For this Memo we need to examine what a company should do with an unexpected increase in cash flow. You will evaluate the alternatives, calculate the value of the options, and provide a recommendation of how the firm should allocate its excess cash.

Welcome on board!

Our executive board is demanding more profits and we are happy to have your expertise to work with.

Our finance department has just projected an increase in tax savings on the first of the year, freeing up some cash. We’re not sure how big this boost to cash flow will be, but they are estimating anywhere between $5,000 and $25,000. The finance department is eager to use this surplus to pay off some of the company debt due at the end of the year. The amount due at the end of the year is $15,625 and is based on a 25% interest rate.

As you might expect, the marketing department has insisted on using the funds for expanding our advertising reach. They estimate revenue to increase with units of advertising (A) according to the function, R(A) = 1000*A1/2. Unfortunately, we won’t realize this benefit until one year after incurring the cost of advertising, C(A) = 20A, today.

Of course, we could always stash the cash tax savings in a mutual fund at 4% to save for later.

Could you work out what the optimal level of advertising should be, and the resulting profit? And, determine which department is the best option to pursue, if any?

Answer rating: 100% (QA)

To calculate the optimal level of advertising we need to find the point where marginal r... View the full answer