Includes review slides credited to K. Neff

1. Finance: Week 3
Synthesis and Exam Review
Professor Whitaker
Sotheby’s Institute New York
Principles of Business I
October 12, 2011

2. Agenda
• After-lunch Film (risk, return, uncertainty,
hope)
• Expected Value
• Split Assignments
– (a) Review of NPV
– (b) Research Projects
• “Teach us Something in 3 Minutes”

3. Midterm
• Wednesday, October 26, 1-4pm in Lex 1
• Open book, open notes, bring computer or
calculator
• Review session Friday, October 21, 12:30-
2pm, Lex 1
• Problem Set Review

4. Film of the Day

5. Expected Value
If I play poker with Bob and Anne, these three things could happen:
• A 50% chance of making $20
• A 30% chance of losing $20
• A 20% chance of breaking even
Expected value = the probability of an outcome x the value of the outcome
What is the expected value of each outcome?
50% chance of $20 = .5 x $20 = +$10
30% chance of $20 = .3 x -$20 = -$6
20% chance of zero = .2 x $0 = 0
Sum these: the game overall has an EV of +$4
© Amy Whitaker amy.whitaker@gmail.com

6. Expected Value
Example 2:
I am going to teach a class and charge $30.
• If I get great attendance, 100 people will come.
($30 x 100 people = $3,000)
• If I get poor attendance, 20 people will come.
($30 x 20 people = $600)
At 50/50 odds, that is $1500 + $300 = $1800
At 20/80 odds, that is $600 + 480 = $1080
© Amy Whitaker amy.whitaker@gmail.com

7. Breakeven Analysis
At what point to I recoup my costs and start making a profit?
Example:
To start a school, I need $5000 for rent, supplies, equipment. For each
student, a foundation gives me $150. I have to spend $50 of that on supplies
for that student. At what point do I break even?
Break Even = Total Fixed Cost = 5000 = 5000 =
Revenue – Variable Cost 150 – 50 100
50 students
© Amy Whitaker amy.whitaker@gmail.com

8. “Breakeven” thinking in NPV
In the homework, you bought a Picasso for
$10mn, and you knew you could sell it for $14mn in
10 years.
PV = 14mn / (1.05)^10 = $8.59mn
If I invested the $10mn in a bond yielding 5%, in 10
years, I would have 10mn x (1.05)^10 = $16.3mn.
This is your mental investment “hurdle.”

9. Compounding and Discounting
(moving money through time)

10. Lottery Ticket
You have won the lottery!
Would you rather have a
lump sum payment of
$10 million, or $1.2
million every year for 10
years?

11. Artist’s Retainer
There is a hot young artist you really want to sign to
your gallery. It is the 1980s and people are paying
artists retainers.
If you pay this artist, Fred Lois Smith, $40,000 per
month for a year, he will make work you can sell in
your gallery in one year’s time. Because of Fred’s
cost of materials, he requests that you pay the
amount up front at the start of the year. How much
do you have to make from Fred’s show for this to be
worth it?

12. A Friend in Need. . .
• You loan $10,000 to your best friend Jane who
is in dire straights. Your friend is good to her
word though and does return the money to
you, five years later. You don’t mind, but your
other friend Ned insists this isn’t really
$10,000. You appease Ned by doing a present
value calculation at 5%. Obviously, Ned is an
insensitive clod, but is he right?

13. A New Museum in Lichtenstein
The government of Lichtenstein tells the
Guggenheim that they would like to experience
the ‘Bilbao Effect’ in their tiny nation state.
They will pay the Guggenheim a $20mn licensing
fee but only if the project is successful. If 3
million visitors have come to the museum each
year starting in years 5 to 10, then in year 10,
the government will pay the Guggenheim
$20mn. What is the Gugg’s max budget at the
beginning of year 1?

14. The Balance Sheet
A = L+E
LIABILITIES
ASSETS =
[Credit:
Katie Neff]
SHAREHOLDERS’
EQUITY

15. Balance Sheet Components
Short-term Assets Short-term Liabilities
 Inventories  Accounts Payable
 Accounts Receivables  Income Taxes Payable
 Cash  Short-term borrowing (within 1 year)
 Financial investments held for short- Long-term Liabilities
term
Long-term Assets  Long-term borrowings (more than 1
year)
• Property
Shareholders’ Equity
• Plant and Machinery
 Retained Earnings
• Patents
 Capital invested / Common Stock
• Goodwill
[Credit:
Katie Neff]

16. Income Statement
Income = Revenue - Expenses

17. Income Statement
Sales $1,000
Cost of Goods Sold (COGS) (500)
Gross Profit 500
Selling, General & Administrative (SG&A) (200)
Operating Profit 300
Interest Cost (50)
Profit Before Taxes 250
Tax Cost (40)
Net Income $210
[Credit:
Katie Neff]

18. Income Statement Example:
Create an Income Statement for the
Month of May
• During the month of May, Bryan Inc. sold 100 products at a price of
$100 each.
• 20% of these customers paid in cash.
• Each product costs Bryan Inc. $50 each to procure (Bryan Inc. is a
reseller, not a manufacturer)
• The total monthly cost of the two employees (one for sales and one
for administration) is $1,500.
• The monthly rental cost of the small office space they use is $1,000
• They do not need any warehouse space since they deliver direct
from their supplier to the customer.
• The average monthly cost of the utilities is $500.
• Bryan Inc. has a bank loan of $10,000 incurring a monthly interest
rate of 1.0%.
• The tax rate is 30% of profits
[Credit:
Katie Neff]

19. Income Statement Example:
Sales 10,000
Cost of Goods Sold (5,000)
Gross Profit 5,000
Sales, General & Administrative (SG&A) (3,000)
Operating Profit 2,000
Interest Cost (100)
Profit Before Taxes 1,900
Tax Cost (570)
Net Income 1,330
Sales: 100*$100 = $10,000 Whether they have been paid in cash or not is irrelevant for
the purposes of building the income statement
COGS: 100*$50 = $5,000
SG&A: ($1,500+$1,000+$500) = $3,000
Interest Expense: ($10,000*.01) = $100 [Credit:
Tax Expense: ($1,900*.30) = $570 Katie Neff]