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Analysing price decissions

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If the Rhine Company ignores the possibility that other firms may enter its market, it should set a price of $10,000 for its product, which is a power tool. But, if it does so, other firms will begin to enter the market. During the next two years, it will earn $4 million per year, but in the following the next two years, it will earn $1 million per year. On the other hand, if it sets a price of $7,000, it will earn $2.5 million in each of the next four years, since no entrants will appears.

a. If the interest rate is 10 percent, should the Rhine Company set a price of $7,000 or $10,000? Why? (Consider only the next four years)

b. If the interest rate is 8 percent, should the Rhine Company set a price of $7,000 or $10,000? Why? (Consider only the next four years)

c. The results in parts a and b pertain to only the next four years. How can the firm's manager extend the planning horizon?

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Solution Preview

Please refer attached solution for better clarity of tables and formulas in the cells.

Solution:

a. If the interest rate is 10 percent, should the Rhine Company set a price of $7,000 or $10,000? Why? (Consider only the next four years)

Let us calculate Present Value of Profits coming in next four years based upon 10% discount rate.
PV=Future Value/ (1+r) ^n
r = interest rate/discount rate per period.
n = no. of periods

Year End Case A Case B
Price = 10000 Price = 7000
Profit PV@10% Profit PV@10%
1 4 4/(1+0.1)^1=3.6364 2.5 2.5/(1+0.1)^1=2.2727
2 4 4/(1+0.1)^2=3.3058 2.5 2.5/(1+0.1)^2=2.0661
3 1 1/(1+0.1)^3=0.7513 2.5 2.5/(1+0.1)^3=1.8783
4 1 1/(1+0.1)^4=0.6830 ...

Solution Summary

Solution describes the steps involved in deciding whether lower or higher price should be choosen based upon NPV method.

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