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Business Analytic & Econometrics

Part One

This part is two pages

This week’s DQ revolves around your decision to pursue an MBA. If you were to consider the principles of opportunity cost, MR, and MC; how would these economic concepts impact your justification to complete an MBA? 

Part Two

This Part is 6 pages or what it takes to answer the questions, it could be less than 6 pages .

Chapter 1 Case Designing Managerial. all Questions

Chapter 2 Case American Airlines All Questions. 

Submit in Word with APA formatting with academic sources. 

Chapter One Case Designing Managerial

Case Exercises

Designing a Managerial Incentives Contract

Specific Electric Co. asks you to implement a pay-for-performance incentive contract for its new CEO and four EVPs on the Executive Committee. The five managers can either work really hard with 70 hour weeks at a personal opportunity cost of $200,000 in reduced personal entrepreneurship and increased stress-related health care costs or they can reduce effort, thereby avoiding the personal costs. The CEO and EVPs face three possible random outcomes: the probability of the company experiencing good luck is 30 percent, medium luck is 40 percent, and bad luck is 30 percent. Although the senior management team can distinguish the three “states” of luck as the quarter unfolds, the Compensation Committee of the Board of Directors (and the shareholders) cannot do so. Once the board designs an incentive contract, soon thereafter the good, medium, or bad luck occurs, and thereafter the senior managers decide to expend high or reduced work effort. One of the observable shareholder values listed below then results.

High Effort $1,000,000,000 $800,000,000 $500,000,000
Reduced Effort $800,000,000 $500,000,000 $300,000,000

Assume the company has 10 million shares outstanding offered at a $65 initial share price, implying a $650,000,000 initial shareholder value. Since the EVPs and CEOs effort and the company’s luck are unobservable to the owners and company directors, it is not possible when the company’s share price falls to $50 and the company’s value to $500,000,000 to distinguish whether the company experienced reduced effort and medium luck or high effort and bad luck. Similarly, it is not possible to distinguish reduced effort and good luck from high effort and medium luck.

Answer the following questions from the perspective of a member of the Compensation Committee of the board of directors who is aligned with shareholders’ interests and is deciding on a performance-based pay plan (an “incentive contract”) for the CEO and EVPs.


  • 1. What is the maximum amount it would be worth to shareholders to elicit high effort all of the time rather than reduced effort all of the time?


$240 million

  • 2. If you decide to pay 1 percent of the increase in shareholder value as a cash bonus, what performance level (what share price or shareholder value) in the table should trigger the bonus? Suppose you decide to elicit high effort by paying a bonus should the company’s value rise to $800,000,000. What two criticisms can you see of this incentive contract plan?
  • 3. Suppose you decide to elicit high effort by paying a bonus only for an increase in the company’s value to $1,000,000,000. When, and if, good luck occurs, what two criticisms can you see of this incentive contract plan?
  • 4. Suppose you decide to elicit high effort by paying the bonus when the company’s value falls to $500,000,000. When, and if, bad luck occurs, what two criticisms can you see of this incentive contract plan?
  • 5. If the bonus compensation scheme must be announced in advance, and if you must pick one of the three choices in Questions 23 and 4, which one would you pick and why? In other words, under incomplete information, what is the optimal decision by the Board’s Compensation Committee dedicated to act in the shareholders’ interest?
  • 6. Audits are basically sampling procedures to verify with a predetermined accuracy the sources and uses of the company receipts and expenditures; the larger the sample, the higher the accuracy. In an effort to identify the share price that should trigger a bonus, how much would you, the Compensation Committee, be willing to pay an auditing consultant who could sample the expense and revenue flows in real time and deliver perfect forecasting information about the “luck” the firm’s sales force is experiencing? Compare shareholder value with this perfect forecast information relative to the best choice among the bonus plans you selected in Question 5. Define the difference as the Potential Value of Perfect Forecast Information.
  • 7. Design a stock option-based incentive plan to elicit high effort. Show that one million stock options at a $70 exercise price improve shareholder value relative to the best of the cash bonus plans chosen in Question 5.


$167 million

  • 8. Design an incentive plan that seeks to elicit high effort by granting restricted stock. Show that one-half million shares granted at $70 improves shareholder value relative to all prior alternatives.


$205 million

  • 9. Sketch the game tree for designing this optimal managerial incentive contract among the alternatives in Question 23 and 4. Who makes the first choice? Who the second? What role does randomness play? Which bonus pay contract represents a best reply response in each endgame? Which bonus pay contract should the Compensation Committee of the Board select to maximize expected value? How does that compare with your selection based on the contingent claims analysis in Questions 7 and 8?

Shareholder Value of Renewable Energy from Wind Power at Hydro Co.: Is RE < C?

Despite a decade of subsidies and considerable success in Denmark, Germany, and Britain, renewable energy in the U.S. accounts for only 7 or 8 percent of total energy consumption. Hydroelectric power remains the most successful source of renewable energy in the United States where it accounts for 2.8 percent at a cost of $0.09/kwh (see Figure 1.4). Ethanol and other biofuels account for 1.6 percent, and surprisingly wind power and solar power are good for only 0.7 and 0.1 percent, respectively. Part of the explanation is that the EU is more ambitious, setting a hard goal of 20 percent of energy consumption from renewables by 2020.

Figure 1.4U.S. Average Cost for Electricity Generation 2012 (Equilibrium )

Electricity from renewables in the United States must compete against conventional fossil fuels averaging approximately $.11/kwh costs nationwide. Land-based wind turbines, for example, have now become as inexpensive as conventional coal and natural gas at $.096/kwh and $.098/kwh, respectively, accounting for plant construction, fuel, maintenance, and other operating costs (again see Figure 1.4). Of course with carbon capture and storage, coal becomes much more expensive at $.141/kwh. The extensive shale gas discoveries in the United States have made combined-cycle natural gas-fired power plants cheaper than coal at $.092/kwh.

Solar energy remains a huge disappointment. Photovoltaic technology and storage has progressed but remains in its infancy such that the ratio of yield onto the electric grid relative to 24-hour potential capacity is only 25 percent. Steam-generating solar farms have an even lower energy conversion factor of 20 percent. Consequently even though solar capacity can be dispersed to individual rooftop installations and transmission costs are therefore much lower than wind or geothermal power, solar energy remains the most expensive source of renewable energy at $.153/kwh. With much better technology, geothermal and biomass are major RE successes at $.098/kwh and $.115/kwh, respectively.

Wind farms and massive solar collector arrays already provide 20 percent of the electric power generation in Denmark and 15 percent in Germany. Hydro, a Norwegian aluminum company, has established wind turbine pilot projects where entire communities are electricity self-sufficient. At 80 meters of elevation, class 3 wind energy (steady 22 kph breeze) is available almost everywhere on the planet, implying wind power potential worldwide of 72 million megawatts. Harvesting just the best 5 percent of this wind energy (3.6 million megawatts) would make it possible to retire several thousand coal-fired power plants, 617 of which operate in the United States today.

So-called alternative energy is:

  • (1) renewable,
  • (2)in abundant local supply, and
  • (3)generates a low carbon footprint.

Renewables are naturally replenishing sources including wind, solar, hydro, biofuel, biomass, geothermal, tidal, ocean current, and wave energy. Nuclear energy is not renewable because of the waste disposal issues. To date, by far the most successful renewables are hydroelectric power plants and ethanol-based biofuels, each accounting for about 2 percent of energy worldwide. New sources of renewable energy such as wind and solar power are often judged against fuel oil at $15, natural gas at $3, and coal at $4 per million BTUs (see Figure 1.5). One ton of plentiful high-sulfur-content coal generates approximately a megawatt of electricity and a ton of carbon dioxide . In 2008, the European Union’s cap-and-trade legislation to reduce carbon emissions imposed a $.023 per ton additional  emissions charge atop the $.085 purchase price of coal. Finding renewable energy sources that have full costs lower than coal’s  for a megawatt hour (RE < C) is a reasonable objective of energy policy.

Figure 1.5RE ≥ C? Can Renewable Energy Cost Less Than Coal? 1999–2011

Source: Thomson Datastream; U.S. Energy Information Administration.

Why pursue wind and solar power rather than other alternative energy sources? Nuclear energy has a decades-long timeline for construction and permitting especially of nuclear waste disposal sites. Corn-based ethanol runs up the cost of animal feedstocks and raises food prices. In addition, corn contains only one-eighth the BTUs of sugarcane, which is in abundant supply in the Caribbean and Brazil. Unfortunately, the U.S. Congress has placed a $0.54 per gallon tariff on sugarcane-based ethanol. Natural gas is 80 percent cleaner than coal and extraordinarily abundant in the United States, the world’s biggest energy user. The United States contains almost 30 percent of the known deposits worldwide of natural gas (and coal) but only 3 percent of the proven reserves of readily available and relatively easily accessible crude oil.

A 0.6 megawatt wind turbine that costs $1.2 million today will generate $4.4 million in discounted net present value of electricity over a 15-year period, sufficient to power 440 Western European or American households with 100 percent capacity utilization and continuous 15 mph wind. Mechanical energy in the turbine is converted directly into electrical potential energy with a magnetic coil generator. When the wind does not blow, Hydro has demonstrated and patented a load-shifting technology that consists of a hydrolysis electrolyzer splitting water into oxygen and hydrogen, a hydrogen storage container, and a fuel cell to convert the hydrogen chemical energy back to electrical current (see Figure 1.6). With the three extra pieces of equipment, the capital investment rises from $1.2 million to $2.7 million. Even so, wind power can be quite profitable with full cost recovery periods as short as seven years under ideal operating conditions.

Figure 1.6Continuous Electricity from Wind Power

Of course, frequently the operating conditions with wind power are far less than ideal. Despite the presence of wind at elevation across the globe, few communities want 80+ meter wind turbines as tall as a football field in their backyard sight lines. Lower installations result in less wind and therefore less electricity. In addition, the conversion of one form of energy to another always burns energy. In Hydro’s load-shifting process of converting mechanical energy from the turbine to chemical energy in the electrolyzer and then to electrical energy in the hydrogen fuel cell, about 30 percent of the maximum energy coming directly to the electrical grid from the turbine’s generator when the wind is blowing hard and steady is lost. Experiments in many wind conditions at the Utsira site suggest that baseline output of Hydro’s pilot project in Norway has a maximum energy conversion factor (CF) of 70 percent with 60 percent more typical. Even lower 45 percent CFs are expected in typical operating conditions elsewhere. Seventy percent CF realizes $3.1 million of electricity per turbine.


  1. As a value-maximizing aluminum company, should Hydro invest in wind power in light of the Utsira pilot project? Why or why not?
  2. Larger-scale turbines increase the electricity more than proportionately to the increase in costs. A 1 megawatt turbine costs $2.6 million, with the remaining equipment costs unchanged, for a total required investment of $4.1 million to power approximately 760 households. Electricity revenue over 15 years rises to $7.2 million in discounted present value. What conversion factor allows cost recovery of this larger-scale turbine?
  3. If the net present value of the Utsira project is negative, yet Hydro goes ahead and funds the investment anyway, what ethical obligations does Hydro have to its shareholders? Discuss the role of corporate social responsibility and of back-up plans to address the possible full costing of coal, as in the European Union where carbon permits for a ton of coal have at times increased coal resource costs by 25 percent.
  4. On what basis could shareholder value possibly rise if Hydro invests in negative NPV wind power projects?
  5. Energy entrepreneur T. Boone Pickens has proposed converting the trucking fleet in the United States to liquefied natural gas (LNG) and using wind power to replace the missing LNG in electric power production. What infrastructure issues do you see that must be resolved before the Pickens plan could be adopted?

Chapter Two case American Airlines

Case Exercise

Revenue Management at American Airlines

Airlines face highly cyclical demand; American reported profitability in the strong expansion of 2006–2007 but massive losses in the severe recession of 2008–2009. Demand also fluctuates day to day. One of the ways American copes with random demand is through marginal analysis using revenue management techniques. Revenue or “yield” management (RM) is an integrated demand-management, order-booking, and capacity-planning process.

To win orders in a service industry without slashing prices requires that companies create perceived value for segmented classes of customers. Business travelers on airlines, for example, will pay substantial premiums for last-minute responsiveness to their flight change requests. Other business travelers demand exceptional delivery reliability and on- time performance. In contrast, most vacation excursion travelers want commodity-like service at rock-bottom prices. Although only 15 to 20 percent of most airlines’ seats are in the business segment, 65 to 75 percent of the profit contribution on a typical flight comes from this group.

The management problem is that airline capacity must be planned and allocated well in advance of customer arrivals, often before demand is fully known, yet unsold inventory perishes at the moment of departure. This same issue faces hospitals, consulting firms, TV stations, and printing businesses, all of whom must acquire and schedule capacity before the demands for elective surgeries, a crisis management team, TV ads, or the next week’s press run are fully known.

One approach to minimizing unsold inventory and yet capturing all last-minute highprofit business is to auction off capacity to the highest bidder. The auction for freewheeling electricity works just that way: power companies bid at quarter ‘til the hour for excess supplies that other utilities agree to deliver on the hour. However, in airlines, prices cannot be adjusted quickly as the moment of departure approaches. Instead, revenue managers employ large historical databases to predict segmented customer demand in light of current arrivals on the reservation system. They then analyze the expected marginal profit from holding in reserve another seat in business class in anticipation of additional “last-minute” demand and compare that seat by seat to the alternative expected marginal profit from accepting one more advance reservation request from a discount traveler.

Suppose on the 9:00 a.m. Dallas to Chicago flight next Monday, 63 of American’s 170 seats have been “protected” for first class, business class, and full coach fares but only 50 have been sold; the remaining 107 seats have been authorized for sale at a discount. Three days before departure, another advance reservation request arrives in the discount class, which is presently full. Should American reallocate capacity and take on the new discount passenger? The answer depends on the marginal profit from each class and the predicted probability of excess demand (beyond 63 seats) next Monday in the business classes.

If the $721 full coach fare has a $500 marginal profit and the $155 discount fare has a $100 marginal profit, the seat in question should not be reallocated from business to discount customers unless the probability of “stocking out” in business is less than 0.20 (accounting for the likely incidence of cancellations and no-shows). Therefore, if the probability of stocking out is 0.25, the expected marginal profit from holding an empty seat for another potential business customer is $125, whereas the marginal profit from selling that seat to the discount customer is only $100 with certainty. Even a pay-in-advance no-refund seat request from the discount class should be refused. Every company has some viable orders that should be refused because additional capacity held in reserve for the anticipated arrival of higher profit customers is not “idle capacity” but rather a predictable revenue opportunity waiting to happen.

In this chapter, we developed the marginal analysis approach used in solving American’s seat allocation decision problem. The Appendix to Chapter 14 discusses further the application of revenue management to baseball, theatre ticketing, and hotels.


  1. Make a list of some of the issues that will need to be resolved if American Airlines decides to routinely charge different prices to customers in the same class of service.
  2. Would you expect these revenue management techniques of charging differential prices based on the target customers’ willingness to pay for change order responsiveness, delivery reliability, schedule frequency, and so forth to be more effective in the trucking industry, the outpatient health care industry, or the hotel industry? Why or why not?
  3. Sometimes when reservation requests by deep discount travelers are refused, demanders take their business elsewhere; they “balk.” At other times, such deman- ders negotiate and can be “sold up” to higher fare service like United’s Economy Plus. If United experiences fewer customers balking when reservation requests for the cheapest seats are refused, should they allocate preexisting capacity to protect fewer seats (or more) for late-arriving full-fare passengers?

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