Answer to Question #109123 in Quantitative Methods for David

Question

Using simulated business cases illustrate the following terms as used in linear cost volume profit analysis. 1. Market Equilibrium. 2. The margin of safety

Answer 1

1. These terms can be illustrated with the help of supply and demand diagrams. Market equilibrium occurs when the prices are adjusted so that the demand equals supply. Point E below is the point of market equilibrium.

It means that when the price of the item is $5.5, the equilibrium quantity where the demand matches supply is 4.5 (for example, liters of paint).

If the price increases (the red S line goes higher along the P-axis), the demand will decrease, i.e., point E will go higher and closer to P-axis along D. The market will be at equilibrium again.

If the demand increases (the blue demand line goes right along Q-axis), the prices will increase, i.e., point E will move higher to the right along line S. The market will reach equilibrium.

Each business case have its own equilibrium point.

2. The margin of safety (MoS) determines by how much sales or output can decrease before a business reaches the point of making neither a profit not a loss:

$$MoS=1-\frac{\text{current stock price}}{\text{ intrinsic stock price}}.$$

For instance, a business has current stock price of $1000, but an investor thinks that the intrinsic price is $2500. The margin of safety will be 0.6, or 60%. This value determines how safe a business is to invest. For instance, if an investor buys the considered business for $100, he is safe and his investments are more likely to be wise and safe. If an investor buys this company for $2400, so that the margin of safety is just 4%, his investments are more likely to fail.