# Pricing, Risk & Uncertainty, Capital budgeting and Growth

PART 1: PRICING

1. Exercise:

– Explain clearly to a non-technical audience what transfer pricing is and why globalisation has made it such an important aspect of corporation’s pricing strategies (5 marks)

– Many corporations have been accused of using transfer pricing to avoid corporation tax. Provide a numerical example (other than those provided in the lecture and tutorial) from a real world case to explain and discuss how transfer pricing can be used for this purpose (5 marks).

– The Timex Group, a large multinational watch-maker, has its headquarters in the Netherlands. It has subsidiaries in many countries, including the Timex Group USA and TMX Philippines, Inc. One particular type of specialty watch is produced in the Philippines for export to the Timex Group USA. Suppose the inverse demand function for this in the United States is p=90 -2Q, where p is measured in dollars and Q is measured in thousands of watches per week. These watches are produced at a constant marginal cost of $10 per watch by TMX

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Philippines. Timex USA treats the transfer price charged by TMX Philippines as its marginal cost. If these two subsidiaries are instructed to maximise combined profits, what are the price, quantity, and transfer price? Could TMX Philippines raise its own profit by charging a higher price? (5 marks).

2. Your company: Provide specific examples of pricing strategy (excluded transfer pricing) used by your company and critically evaluate these using the theories and concepts learned in economics courses, including ECON 1081. (10 marks)

PART 2: RISK & UNCERTAINTY 1. Exercise

An investor has two investment opportunities, each involving an outlay of £1,000. The present value of possible outcomes and their respective probabilities are:

￼￼￼￼￼￼￼￼￼￼￼￼￼￼Investment 1

￼￼￼￼￼Investment 2

￼￼￼￼Outcome

￼£4,000 £6,000

￼£3,000 £5,000 £7,000

￼￼￼￼￼Probability

￼￼￼￼0.6 0.4

￼￼￼￼0.4 0.3 0.3

￼a) Calculate the risk of each project and determine which of the two investments the investor should choose. NOTE: Provide all mathematical calculations (4 marks)

b) Thepharmaceuticalindustryissaidtohaveahighaveragerateofreturnandahighcoefficientofvariation.Theelectricityindustry is said to have a low average rate of return and a low coefficient of variation. In which industry are returns more uncertain? Discuss the factors explaining these variations. (3 marks)

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c) Including foreign securities in an investment portfolio can reduce risk and increase the rate of return, but also gives rise to a foreign- exchange risk. Explain with an example what foreign-exchange risk is, and how hedging can help to manage it (3 marks).

2. Your company:

– Using the concepts and theories covered in this course and by providing real world examples, define what risk is, and explain and discuss the top 2 risks your company is mostly exposed to. Make sure to include reference on whether these risks are industry or location specific, or specific to the firm. (10 marks)

– Using the concepts and theories and cases covered in class, critically evaluate the strategies the company has implemented or should implement to cope with these risks (5 marks)

PART 3: CAPITAL BUDGETING

A firm is faced with two mutually exclusive projects, which have the following income streams, in thousands of pounds.

￼￼￼￼￼￼￼Initial capital

￼￼￼￼￼End of 1st year

￼￼￼End of 2nd year

￼￼End of 3d year

￼￼￼￼Project A

￼-2000

￼￼￼￼￼1000

￼￼￼1400

￼￼1000

￼￼￼￼Project B

￼-1200

￼￼￼￼￼￼800

￼￼￼￼1600

￼￼￼—

1. Find the payback period (2 marks)

2. What are the main shortcomings of the payback period as a method for investment appraisal? (2 marks)

3. At an interest rate of 10% calculate their Net Present Values (NPVs) (3 marks) and explain what the purpose of the NPV is and how

it works as a decision-making criteria. (3 marks)

4. Calculate their Internal Rate of Return (IRR) (3 marks) and explain what it is and how it works as a decision-making criteria (2 marks).

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5. Find their Profitability Index (PI) (3 marks)

6. Rank the two projects according to the four criteria above (Payback, NPV, IRR and PI) and comment on your results. (2 marks)

7. The Net Present Value and the Internal Rate of Return of a series of net cash flows will often give the same results. There are, however,

situations in which the NPV and the IRR will differ. What are these cases and which of the two should be preferred in each of these cases? (5 marks)

NOTE: Provide all mathematical calculations

PART 4: GROWTH Your company:

– Using the concepts and theories covered in the course, critically analyse and evaluate the growth strategy your company has followed to date (9 marks)

– Scan the market for a prey that your company could use to grow externally and justify your choice in the light of the concepts and theories covered in the course. (8 marks)

– By comparing the different possible arrangements (merger, acquisition, alliance, JV; horizontal, vertical, conglomerate), specify what type of arrangement would suit your company the most, and analytically and critically discuss what would be the expected advantages, disadvantages and challenges for the company. (8 marks)

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