581. On the other hand, demand for a product or service is elastic if a change in price has a substantial effect on the volume of units sold.582. If the same gas station lowered its prices expecting elastic demand to create market share gains, the competitor across the street would probably match the price reduction, thereby holding each gas station’s market share constant while lowering both competitors’ profits.583. If a company wants to charge higher prices than its competitors, then the company must differentiate its products or services from competing choices in a manner that motivates its customers to accept higher prices.584. A company increases its likelihood of covering all of its costs and maximizing profits if it is capable of choosing optimal prices based on customer demand data rather than computing prices that are arbitrarily chosen without the benefit of customer feedback.585. Third, it needs to multiply a product’s unit product cost by the sum of one plus the markup percentage to determine the product’s selling price.586. A prudent manager would make a small change in price in the direction of the optimal price and then observe what happens to unit sales and to the net operating income.587. Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained.588. The customers’ sensitivity to price is said to be inelastic if a change in price has little effect on the number of units sold.589. In other words, it treats a dollar received today as being of equal value to a dollar received at any point in the future.590. Conversely, the net present value and internal rate of return methods not only focus on cash flows, but they also recognize the time value of those cash flows.591. The payback period is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates.592. The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.593. And finally, the payback method is sometimes used in industries where products become obsolete very rapidly—such as consumer electronics.594. Therefore, if the company’s minimum required rate of return is used as the discount rate, a project with a positive net present value has a return that exceeds the minimum required rate of return and is acceptable.595. The cost of capital is the average rate of return that the company must pay to its long-term creditors and its shareholders for the use of their funds.596. Second, the net present value method is often simpler to use than the internal rate of return method, particularly when a project does not have identical cash flows every year.597. The net present value method assumes the rate of return is the discount rate, whereas the internal rate of return method assumes the rate of return earned on cash flows is the internal rate of return on the project.598. In short, when the net present value method and the internal rate of return method do not agree concerning the attractiveness of a project, it is best to go with the net present value method.599. Investment decisions should take into account the time value of money because a dollar received today is more valuable than a dollar received in the future.600. Our goal in this chapter is to translate this fairly complex principle into a small number of concepts and steps that simplify the process of preparing and interpreting a statement of cash flows.
