Question

Homework 1 1. Upon graduation, you’re hired by a consulting firm. Your first client is the ArcherDaniels-Midland Corporation (ticker: ADM). ADM is a large agribusiness firm headquartered here in Chicago, with over $81 billion in net revenue on over $44 billion in assets in 2014. Your task is to evaluate the operation of ADM’s ethanol producing plant in Peoria, IL to ensure that its continued operation is profitable for the firm. After a bit of research, you’ve learned several basic facts about ethanol. The ethanol industry converts various feedstocks to ethanol (alcohol) for use as fuel. In the USA, it’s a $2.5 billion dollar industry, with approximately 230 processing plants owned by over 120 different firms. The primary feedstock (raw material) is corn, due to its price and availability. Plants are located throughout the nation, though primarily in the Midwest to reduce transportation costs for the feedstock. There are two distinct production technologies that use different parts of the feedstock: Cellulosic production uses the cobs and other commonly discarded bits of the harvested corn, and so shows some promise as an environmentally sound technology for the future, but currently is so expensive that it comprises less than ½ of 1% of US production. The vast majority of US ethanol production is sugar/starch production, which transforms the sugars and starches within the corn kernels into fuel. (Note that when you store the ethanol in large metal containers after distillation, you’re making ‘ethanol’; when you do it in oak casks, it’s called ‘whiskey’ or ‘bourbon’, depending on the region.) Within the sugar/starch category of corn ethanol plants that comprises 97% of US production (about 2.5% of plants use feedstocks other than corn), there are two processing technologies: Wet milling and Dry milling. These processes differ in their capital intensiveness and in the cost and efficiency of extraction of usable material. Key data for the two processes are given in this table. Assume a cost of capital of 8% per year. 2 Ethanol Production Table. All costs given in dollars per gallon of ethanol.1 Technology Feedstock costs Processing costs Overhead (when at capacity) Capital cost (when at capacity) Capacity (average, in millions of gallons/year) Number of plants Wet milling $0.40 $0.57 $0.08 $1.61 100 80 Dry milling $0.53 $0.40 $0.10 $1.23 50 150

Task 1: Draw the marginal cost curve and the average total cost curve of a wet milling ethanol plant. Assume that the overhead cost is not recoverable if the plant shuts down temporarily. Task 2: Draw the marginal cost curve and the average total cost curve of a dry milling ethanol plant.

Task 3: ADM’s Peoria plant is a wet-milling plant. Suppose the price of ethanol were $1.02 per gallon. Would ADM wish to temporarily suspend operations (shut down) at the Peoria plant? What is the minimum ethanol price at which operating the Peoria plant is optimal for ADM?

Task 4: Draw the current short-run industry supply curve for ethanol.

Task 5: Verify that the current equilibrium price of $1.53 is consistent with the shortrun supply curve you derived above, combined with the demand function � = 46.1 − 20�, where Q is billions of gallons per year.

Task 6: Suppose the demand for ethanol changes to � = 23.05 − 10�. What do you predict will be the new price in the short run? How much ethanol will be produced in the new short-run equilibrium? How much will be produced by dry-milling plants? Wet-milling plants? 1

Actual plant capacities and costs vary more than is shown here. 3 2. AbbVie Pharmaceuticals (headquartered in Lake Forest, IL) has commenced a $10 million R&D project to develop a new drug to treat a rare disease. So far, it has spent $6 million of the $10 million, and preliminary results are positive. If the additional $4 million is invested, the drug will certainly be completed and is expected to generate profit of $18 million in present value for AbbVie. Meanwhile, a research biologist at Illinois Tech has independently developed a treatment for the same disease. The scientist has offered to sell her invention to AbbVie for $2 million. Her drug would be just as effective as AbbVie’s drug, and would also generate profit of $18 million in present value.

a. Should AbbVie buy the drug for $2 million?

b. What is the most AbbVie should be willing to pay for the Illinois Tech researcher’s drug?

c. How would your answer change if the Illinois Tech biologist had developed her drug two years ago, before AbbVie started its own R&D project?

d. Suppose that Merck has also expressed interest in the biologist’s invention. If Merck buys the drug, there is a 50% chance that it will beat AbbVie’s drug to market. If that happens, suppose the profit of the second drug to market is zero. Now how much should AbbVie be willing to pay for the drug? How much should Merck be willing to pay?

Answer 1

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