ISSN 1656-8788

INSIDE
Feasibility Study: Payback Period
Feasibility study is probably the culminating project for those who major in business. It is also an important subject for those majoring in HRM. Feasibility study is a preliminary study undertaken to assess whether a planned project is likely to be viable. (page 5)

September-October 2006

Government Regulation of Markets

Mr. Cristobal Pagoso

In economics, a monopoly (from the Latin word monopolium - Greek language monos, one + polein, to sell) is defined as a persistent market situation where there is only one provider of a product or service. Monopolies are characterized by a lack of economic competition for the good or service that they provide and a lack of viable substitute goods. Monopolies are often distinguished based on the circumstances under which they arise. The broadest distinction is between monopolies that are the result of government intervention and those that arise without it (e.g. sole access to a resource, economies of scale, or consistently out competing all other firms). Thus, the two broadest categories are de jure monopoly (also called legal monopoly and statutory monopoly) which is one that is protected from competition by government, and de facto monopoly which is one that exists without government protection. This paper discusses the role of government in regulating markets in the country.

Monopolies, like Meralco tend to charge higher prices. To protect consumers from excessive prices due to monopolies, most developed countries have anti trust laws. There are some industries that really require large amount of start up capital. Putting up an electric plant requires billions of pesos of investment. This also applies for venture like railroads and postal services. These industries cannot operate under competitive conditions. Billions of pesos are needed to put up an electric plant. Too many competitors mean inability of proponents to get back their investments because of high cost and a decreasing market share brought about by competitors.It would be uneconomical to allow two or more electric plants to operate in the area. In order to avoid unwarranted competition, despoiling the environment and misallocation of resources, the government assigns only one electric company to operate in the area. The government gives a company an exclusive franchise to operate

in that area. The creating a monopoly. We monopoly. call this

government

is

thus

Public Regulation of Private Industry As mentioned earlier if monopolies are left alone, they charge high prices to maximize their profits. There are essential goods and services that have to be provided to the people. Some examples are: electricity, railways, and postal services. The government awards a franchise to a monopoly, say to Meralco, with the condition that its rates will be regulated by the government.

condition

natural

In exchange for the privilege of holding the franchise, the government exercises regulatory powers over the franchise holders. In case of energy matters, we have the Energy Regulatory (ERC) exercising this power. The Planning Function The Philippine is a market economy. Private enterprise is the hallmark of the market economy. Corporations are the core of the economy. They need to plan in order to give direction to the company and achieve their growth and profit targets. Vision: Sustainable Development and growth with Social Equity The Medium Term development Plan (MTPDP) of 1999-2004, envisions a sustainable development path anchored on growth with social equity. The number of poor families and the incidence of poverty is targeted to be reduced from 32 percent in 1997 to 25 - 28 percent by 2004. Access of the disadvantage to government institutions must be improved and rural areas and regions outside the National Capital Region must have a larger contribution to economic growth. The President of the Philippines is responsible for planning the directions and activities leading to the socio- economic enlistment of the people. She assisted by the Director General of the National Economic and Development Authority (NEDA) and other executive branches of the government. The government has to allocate economic resources to achieve this vision.

Figure 1. Regulation of a Monopoly

Regulation of a Monopoly Figure 1, illustrates graphically the effect of the government regulation of monopoly. If a monopolist is left alone, it will charge a high price (P1) and will produce less output (Q1). Consider the case for PLDT when it was a monopoly It took years t get a telephone line. For them, it is not profit maximizing to produce much output and excellent service. At a high price and limited output, only a limited number of people are benefited, while PLDT pocketed high profits.

LCCM Research Digest

The government would like price to be lowered to P2. At this price, Meralco or any other franchisee would get normal profit. Also at this price, more people would enjoy the benefits of electricity or telephone service. There will be a tendency for the franchisee to ask for a higher price, say, close to P1; there will be a tendency for the government regulatory to have a price close to P2. The haggling goes on between the franchisee and the government regulatory agency, until an agreement is reached between the two. This agreement should be beneficial to both the franchisee and the people represented by the regulatory agency.

is claimed that the cost of running dual water lines to every home in a community would be a waste of resources. Governments grant legal monopolies in the form of patents, trademarks, and copyrights. Holders of these de jure monopolies enjoy the protection of federal law when marketing or licensing the products and services to which they apply. Eco Link: Government Regulation of Other Sectors in the Economy Case Study

Synthesis 1. The government plays a very important role in delivering services and protecting the welfare of the people. 2. Natural monopolist exists in the Philippine economy but they are regulated by the government. 3. The primary objective of the government is to work for the improvement of the peoples standard of living. 4. For the benefit of the consumers and society as whole, regulations tends to lower the price and raise costs in the regulated industry. In many countries, almost all public utilities operate as monopolies granted by state and local governments. These include electricity, water, sewer, natural gas, cable television, and telephone services. It is believed by some that these services must be provided through legal monopoly because the costs to a nation or economy to have multiple providers are greater than the cost of only having one provider. For example, it LCCM Research Digest
Source:www.mayo.edu/.../images/pediatricnursing.jpg.

The commission on Higher Education yesterday said it would close down erring Review Centers starting November next year. In memorandum Order 49 dated November 3, CHED gave Review Centers a grace period of one year to meet the requirements. A Nursing Review Center for instance, has to have its own nursing school or has to tie up with one. CHED Chairman Carlito Puno said his agency has asked the Department of Trade and Industry not to accept new applications for Review Centers in the country following the approval of the memorandum containing 3

the rules and regulation for Executive Order 556 which regulates operations of Review Centers. The memorandum also provides an alternative to the existing Review Centers that fail to meet standards. Moreover, the memorandum stipulates that: Failures of existing review centers to fully comply with the above shall bar them from existing as review centers and they shall be deemed as operating illegally as such. Review Centers covered by the memorandum are those that offer to the public and/or to specialized groups whether for a fee or a free academic program intended to refresh and enhance the knowledge or competencies and skills requiring licensure examinations. But Review Centers for bar examinations, which are under the supervision of the Supreme Court are not included. Based on CHED records, 20 percent or 200 of the 1,000 Review Centers for nursing, engineering, medicine, accountancy and other courses covered by the licensure examination of the professional Regulation Commission, have official tie ups with duly accredited schools. The rest are operating on their own or considered as fly-by-night Review Centers.

government has the capacity to judge the optimum size of the market and to refuse entry to prospective new proprietors once that limit has been reached. This in turn would benefit the students for they are assured that the services they get from the money they paid for Review Centers are at a Pareto optimum level. References: Blinder, Alan S, William J Baumol and Colton L Gale (June 2001). 11: Monopoly, Microeconomics: Principles and Policy (paperback) (in English), Thomson SouthWestern, 212. Retrieved on October 2006. Fabella, R. ( 1993)Consumer Resistance and Monopoly Behavior under Franchise Contestability, Public Choice 76 (1993): 263-271. Ramos, E. (2006).PCCI Also Hits Monopoly. Manila Standard Today. Retrieved on http: // www. manilastandardtoday. Com /? page = business 01_july19_2006 Sulmerin, F. (November 15, 2006). Review Center Purge Begins .Manila Standard Today.

Mr. Cristobal M. Pagoso Faculty School of Business and Accountancy Research Interests: Economic Education and Labor Economics Contact Number 736-02-356 loc. 162

Insights The rationale behind these two linked objectives is that it would be undesirable to have unfettered and unplanned proliferation of Review Centers. An objective of orderly development implies that the public would not be well served by an environment where competition might result in some Review Centers closing due to poor financial viability or new Review Centers opening to compete with existing review. Moreover, it assumes that LCCM Research Digest

The Research Digest is now accepting contributions for the Nov.-Dec. Issue. Feel free to visit us for inquiries.

Feasibility Study: Payback Period

Ms. Solita Dranto

difficult to accept a feasibility study that shows these results, it is much better to find this out sooner rather than later, when more time and money would have been invested and lost. It is tempting to overlook the need for a feasibility study. Often, in an organizational set-up, the steering committee may face resistance from potential members on the need to do a feasibility study. Many people will feel that since they know that the proposed venture is a good idea, so why carry out a costly study just to prove what they already know? The feasibility study is important because it forces the planning committee to put its ideas on paper and to assess whether or not those ideas are realistic. It also forces the planning committee to begin formally evaluating which steps to take next. A feasibility study should examine three main areas: marketing issues; technical and organizational requirements and financial concerns. a. Marketing Issues - The primary area that the feasibility study needs to address is potential market opportunities for the business. If an adequate level of demand does not exist for the product and the company does not know how to differentiate its product so that it can compete with established industry players, then the proposed venture should not be pursued. b. Technological and organizational requirements - This area concerns the internal set-up of an organization which deals with plant and equipment issues as well as the managerial and organizational issues.

Source: www.futai.com.tw/eip/img1/4b.jpg

Feasibility study is probably the culminating project for those who major in business it is also an important subject for those majoring in HRM. Feasibility study is a preliminary study undertaken to assess whether a planned project is likely to be practical and successful and to estimate its cost. One aspect of the feasibility study is the financial aspect. It measures or probes into the financial viability of the proposed business venture. The feasibility study needs to answer the question: Does the idea make economic sense? The study should provide a thorough analysis of the business opportunity, including a look at all the possible roadblocks that may stand in the way of the organizations success. The outcome of the feasibility study will indicate whether or not to proceed with the proposed venture. If the results of the feasibility study are positive, then the organization can proceed to develop a business plan. If the results show that the project is not a sound business idea, then the project should not be pursued. Although it is LCCM Research Digest

c. Financial overview- based on the estimates that have been gathered from the preceding sections of the study, the company needs to determine its overall financial situation. Being quantitative in nature, this must be supported by computations, schedules and financial reports.

Php72,000 of its project cost, and by the end of the third year, it wouldve recovered Php113,000 of its project cost. The computation below show amount to be recovered by Hans Inc. Year 1 2 3 4 5 Operating cash inflows ( Php) 35,000 72,000 113,000 158,000 213,000 the

One such useful measure is the payback period. It may be an unsophisticated/ analysis or technique but it is practically cannot be undermined. Payback period is the length of time it takes the business to recover its investment. The Payback Period is defined as the length of time required to recover an initial investment through cash flows generated by the investment. The Payback Period shows the level of profitability of an investment in relation to time. The shorter the time period the better the investment opportunity:

Table 2. HANS, Inc. Operating Cash Flow Inflow The project cost will be recovered before the end of the third year. To be exact it is:

2 years +

28,000 = 2.68 years 41,000

Put other way, right after 2.68 years, Hans Inc. will start receiving cash over and above its project cost. For example HANS, Inc. has the following financial data for the next five years.
1 Net income after tax 2 3 4 5

The type of the operating cash flows in the example exhibits a mixed stream type of cash flows. This is the type of cash flows that students will likely to encounter in their feasibility study because of inflation factor. The Payback Period is a tool that is easy to use and understand, but it does have its limitations. Payback period analysis does not address the time value of money, nor does it go beyond the recovery of the initial investment. As another example, consider the implementation of a Human Resources (HR) software application that costs $150 thousand and will generate $50 thousand in annual savings in four years (the project duration):

20,000

22,000

26,000

30,000

40,000

Add: total depreciation and amortization Operating cash inflows

15,000

15,000

15,000

15,000

15,000

35,000

37,000

41,000

45,000

55,000

Table 1. HANS, Inc. Sample Financial Data. Assuming that the project cost is Php 100,000, then, by the end of the first year, Hans Inc., would have recovered Php35,000 of its project cost, and by the end of the second year, it wouldve recovered a total of LCCM Research Digest

Initial Cost in $ Year 1 Year 2 Year 3 Year 4

150,000 50,000 50,000 50,000 50,000 Cash flow: Initial/ remaining Net benefit:

1 60K 150K 90K

2 60K 90K 30K

3 40K 30K 10K

4 20K 10K 30K

The Payback Period is calculated to be three years by dividing the initial investment of $150 thousand over the annual cash flows of $50 thousand. This equation is only applicable when the investment produces equal cash flows each year. Now consider the software implementation with the same initial cost but with variable annual cash flows:
Initial Cost in $ Year 1 Year 2 Year 3 Year 4 150,000 60,000 60,000 40,000 20,000

The Payback Period is then calculated by dividing the Net Benefits of the final year in which there is a negative cash flow (no profits) by the total cash flow for the subsequent (profitable) year. This ratio is added to the final year of negative cash flow. In the example above, Year 2 is the last year with a negative cash flow and the Payback Period is 2 + ($30,000 / $40,000) or 2.8 years. Discounted Payback Period Equation The discounted Payback Period equation modifies the original Payback Period equation by incorporating the time value of money. The Net Benefits for each year are reduced, or discounted, at the cost of capital to the company. The individual Present Values (Net Benefits) for each year are added together until the sum of the Present Values changes to positive. The number of years necessary to change loss to profit is the Discounted Payback Period. Using a Discounted Payback Period equation improves the accuracy of the original Payback calculation; however, any benefits that occur after the initial investment is paid back are ignored. Some folks argue that if you go through the trouble of discounting cash flows to introduce the time value of money, you may as well employ a more accurate calculation, such as Net Present Value (NPV). Nevertheless, the Discounted Payback Period can be used in combination with NPV to help you understand the timing dynamics for technology investments.

The payback is calculated by looking at the cash flows and establishing the year the investment is paid off. At the beginning of Year 2, the company has recovered $120 thousand of the original $150 thousand. At the end of Year 2, the remaining $30 thousand is recovered with the cash flow of $40 thousand earned during this period. The payback period is then 2 + ($30 thousand/$40 thousand) or 2.8 years. The equation above can only be used when the cash flows are the same every year for the duration of the project. If the initial investment is spread out over several years, or the benefits change over time, then the Payback Period is calculated by looking at the Net Benefits, using the formula below:

The first step is to determine the Net Benefits. The Net Benefits are equal to the Benefits minus any initial or remaining Costs: LCCM Research Digest 7

The payback period method is a simple and widely used financial tool to evaluate the value of investments. It provides managers with a concept that can be readily communicated across the organization. The payback period also gives some indication of the level of risk of a project by separating projects that require a short time to recover their investment from those that require a longer time period.
Companies use Payback Period methodology as an initial screening tool to determine the profitability of software or technology investments. If the investment cannot be recovered in one or two years, then the project is rejected and no further analysis is completed. The impetus behind this methodology is the unpredictability of cash flows beyond two years for technology investments. The method is particularly valuable when used in combination with a robust financial analysis tool such as Net Present Value (NPV). However, the payback period has also its limitations. The methodology ignores any benefits that occur after the breakeven point. This simplification can cause problems when projects have identical payback periods but one has greater cash flows following the breakeven point. As a result, the tool may not accurately estimate the value of the project whose benefits occur after the initial investment costs are repaid. The methodology does not take into account risks and the time value of money. The methodology foregoes any discounting and the opportunity cost of capital. These omissions in the payback period methodology will overvalue the investments on an absolute basis. Nonetheless, the Payback Period calculation can still be useful for comparing projects that are assumed to have equal risk. This is a good example of knowing LCCM Research Digest

when the limitations of a tool can play in favor of simplifying the analysis. Other options such as Net Present Value (NPV) or Real Options are perhaps more accurate, but
the calculations are more complex and involved.

References:
Pinson, L., Jinnett, J. (1996). Anatomy of a Business Plan (3rd ed.). Upstart Publishing Company Retrieved from www.odellion.com on August 2006.
Ms. Solita Dranto
Faculty School of Business and Accountancy Research Interests: Management Accounting Contact Number 736-02-35 local 160

LCCM Research Digest is published by the Research and Publication Center to serve as a sounding board of up to date ideas and actions related to research, classroom management and material delivery of the faculty in the different schools of the College. It encourages and welcomes condensed versions or a short summary of research or review essays, conference papers, lecture notes, teaching guides and other classroom materials for its bimonthly publication. Editorial Board: Sr. Imelda A. Mora, OSA, LCCM President, Mr. Geronimo Suliguin Jr. Director-Research Center, Dr. Divina Edralin, Consultant Managing Editor: Carmela R. Claud For comments, suggestions and contribution, call (632) 736-02-35 loc. 173 or 313-05-09 or e-mail us at res@lccm.edu.ph. Also visit http://researchdigest.blogspot.com.

La Consolacion College Manila Quality Policy The administrators and personnel of La Consolacion College Manila are committed to continuously improve its quality management system, meeting student clientele and regulatory requirements This objective shall be accomplished through the application of the following: 1. Student Clientele Satisfaction. We perform task with the student-clients in mind to provide quality education and academic services. Continuous Improvement. We seek to continuously improve our services and processes, promote individual and holistic excellence through technical and professional competence, communication skills; religious- values education and information technology, and enhance safety in our community and environment. Effective Quality system. We will comply with the requirements of the international standard for quality system.

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