable will this project be if Shippuden has the option to delay the development and the production?

What would have been the right action for Shippuden if the development and production of the toy had cost $6 billion instead of $7.2 billion originally? Should Shippuden develop and start production in this case?

Solution to Management Science Series #192: Accounting for Investments in Other Companies and Financial Forensics 🕵️

A publicly traded company, Museum Enterprises (ME) has had rough years lately not living up to the expectations of financial markets and equity investors, missing all of its target earnings.

ME, which stores and sells art collectibles, believes that organic growth is not viable given the current market conditions.

So, at the end of the last fiscal year, it purchased 65% of equity in Castle Entertainment. At the end of this fiscal year, Castle recorded $500M in revenues and incurred total expenses amounting to $230M.

-How will this investment affect ME’s revenues and operating income? Give a quantitatively concrete answer.

-How will this investment help ME’s income before income taxes? Give a quantitatively concrete answer.

-Assume that ME has 40 million shares of stock issued and outstanding and the corporate tax rate for ME is 21%. How will ME’s investment in Castle affect its EPS this year; calculate it!

On education and financial literacy and how financial literacy taught early can impact our world for the better

Remember what I posted on the 7th of February, 2022:
https://bit.ly/3NC9y1f
On the 22nd of March, 2022, it is required for high school students in Florida to take a financial literacy course before graduation.
Financial literacy has always been important and many people, especially young people, has not had the tools to develop their understanding towards finance and investment management.
This knowledge is required.
Countries educating their youth on finance and investment will be more likely to reap the rewards in the future as the youth will be able to make sound financial decisions without squandering their time, money, as well as their country’s wealth.
In this article, I try to idealize a world in which financial literacy is prevalent, elaborating on what could be done to increase financial literacy and how it could change the financial decisions of current and next generations while also providing some snippets and true stories from my own life. I also briefly investigate how financially literate generations will impact the world we live in macroeconomically.

Solution to Management Science Series #191: Binomial Model at Its Finest: Okami Games Example 🎮

Okami Games is a prominent video game developer and publisher financed by both debt and equity. Okami is planning to undertake a new AAA-level game.

If this game garners critical acclaim, the value of Okami in a year will be $560M. If the game fails miserably, Okami’s value will be $430M. Current enterprise value of Okami is $495M, which takes the prospect of the new game into consideration.

Okami has outstanding zero coupon bonds due in a year with a face value of $520M. The yield on a 1-year US Treasury Bill is 4% EAR. Okami does not pay any dividends.

-First, use the binomial model to calculate the current value of Okami’s debt and equity.
-If Okami has 400,000 shares of common stock outstanding, what is the price per share of Okami’s equity?

Okami has also another option to develop a brand-new triple-A game of the survival horror genre. This new game is expected to either increase the value of Okami to $600M or decrease Okami’s value to $400M by the end of the year.

Okami believes that the value of the firm today will remain at $495M even if this new project replaces the preceding one.

-First, use the binomial model to calculate the current value of Okami’s debt and equity if Okami chooses this new project over the preceding one. Calculate the price per share of Okami’s equity accordingly.

-Without calculating any values, could you make a definite claim on which project would benefit the shareholders and the bondholders? Subsequently, corroborate your claim with the algebraic solution.

Securing the longevity of companies

If only you had known these before investing in a tech venture (or any private company)
Some well-known secrets 😉
#2
It is hard to assess how long a company will live.
Of course, any founder will want his/her company to live as long as possible but as is the case with people, companies cease to exist, too.
Sometimes, they evolve, holding a little longer and defying their fate.
However, for many tech ventures, the lifespan is short although they live by dog years.
How long was the average lifespan of a tech venture born in the original dot-com era after the venture had gone public?
It was 3 years.
In this article, I’ve focused on some of the factors affecting the longevity of companies, providing some real-world examples of successful and unsuccessful ones.

Solution to Management Science Series #190: Real-world application of the binomial model: Milk Example 🧮

Real-world application of the binomial model

You have built a trading company called ‘Gold Milk’. The company buys milk from farmers at the wholesale price and resells it to the diary companies and restaurant chains at a higher retail price.

Gold Milk generates its revenues mostly during the spring period. Today is December 1st and milk sells for $2.40 per gallon. Based on your models, milk prices will be either $3.50 or $1.35 per gallon on March 1.

You do not know the probabilities of each state occurring. The three-month risk-free rate for borrowing and lending is 1.5%. Gold Milk has the ability to pass the price changes onto its customers and adjusts prices accordingly in March.

Diary King is a diary company and wants to buy milk from you. The company plans to buy 2 million gallons of milk from Gold Milk at $2.50 per gallon on March 1st. Diary King says that it can pay you $1,500,000 up front on December 1st for this contract in order to mitigate your risk.

Should Gold Milk sign the contract with Diary King?