978-1285190907 Chapter 1 Part 1

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CHAPTER 1

OVERVIEW OF FINANCIAL REPORTING, FINANCIAL

STATEMENT ANALYSIS, AND VALUATION

Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases

1.1 Porter’s Five Forces Applied to the Air Courier Industry.

Buyer Power. Air courier services are a commodity. Firms in the industry offer

similar overnight or two-day deliveries. Firms also provide opportunities to track

shipments. Business customers can negotiate favorable shipping terms based on the

volume of shipments. Thus, buyer power among large corporate customers is high.

Supplier Power. The principal inputs are labor services, equipment, and informa-

tion systems. Except for pilots and some information processing specialists, the

skill required to offer air courier services is relatively low. Therefore, competition

for jobs reduces supplier power. The principal items of equipment are airplanes,

trucks, and sorting equipment. The number of suppliers of this equipment is rela-

tively small, but the equipment offered is largely a commodity. Thus, equipment

supplier power is relatively low. Information systems are critical to scheduling,

tracking, and delivering parcels. Hiring individuals with the education and skills

needed to design and maintain this information system is not difficult because these

skills and education are not unique. Thus, supplier power is low.

Rivalry among Existing Firms. Seven air couriers now carry a 90% market share.

Fed Ex and UPS have the largest market shares and compete heavily. Smaller firms

compete more in particular geographical or customer markets. Thus, rivalry is rela-

tively high.

Threat of New Entrants. The cost of acquiring equipment, developing national

and international delivery networks, and overcoming entrenched firms in an already

crowded market makes the threat of new entrants low.

Threat of Substitutes. The main threat to transportation of letter parcels is digital

transmission, and that threat is high. The threat of substitutes for transportation of

packages is low.

1.2 Economic Attributes Framework Applied to the Specialty Retailing Apparel

Industry.

Demand. Firms attempt to compete on design, colors, and other product attributes,

but apparel is largely a commodity. Demand is somewhat cyclical with economic

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

conditions; customers tend to delay purchases or trade down during economic

downturns. Demand is seasonal within the year. Demand grows at the growth rate

in population, which suggests that apparel retailing is a relatively mature market.

To the extent that retailers can generate customer loyalty, demand is not highly

price-sensitive. However, given the similarity of product offerings across firms,

firms cannot price their goods too much out of line with those of their competitors.

Supply. In most markets, there are many firms selling similar apparel. The barriers

to entry are not particularly high because an apparel line and retail space are the

most important ingredients.

Manufacturing. The manufacturing process is labor-intensive. The manufacturing

process is relatively simple, and firms source their apparel from Asia, which has

low wages.

Marketing. Because of the large number of suppliers selling similar products,

apparel-retail firms must stimulate demand with attractive store layouts, colorful

product offerings, and various sales promotions.

Investing and Financing. Firms must finance inventory, usually with a combina-

tion of supplier and bank financing. The risk of inventory obsolescence is some-

what high if the product offerings in a particular season do not sell. Firms tend to

rent retail space in shopping malls, so they need to engage in extensive long-term

borrowing.

1.3 Identification of Commodity Businesses.

Dell. Dell’s products—computers, servers and printers—are commodities. Dell

tends not to develop the technologies underlying these products. Instead, it pur-

chases the components from firms that develop the technologies (semiconductors

and computer software). Dell’s direct-to-customer marketing strategy is not unique,

but the extent to which Dell performs this strategy better than anyone else in the

industry gives it a competitive advantage. Its size, purchasing power, quality con-

trol, and efficiency permit it to operate as a low-cost provider.

Southwest Airlines. Airline transportation is a commodity service in the sense that

seats on one airline cannot be differentiated from seats on another airline.

Southwest Airlines’ strategy is to be the lowest cost provider of such services,

thereby differentiating itself on low prices.

Microsoft. The basic idea of a commodity product is that the product offerings of

one firm are so similar to those of other firms that customers can easily switch to

competitors’ products if price becomes an issue. The technological attributes of

computer software are duplicated relatively easily, a commodity attribute. However,

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

Microsoft’s size permits it to invest in new technology development and keep it on

the leading edge of new technologies. Microsoft also has a huge advantage in terms

of installed base, meaning that most customers almost have to purchase its software

to be able to use application programs and to communicate with other computer

users. Thus, its products are inherently commodities but Microsoft is able to over-

come some of the disadvantages of commodity status.

Johnson & Johnson. Johnson & Johnson operates in three business segments:

consumer health care, pharmaceuticals, and medical equipment. It derives the

majority of its revenue and profits from the latter two industries. Patents protect the

products of these two industries, which give the firm a degree of market power.

Until another firm creates a new product that dominates the patented product of

Johnson & Johnson, its product is not a commodity. However, rapid technological

change makes most products obsolete before the end of the patent’s life. Johnson &

Johnson’s products probably have fewer commodity attributes than the other three

firms in this exercise.

One of the purposes of this exercise is to illustrate that firms can pursue product

differentiation strategies and low-cost leadership strategies and, if performed well,

can gain “most admired status.”

1.4 Identification of Company Strategies. The strategies of Home Depot and Lowe’s

are marked more by their similarities than by their differences. Both firms sell to

the do-it-yourself homeowner and the professional builder, plumber, or electrician

at competitively low prices. Their in-store product offerings are similar, roughly

evenly split between building materials, electrical and plumbing supplies, hardware,

paint, and floor coverings. Their store sizes are approximately the same. Both use

sales personnel with expertise in a particular home improvement area to offer

advice to customers. Both rely on third-party credit cards for a large portion of their

sales to customers. Home Depot is slightly less than twice the size of Lowe’s in

terms of number of stores. Home Depot’s stores span the United States, whereas

Lowe’s tends to locate in the eastern United States. However, Lowe’s is expanding

westward.

1.5 Researching the FASB Website. The answer will change over time as the FASB

updates its activities. The purpose of the exercise is to familiarize students with the

FASB website and the kinds of information they can find there.

1.6 Researching the IASB Website. The answer will change over time as the IASB

updates its activities. The purpose of the exercise is to familiarize students with the

IASB website and the kinds of information they can find there.

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

1.7 Effect of Industry Economics on Balance Sheets. Among the three firms, Intel

faces the greatest risk of technological change for its products. Although the

manufacture of semi-conductors is capital-intensive, Intel does not add financial

risk to its already high business risk. Thus, Firm B is Intel. The revenues of

American Airlines and Walt Disney change with changes in economic conditions,

subjecting them to cyclical risk and, thereby, reducing their use of long-term debt.

Besides producing movies and family entertainment, Disney operates theme parks,

which the firm does not include in property, plant, and equipment. This will reduce

its property, plant, and equipment to total assets percentage. American Airlines has

few assets other than its flight and ground support equipment. Thus, Firm A is

Disney, and Firm C is American Airlines. It may seem strange that Disney has

smaller proportions of long-term debt in its capital structure compared to American

Airlines. One possible explanation is that the assets of American Airlines have a

more ready market in case a lender repossesses and sells them than does the more

unique assets of Disney. The more ready market reduces the borrowing cost. In this

case, however, the explanation lies in the fact that American Airlines has operated

at a net loss for several years and has negative shareholders’ equity. The result is a

higher ratio of long-term debt to assets for American Airlines than for Disney.

1.8 Effect of Business Strategy on Common-Size Income Statements. Firm A is

Dell, and Firm B is Apple Computer. The clues appear next.

Cost of Goods Sold to Sales Percentages. One would expect Dell to have a higher

cost of goods sold to sales percentage because it adds less value, essentially

following an assembly strategy, and competes based on low prices. Apple Com-

puter can obtain a higher markup on its manufacturing costs because it creates more

unique products with a somewhat unique consumer following.

Selling and Administrative Expense to Sales Percentages. Both Dell and Apple

Computer engage in extensive promotion to market their products to consumers,

thereby increasing their selling expenses. One might expect Apple Computer to

spend more on marketing and advertising than Dell would spend. One also might

expect Dell, as a producer of commodities, to be more focused on controlling costs

such as administrative expenses. So it is interesting that Apple’s selling and

administrative expense are considerably smaller than Dell’s.

Research and Development Expense to Sales Percentages. Apple Computer is

more of a technology innovator than Dell, thereby giving Apple Computer a higher

R&D (research and development) expense to sales percentage.

Net Income to Sales Percentages. These percentages are consistent with the strat-

egies of these firms. Compared to Dell, Apple Computer has a much higher profit

margin.

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

1.9 Effect of Business Strategy on Common-Size Income Statements. Firm A is

Dollar General, and Firm B is Macy’s. Department stores sell branded products for

which the stores can obtain a higher markup on their acquisition cost. Discount

stores price low in an effort to gain volume. Thus, the cost of goods sold to sales

percentage of Macy’s should be lower than that of Dollar General. Department

stores engage in advertising and other promotions to stimulate demand. Also, their

cost for space is higher. These factors should increase their selling and

administrative expense to sales percentage. Dollar General maintains a high level of

debt, so interest expense (included in all other items) is much higher than it is for

Macy’s. One would expect that the department stores have a higher net income to

sales percentage.

1.10 Effect of Industry Characteristics on Financial Statement Relations. There are

various strategies for approaching this problem. One strategy begins with a

particular company, identifies unique financial characteristics (for example, hotel

and casino companies have a high proportion of property, plant, and equipment

among their assets), and then searches the common-size data in Text Exhibit 1.22 to

identify the company with that unique characteristic. Another approach begins with

the common-size data in Text Exhibit 1.22, identifies unusual financial statement

relations [for example, Firm (8) has a high proportion of receivables], and then

looks over the list of companies to identify the one most likely to have substantial

receivables among its assets. We follow both strategies here. All of the data are

scaled by total revenues (except for the final data item, which is cash flow from

operations over capital expenditures); so throughout this discussion when we refer

to a “percentage,” it is a percentage of revenues. The data from Text Exhibit 1.22 in

the text, with company names as column headings, are presented at the end of this

solution in Exhibit 1.B.

The two financial services firms will have balance sheets dominated by cash,

securities, and loans receivable. Firms (8) and (1) meet this description. Cash and

securities present 2,256% for Firm (1), typical of a securities firm, suggesting that it

is Goldman Sachs. Firm (8) also has a high percentage of cash and securities

(2,198%), consistent with Citigroup’s involvement in a wide range of financial

services. In addition, receivables comprise a higher percentage for Firm (8) than for

Firm (1) [1,384% for Firm (8) versus 352% for Firm (1)], distinguishing Firm (8) as

Citigroup and Firm (1) as Goldman Sachs. Neither firm is fixed-asset-intensive,

reporting immaterial amounts of PP&E relative to revenues.

Firms (2), (5), and (7) have high percentages of property, plant, and equipment

and are clearly fixed-asset-intensive. These firms are Carnival Corporation (2),

Verizon Communications (5), and MGM Mirage (7). These firms are capital-asset-

intensive business models—operating cruise ships, telecommunications networks,

and hotel and casino chains, respectively. Firm (2) and Firm (7) have similar

property, plant, and equipment percentages and depreciation and amortization

expense percentages. Firm (5) has the highest depreciation and amortization

expense percentage, which implies a shorter depreciable life for its depreciable

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

assets compared to Firm (2) and Firm (7). Due to technological obsolescence, the

depreciable assets of Verizon likely have a shorter life than the casinos and hotels

of MGM or the ships of Carnival. Thus, Firm (5) is Verizon. Note that Verizon does

not amortize its wireless licenses, meaning amortization of these licenses will not

explain the higher depreciation and amortization expense to revenues percentage

for Firm (5). The percentage of accumulated depreciation to the cost of property,

plant, and equipment also is much higher for Firm (5) than for Firm (2) or Firm (7),

a consequence of Firm (5)’s higher depreciation and amortization expense. Another

distinguishing characteristic of Firm (5) is that it has a lower cost of sales

percentage than does Firm (2) or Firm (7). Verizon’s services are more capital-

intensive, not labor-intensive, compared to those of Carnival and MGM, which

lowers Verizon’s operating expense line. Also, Carnival and MGM sell meals as

part of their services, including the cost in cost of sales. Of the three firms, Firm (5)

has the highest selling and administrative expense to revenues percentage.

Telecommunication services are more competitive than luxury entertainment,

which increases marketing expenses and lowers revenues for Verizon.

To distinguish Firm (2) (Carnival) from Firm (7) (MGM Mirage), recognize that

Firm (7) finances more heavily with long-term debt, consistent with hotel and

casino properties supporting higher leverage than cruise ships. Firm (7)’s higher

proportion of long-term debt might suggest that compared to ships, hotels and

casinos serve as better collateral for loans. Another possibility is that MGM simply

chose to use debt more extensively than did Carnival. Firm (7) has a higher selling

and administrative expense percentage and thereby a lower net income percentage.

Distinguishing these two firms is a close call. The land-based services of MGM are

probably more competitive because of the direct competition located nearby and the

low switching costs for customers. Once customers commit to a cruise, their

switching costs are higher. Thus, one would expect MGM to have higher marketing

costs and a lower net income to revenues percentage. This reasoning suggests that

Firm (7) is MGM and Firm (2) is Carnival.

Three firms have R&D expenses: Firms (3), (6), and (12). These firms are

Johnson & Johnson, Cisco Systems, and eBay, respectively. All three firms have

high profit margins; high proportions of cash and marketable securities; low

proportions of property, plant, and equipment; and low long-term debt. All are

consistent with technology-based firms. These firms differ on their R&D

percentages, with Firm (12) having the lowest percentage. Both Johnson & Johnson

and Cisco invest in R&D to create new products, whereas eBay invests in

technology to support the offering of its online services. The clue suggests that

eBay is Firm (12). In addition, Firm (12) differs from Firm (6) and Firm (3) in that

it has no inventory, consistent with eBay’s business model of being a market-

making intermediary rather than a producer. Firm (12) also differs from Firm (6)

and Firm (3) in the amount of intangibles. Intangibles dominate the balance sheet of

Firm (12). The problem indicates that eBay has grown its network of online

services largely by acquiring other firms, which increases goodwill and other

intangibles. Thus, Firm (12) is eBay.

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

It is difficult to distinguish Firm (3) as Johnson & Johnson and Firm (6) as

Cisco. A few subtle differences between the percentages for these two firms are as

follows: As a high-tech company, Cisco requires more R&D than Johnson &

Johnson does, which generates revenues from branded over-the-counter consumer

health products, which do not require as much R&D investment. This suggests that

Johnson & Johnson is Firm (3) and Cisco is Firm (6). In the same vein, Cisco will

turn over inventory faster than Johnson & Johnson will, which is revealed in

Cisco’s having a lower inventory percentage compared to Johnson & Johnson.

This leaves four firms: Firms (4), (9), (10), and (11). The four remaining firms

are Kellogg’s, Amazon.com, Molson Coors, and Yum! Brands, respectively.

Amazon.com is likely the least fixed-asset-intensive of the firms. It must invest in

information systems but does not need manufacturing or retailing assets, as the

other three do. In addition, Amazon will require the highest levels of R&D among

the four firms. This suggests that Firm (9) is Amazon.com. Firm (9) also has the

highest cost of sales percentage of the four firms, consistent with Amazon.com’s

low value added for its online services. It is interesting to compare the cost of sales

to revenues percentages for Amazon.com and eBay [Firm (12)]. Amazon.com

includes the full selling price of goods sold in its revenues whenever it takes

product risk and the cost of the product sold in the cost of sales. On the other hand,

eBay does not assume product risk, so its revenue includes only customer posting

and transaction fees and advertising fees. Its cost of sales percentage is quite low

because it includes primarily compensation of personnel maintaining its auction

sites.

This leaves Firm (4), Firm (10), and Firm (11). Firm (11) has the smallest

inventories percentage, consistent with a restaurant selling perishable foods. The

cost of sales percentage for Firm (11) is the highest of these three remaining firms.

The extent of competition in the restaurant business is likely higher than that for the

branded food products of Molson Coors and Kellogg’s, consistent with lower value

added (higher cost of sales percentage) for Firm (11). Thus, Firm (11) is Yum!

Brands.

Firm (10) has a significantly higher intangibles to revenues percentage than

does Firm (4). Molson Coors has made significant investments in acquisitions of

other beer companies in recent years, which increased its goodwill. Kellogg’s has a

smaller yet still significant goodwill percentage, consistent with Kellogg’s’ strategy

of acquiring other branded foods companies and recognizing goodwill. Firm (10) is

Molson Coors, and Firm (4) is Kellogg’s.

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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in whole or in part.

Exhibit 1.B—(Problem 1.10) (Text Exhibit 1.22)

Goldman

Sachs

Carnival

CorpJ&JKellogg’sVerizonCisco

MGM

MirageCitigroup

Amazon

.com

Molson

CoorsYumeBay

123456789101112

BALANCESHEET

Cash&marketablesecurities2,256.1%4.1%20.1%2.0%10.6%96.9%4.1%2,198.0%26.0%4.5%1.9%39.3%

Receivables352.82.815.28.912.08.84.21,384.84.013.32.05.1

Inventories—2.47.97.02.13.01.5—8.94.01.3—

Property,plant,andequipment,atcost—286.843.055.4221.533.8278.8—7.841.461.132.9

Accumulateddepreciation —(59.8)(20.4)(32.5)(132.6)(22.6)(52.8) —(2.6)(14.1)(28.3)(18.9)

Property,plant,andequipment,net—%227.0%22.5%22.9%88.9%11.2%226.0%—%5.3%27.3%32.9%14.0%

Intangibles—36.543.439.875.240.56.0101.95.0109.48.390.9

Otherassets 57.3 7.224.0 4.8 19.028.3 81.0 208.5 7.259.711.4 33.3

Totalassets2,666.2%280.0%133.2%85.4%207.9%188.6%322.9%3,893.3%56.4%218.2%57.9%182.6%

Currentliabilities2,080.8%37.8%32.7%27.7%26.6%37.8%41.7%2,878.4%30.0%20.7%15.3%43.4%

Long‐termdebt390.969.112.731.748.228.5172.2596.10.438.431.6—

Otherlong‐termliabilities92.65.621.114.690.215.353.8171.34.433.912.09.4

Shareholders’equity 101.9167.5 66.711.3 42.8107.0 55.1 247.521.4125.3(1.0)129.8

TotalLiabilitiesandShareholders’

Equity2666.2%280.0%133.2%85.4%207.9%188.6%322.9%3893.3%56.4%218.2%57.9%182.6%

INCOMESTATEMENT

Operatingrevenues100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%

Costofsales(excludingdepreciation)or

operatingexpenses(54.6)(61.6)(29.0)(58.1)(40.1)(36.1)(56.0)(73.4)(85.8)(59.5)(75.1)(26.1)

Depreciationandamortization(2.0)(9.9)(4.4)(2.9)(15.0)(1.5)(10.8)(5.0)(1.5)(5.7)(4.9)(2.8)

Sellingandadministrative(1.4)(12.1)(29.3)(23.7)(27.6)(27.6)(19.3)(5.1)(2.6)(27.9)(7.6)(33.7)

Researchanddevelopment(1.6)—(12.2)——(14.6)—(7.7)(5.1)——(8.5)

Interest(expense)/income9.5(2.8)(0.1)(2.5)(1.9)1.0(8.5)78.4—(1.8)(2.0)1.3

Incometaxes(14.3)(0.1)(6.2)(3.8)(3.4)(4.3)(2.6)(16.0)(1.0)(2.2)(2.8)(4.7)

Allotheritems,net (8.0) 0.1 1.6 —(5.5) — 2.3(28.8)(0.3) 5.2 0.4 —

Netincome27.6%13.6%20.3% 9.0% 6.6%17.0% 5.3%42.3% 3.7% 8.0%8.0%25.5%

Cashflowfromoperations/capital

expendituresn.m.1.04.92.71.59.81.0n.m.8.81.81.65.1

Chapter 1

Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

1-9

in whole or in part.

1.11 Effect of Industry Characteristics on Financial Statement Relations. There are

various strategies for approaching this problem. One strategy begins with a

particular company, identifies unique financial characteristics (for example, electric

utilities have a high proportion of property, plant, and equipment among their

assets), and then searches the common-size data in Text Exhibit 1.23 to identify the

company with that unique characteristic. Another approach begins with the

common-size data in Text Exhibit 1.23, identifies unusual financial statement

relations [for example, Firm (10) has a high proportion of receivables], and then

looks over the list of companies to identify the one most likely to have substantial

receivables among its assets. We follow both strategies here. All of the data are

scaled by total revenues (except for the final data item, which is cash flow from

operations over capital expenditures); so throughout this discussion when we refer

to a “percentage,” it is a percentage of revenues. The data from Text Exhibit 1.23 in

the text, with company names as column headings, are presented at the end of this

solution in Exhibit 1.C.

Firm (10) stands out because it has the highest proportion of receivables among

its assets and the most substantial borrowing in its capital structure. This balance

sheet structure is typical of the finance company, HSBC Finance. We ask students

why the capital markets allow a finance company to have such a high proportion of

borrowing in its capital structure. The answer is threefold: (1) Finance companies

have contractual rights to receive future cash flows from borrowers (the cash flow

tends to be highly predictable); (2) finance companies lend to many different

individuals, which diversifies their risk; and (3) borrowers often pledge collateral to

back up the loan, which provides the finance companies with an alternative for

collecting cash if borrowers default on their loans. Thus, the low risk in the asset

structure allows the firm to assume high risk on the financing side. We use this

opportunity to ask students how this firm can justify recognizing interest revenue

on its loans as the revenue accrues each period when it has an uncollectible loan

provision of 29.1% of revenues. Two points are noteworthy: (1) The concern with

uncollectibles is not with the size of the provision, but with how much uncertainty

there is in the amount of the provision (a high mean with a low standard deviation

is not a concern, but a high mean with a high standard deviation is a concern) and

(2) revenues represent interest revenues on loans, whereas the provision for

uncollectibles includes both unpaid principal and interest (thus, the 29.1% provision

does not mean that the firm experiences defaults on 29.1% of its customers each

year). Given that loans are nearly 700% of revenues and the provision for

uncollectible loans is 29% of revenues, it implies a roughly 4% loan loss provision.

The cash flow from operations to capital expenditures ratio is high because of the

low capital intensity of this firm.

Chapter 1

Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

1-10

in whole or in part.

Firm (4) also is likely to be a financial services firm because it has a high

proportion of cash and marketable securities among its assets and a high proportion

of liabilities in its capital structure. This balance sheet structure is typical of the

insurance company, Allstate Insurance. Allstate receives cash from policyholders

each period as premium revenues. It pays out the cash to policyholders as they

make insurance claims. There is a lag between the receipt and disbursement of cash,

which for a property and casualty insurance company can span periods up to several

years. Allstate invests the cash in the interim to generate a return. The high

proportion of current liabilities represents Allstate’s estimate of the amount of

future claims arising from insurance coverage in force in the current and previous

periods. We ask students at this point to comment on the quality of earnings of an

insurance company. Our objective is to get students to see the extent of estimates

that go into recognizing claims expenses in a particular period. Claims made from

accidents or injuries during the current year related to insurance in force during that

year require relatively little estimation. However, policyholders may sustain a loss

during the current period but not file a claim immediately. Also, estimating the cost

of a claim may present difficulties if the claim amount is difficult to estimate (such

as with malpractice insurance) or if policyholders contest the amount Allstate is

willing to pay and the case goes through adjudication. Thus, the potential for low

quality earnings is present with insurance companies. We then point out that the

amount shown for other assets represents the unamortized portion of the cost of

writing a new policy (costs of investigating new policyholders to assess risk levels,

commissions paid to insurance agents for writing the new policy, and filing fees

with state insurance regulators). We ask why insurance companies do not write off

this amount in the year of initiating the policy. The explanation is one of matching.

Insurance companies recognize premium revenues over several future periods and

should match both policy initiation costs and claims costs against these revenues.

The cash flow from operations to capital expenditures ratio is high because of the

low capital intensity of this firm.

Four firms report R&D expenditures: Firm (1), Firm (2), Firm (5), and Firm

(12). Dupont, Hewlett-Packard, Merck, and Procter & Gamble will incur costs to

discover new technologies or to develop new products. By far, Firm (2) has the

highest R&D expense percentage and the highest profit margin. This firm is Merck.

Pharmaceutical companies must invest heavily in new drugs to remain competitive.

Also, the drug development process is lengthy, which increases R&D costs.

Pharmaceutical companies have patents on most of their drugs, providing such

firms with a degree of monopoly power. The demand for most pharmaceuticals is

relatively price inelastic because customers need the drugs and because the cost of

the drugs is often covered by insurance. The manufacturing process for

pharmaceuticals is capital-intensive, in part because of the need for precise

measurement of ingredients and in part because of the need for purity. Note that

Merck has a relatively high selling and administrative expense percentage. This

high percentage reflects the cost of maintaining a sales staff to market products to

physicians and hospitals and heavy advertising outlays to stimulate demand from

consumers.