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Analysing price decissions

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?

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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