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Financial Economics Literature for Managers

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Financial economics provides people with the knowledge on thecorrelation of and interdependencies offinancial variables, for example, shares, prices, and interest rates.This means that financial economics concerns with the apportionmentof economic resources over time and spatially in an indeterminateenvironment. On the other hand, macroeconomics concerns with thebehaviour of the aggregate economy. In this regards, the paper willprovide answers to macroeconomics and financial economics prompts toprovide an understanding of numerous aspects of finance andeconomics. Aggregate demand, macroeconomics objectives, governmentrole in the economy, public goods, production, opportunity costs,financial ratios will be discussed.

Question 1

1(a). Explain the three classifications of production and giveexamples for each

Batch, job, and mass production refer to the classification ofproduction. Job production comprises the production of productsaccording to the orders obtained from the client (Murthy 2005). Inthis production, the equipment and machines are adjusted accordinglyto suit a certain job’s requirements. Some of the examples of thistype of production include bridge building, dam construction, andshipbuilding. Batch production relates tothe repetitive production (Bénabou and Tirole2016). It involves the production ofidentical products in batches based on the customers’ demand or onthe projected future demand for the products. This method is widelyused in motor manufacturing, tinned food, and confectionery.

Flow or mass production entails large-scaleand continuous production of standardised goods or products (Bénabouand Tirole 2016). This kind ofproduction is continuous due to anticipated future demand for theproducts. As such the method involves producing the same type ofproduct in order to meet the market or assembly line’s demand(Murthy 2005). Examples of flow production include the manufacturingof fast food, guns, and cars.

(b). Explain the opportunity costs and give examples

The opportunity cost denotes the value that a person or an entity hasto forego to make a specific purchase or investment. Mankiw (2014)refers to the opportunity cost as what a person gives up to getanother item, which means it is the worth of the best-relinquishedalternative. Given the presence of limited resources, a person needsto make a preference between mutual alternatives. Mankiw (2014) saysthat the opportunity cost is the cost incurred for not enjoying thebenefit of the other choice

John has $700 and he wants to buy a laptop and a phone, but bothcosts $700 each. If he buys a laptop, the opportunity cost is thephone. In another instance, when the government spends $7 billion topay rates for a debt, the opportunity cost is the program thegovernment might have spent the money on.

(c). Explain the purpose and evolution of the UK standardIndustrial Classification

The purpose of UK standard and industrial classification (SIC) is toclassify business organisations as well as other units based on thekind of economic activity that such businesses engage in. It wasintroduced in the UK in 1948 and it has undergone great evolutionsince then (Chartered Insurance Institute 2013). This classificationis used as a framework for the analysis, presentation, tabulation,and collection of data. Moreover, it can serve administrativepurposes (Chartered Insurance Institute 2013. Non-governmental bodiescan use SIC to classify industrial economic activities into variousstructures.

Different SIC systems have been developed in the country over time(Chartered Insurance Institute 2013. These systems have beenestablished in order to meet the changes that have been occurring inthe UK industry. For instance, the UK SIC of 1980 was focused more onthe manufacturing sector (Chartered Insurance Institute 2013). On theother hand, the UK SIC of 2007 is more focused on the IT sector. Ingeneral, the SIC systems has been evolving and it is expected toevolve in order to meet future changes in the industry.

(d). The shift in the demand curve and the movement along a demandcurve

A variation in a product’s price result to a movement along thedemand curve (Sloman and Jones 2014). Suchmovement is either referred to as contradictions or extensions. Anextension refers to a downward movement along the curve due to adecline in price. A contraction denotes an upward movement due to anincrease in price (Sloman and Jones 2014).In figure 1 below, point a denotes a contraction while point (b)denotes an

Figure 1: Movement along the demand curve. Source: Baumol and Blinder(2008)

A change in demand results in the shift in the demand curve (Slomanand Jones 2014). Baumol and Blinder (2008) contend that thedemand curve can either shift to the left or to the right. In thisregard, an increase in demand (with the price remaining constant)will lead to the shift to the right. In contrast, a decrease indemand will lead to the shift in the demand curve to the left. Figure2 below illustrates the shifts in the demandcurve. In the figure, an increase in demand result to demand shiftfrom D0 to D1 and a decline shifts the curvefrom D0 to D2.

Figure 2: Shifts in the demand curve: Adapted from Mankiw (2014)

(e). Explain the income and substitution effect on an increase inprice

The income effect illustrates the effect of a rise in purchasingpower on consumption (Mankiw 2014). The substitution effectillustrates how shifting relative prices affect consumption.

A price increase of product Y shifts thebudget line from B1 to B2. Consumption changes his bundle from A toB. The consumption of good Y, drops from Y1 to Y2. This movement fromA to B illustrates the impact of a price change. A Substitutioneffect ensues since Y is more expensive relative to the substitutegood. An income effect ensues since real income has declined.












Y2 Y3 Y1

Figure 3. The effect of income and substitution effect on a pricerise

A price increase of product Y shifts thebudget line from B1 to B2. Consumption changes his bundle from A toB. The consumption of good Y, drops from Y1 to Y2. This movement fromA to B illustrates the impact of a price change. A Substitutioneffect ensues since Y is more expensive relative to the substitutegood. An income effect ensues since real income has declined.

Question 2

2(a). Explain two types of market and give examples for each

Mankiw (2014) defines a market as a collection of sellers and buyersof goods and services. Examples of a market include the financialmarkets and consumer markets. Consumer markets are structures for theexchange of goods for consumption (Baumol and Blinder 2008). Forexample, food retail markets, auction markets, used goods market,stores, and marketplaces.

The financial market is a structure where liquid assets are exchanged(Besley and Brigham 2013 Mankiw 2014). For instance, stock markets(NASDAQ and NYSE) where shares are exchanged and bond markets.Futures market are where buyers and sellers exchange contracts(Besley and Brigham 2013). Other examples includecurrency markets for the exchange of currencies, money markets forborrowing and lending, and prediction markets.

(b). Define a public good and give examples of public goods

A public good denotes a good that individuals can consume withoutdiminishing its availability to other consumers (Mankiw 2014). Thismeans that it is a non-competitive and non-excludable good sinceindividuals cannot be omitted from use. It is usually provided bygovernments and organisations to all people without a profit (Baumoland Blinder 2008).

Examples of public goods include national security, some publicinfrastructures, street lighting, and fresh air. National security isprovided to all people by the government while some infrastructuressuch as roads are free for use.

(c). Explain the three ways in which government intervenes in themarket

Government intervention refers to the regulatory measures taken bythe government to affect the business decisions made byorganisations, groups, or individuals (Anderson and Yotov 2016Baumol and Blinder 2008). It refers to government policy that triesto change the production’s direction in favour of some sectors ofthe economy.

The government can intervene in the market through taxation. In thisregard, the government can increasetaxes on goods to discourage consumption (Hyman 2013). For example,the government can increase the tax oncigarettes and beer in order to make theseproducts expensive. The government can provide subsidies to a certainsector of the economy in order to enhance its growth (Mankiw 2014).Finally, the government can intervene in the market by providingessential goods and services to the citizens such as water,electricity, and housing.

(d). The four key macroeconomic policy objectives pursued bygovernments

Governments pursue economic growth, full employment, the balanceof payments, and price stability. Mankiw (2014) contend that highprice levels result to high inflation levels. Thus, governmentsthrough monetary policies intervene to stabilise prices to inhibitrecessions. International trade and foreign direct investment aresignificant in an economy (Sloman and Jones 2014). A balanced paymentin equilibrium ensures enough savings and investments, which lead toeconomic development.

Governments pursue full employment to ensure a stable economy. Lowlevels of employment lead to high costs since households are unableto pay taxes (Mankiw 2014). Firms also increase prices to meetprofits since the purchasing power of consumers is low (Mankiw 2014).Low levels of employment mean underutilisation of resources, whichresults in high levels of poverty. Pursuingstable economic growth allows a government to redistribute wealth andsocial overheads effectively. Furthermore, it inhibits lowdevelopment, low living standards, and high poverty levels.

(e). Explain the circular flow of income

It is an economic model that represents the way money flows throughthe given economy (Besley and Brighan 2013 Heinemann 2005). Thesimple version of this model models the economy as consisting offirms and households. It shows how the Gross Domestic Product (GDP)or national income is circulated. Figure 3 below depicts the circularflow of income.

Figure 4: The circular flow of income. Source: Heinemann (2005)

Injections refer to additions in the flow. This includesall the income to the economy which is spent within the economy(Mankiw 2014). However, the income that leaks out of such circularflow is referred to as withdrawals or leakages. Withdrawals includespending on imports, savings, and taxation(Heinemann 2005). Inner flows include rent, interest, wages, andprofits.

Question 3

3(a). Define and give examples of each of the four major areas offinance

The major areas of finance are financial markets and institutions,public finance, investments, and financial services. Financialmarkets are the systems for exchanging liquid assets (Mankiw 2014).Financial markets include capital markets, debt markets, equitymarkets, and money markets (Brighan and Ehrhardt 2007). Investmentsdenote the utilisation of capital or cash to acquirerevenue-generating assets. This area involves determining the risks,values, and return on investment of the acquired assets.

The Financial service deals with the management of money. Banks andfinancial facilities are greatly involved inhelping firms and people determine the best ways to invest theirmoney (Anderson and Yotov 2016 Crosson and Needles 2013). Onthe other hand, public finance describes the management of financesin the sub-national, sovereign states, and public entities. This areais concerned with budgeting processes, sources of revenue and debtissuance (Hyman 2013). Central banks influence credit and monetaryconditions and act as the lenders of last resort in this area.

(b). Explain the determinants of market interest rates

The determinants include the expected inflation, default-riskpremium, maturity premium, liquidity premium, and real risk-freetrade (Saborowski and Weber 2013). The expected inflation will resultin an increase in prices due to the decline in the purchasing powerof the currency (Bénabou and Tirole 2016).Therefore, the future nominal rate is equal to the real rate plusinflation.

The default-risk premium refers to the likelihood that borrower willmake the pay the amount owed in time (Brighan and Ehrhardt 2007).This determinant is based on the organisation of individual’screditworthiness. On the other hand, liquidity premium alsodetermines the interest rate. A less liquidity security attractshigher interest rate and vice versa (Saborowski and Weber 2013). Withregard to maturity premium, the longer the maturity period the higherthe interest rate.

(c). Explain the four basic financial statements

The income statement reflects an organisation’s losses, expenses,gains, and revenues (Crosson and Needles 2013). It normally consistsof two columns, with one column having revenues and gains while theother consisting of expenses and losses. Its main purpose is todetermine the company’s net loss or profit (Crosson and Needles2013). The balance sheet consists of an organisation’s assets onone side and liabilities on the other. Both assets and liabilitiesare classified as long-term and current assets and liabilitiesrespectively.

The cash flow statement reflects an organisation’s amount of cash.It includes all the items that affecting the company’s cashbalances (Bénabou and Tirole 2016Crosson and Needles 2013). The statement consists of operatingactivities and investing activities. Nevertheless, the other sectionshows the financial activities. Such section reflects the outflowsand inflows of cash relating to the issued financial securities ofthe company. The statement of shareholder’s equity reflects thenecessary changes in the shareholder’s equity during a certainreporting period (Brighan and Ehrhardt 2007). The items included inthis statement include changes due to reported losses or profits,dividend payments, and repurchase or sale of stock.

(d). Calculate four ratios for Marks and Spencer statement

Liquidity ratios

Current ratio: During the period, total current assets (CA) stood at1,368,500 while total current liabilities (CL) stood at 2,349,300.

Current ratio = CA / CL = 1,368,500 / 2,349,300 = 0.58. This meansthat the company is incapable of paying its obligations or short termliabilities. This is bad for the company as it will have challengestranslating inventories into cash.

Market ratios

Earnings per share: It is denoted as the value of earnings divided bythe number of shares. Total earnings for the firm stood at 506,000after tax. The weighted number of shares stood at 1,615,000

EPS = 506,000 / 1,615,000 = £0.31 or 31 pence

The ratio illustrates that the company has generated enough earningsto pay for the shareholders’ dividends.

Debt management ratios

Debt ratio: This reflects the proportion of a firm’s assetsprovided through debt.

Debt ratio = total debts / total assets

Debts for the firm stood at 2,463,600 and total assets stood at7,903,000

Debt ratio = 2,463,600/ 7,903,000

= 0.312 or 31%

The firm’s debt ratio is high, which provides a high risk

Asset management ratio

DSO (days sales outstanding): Evaluates the days a firm takes tocollect money after a sale.

DSO = Accounts receivables / revenue

= 309,500 (trade receivables for the firm) / 10,309,700 = 0.030 or 3days, which shows the company collects its revenue on time.

Question 4

4(a). Describe the importance of capital budging decisions

Capital budgeting refers to the process that organisations employ indetermining the merits of a certain investment project (Bénabouand Tirole 2016). It helps theorganisation to assess the viability of the project and decide onwhether to undertake it or not. Capital budgeting decisions enablethe company to foster its growth initiatives based on the project’srate of return (Baumol and Blinder 2008). Additionally, some capitalinvestment decisions enable a company to enhance goodwill throughsocial responsibility.

The first step in budgeting decisions involves identifying thenecessary investments proposals. In this case, the top management hasto define the available investment opportunities and submit theproposals. Then, the management screens the proposals. At this stage,the committee examines different proposalsand selects the most viable ones (Crosson and Needles 2013). Thethird stage is the evaluation of the proposals. In this case, theevaluation of the proposals is done using various methods. The fourthstep is referred to as fixing the property.At this stage, the committee tries to provide predictions regardingthe proposal that will generate more economic or profit consideration(Bénabou and Tirole 2016Brighan and Ehrhardt 2007). The project can be rejected or approved.The last step is the implementation of theproject by a competent authority. The final step involves reviewingthe project’s actual performance against the standard results.

(b). Describe how the net present value is used to makeinvestments

NPV refers to the difference between the current cash inflow and thecurrent cash outflow. According to Sloman and Jones (2014), itenables businesses to evaluate whether to invest ina certain project or not. It is more convenient than othertechniques. It takes into consideration both time and risk variables.

Before applying this technique, it is important to determine whetherthe project is a mutually independent on exclusive one. Independentprojects are not influenced by other projects’ cash flows (Besleyand Brighan 2013). In contrast, mutually exclusive projects areinfluenced by other projects’ cash flows. With regard toindependent projects, a project is only acceptable if its NPV isgreater than zero (Besley and Brighan 2013). With regard to mutuallyexclusive projects, a project having the highest NPV value isaccepted. However, both projects are rejected if their NPV isnegative.

(c). Explain the yield curve

A yield curve shows the numerous interest rates or yields acrossmultiple bond lengths, for example, 4 months, 4 years, 40 years, fora similar debt contract. Thus, it illustrates the correlation betweenthe cost of borrowing and the period of maturity of a debt. Thecurves may differ because of investors’ prospects about futureprice increases, which lead to an upward sloping curve (Sloman andJones 2014). Sloman and Jones (2014) contend that the curves maydiffer depending on the preference of lenders and borrowers. Thismeans that the demand and supply of funds affect the shape of thecurve.

Figure 5. A future decrease in interestrates (Adapted from Bénabouand Tirole 2016)

For shorter maturities, the slope is flat, which shows that interestrates are expected to fall. For longer maturities, the slope is steepbecause borrowers expect the interest rates to increase sharply. Thecurve shows that the market expects inflation to decrease in futurebut later increase.

Figure 6: A future increase in interest rates (Adapted from Bénabouand Tirole 2016)

The steep slope for shorter maturities shows that interest rates areexpected to increase. For longer maturities, the slope is downwardbecause borrowers expect the short-term interest rates to decreasesharply. The curve shows that the market expects inflation toincrease in future but later decrease

(d). Choosing a project

r = 10%, t = 5 years, Starting investment for each project = 50,000

NPV for project A

Annuity payment = 15, 625 for each year. Thus, NPV for A = 15,625[{1/10%} – {1/ (10% * (1 + 10%)5}] – 50,000

= 15,625 [{10} – {1/0.10 * (1.61051)}] – 50,000

= 15,625 [10- {1/0.161051}] – 50,000

= 15,625 [10 – 6.2092] – 50,000

= 15,625 * 3.7908 – 50,000 = 59,231.25 – 50,000 = 9,231.25

NPV for project B

FV = 99,500. Thus, NPV for B = 99,500 [{1/ (1 + 10%)5}] –50,000

= 99,500 [{1/ (1.1)5}] – 50,000

= 99,500 [1/1.61051] – 50,000

= 99,500 * 0.6209 – 50,000


Thus, project B should be chosen because it has a higher NPV thanproject A


The provision of finance and economics knowledge is paramount inhelping people making choices given the limited availability ofresources. The paper has provided significant information onaggregate demand, the variables involved in the market, the use ofNPV in making financial decisions, and the role of government.Furthermore, it has provided information on macroeconomicsobjectives, financial ratios, yield curve, financial statements,areas of finance, and capital budgeting decisions. These aspects aidin increasing the knowledge on financial and economics matter.

Reference List

Anderson, J.E. and Yotov, Y.V., 2016. Terms of trade and globalefficiency effects of free trade agreements, 1990–2002.&nbspJournalof International Economics,&nbsp99, pp.279-298.

Baumol, W. J., and Blinder, A. S., 2008.Macroeconomics: Principles and policy. London: Cengagelearning.

Bénabou, R. and Tirole, J., 2016. Mindfuleconomics: The production, consumption, andvalue of beliefs.&nbspJournalof Economic Perspectives,30(3),pp.141-64.

Besley, S. and Brigham, E.F., 2013.&nbspPrinciples of finance.Cengage Learning.

Brighan, E. and Ehrhardt, M.C., 2007.Financial management: Theory &amp Practice. London: CengageLearning.

Chartered Insurance Institute., 2013. The UK’s new financialservices regulatory landscape. Chartered Insurance Institute

Crosson, S. V. and Needles, B. E., 2013. Managerial accounting.London: Cengage Learning.

Heinemann. 2005. Heinemann economics for Edexcel. London:Heinemann.

Hyman, D.N., 2013. Public finance: a contemporary application oftheory to policy. London, Cengage Learning.

Mankiw, N.G., 2014.&nbspPrinciples of macroeconomics. CengageLearning.

Saborowski, C. and Weber, S., 2013.Assessing the determinants of interest rate transmission throughconditional impulse response functions. New York: InternationalMonetary Fund.

Sloman, J. and Jones, E., 2014.&nbspEssentialeconomics for business. PearsonHigher Ed.

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