Week 11: Real World Applications 10

Assume Daewoo, a hypothetical oil extraction company, has the following cost structure. It spends:

• $40/barrel on labor costs, raw materials, energy, and • $35/barrel on interest, depreciation, insurance, and administrative staff expense.

Read the textbook carefully, and answer the following questions.

• A recession hits, the market price of crude oil falls to $50 per barrel, and the profitability takes a hit. Should Daewoo keep running the mine? Elaborate.
• Russia invades Ukraine, the market price shoots up well above $100 per barrel, and competitors announce new expansion plans. Should Daewoo add the new capacity? Elaborate.

Daewoo is a capital intensive company. Most of capital intensive company’s have many capital costs that can not easily be lowered. When a capital intensive company faces a recession, the company will continue to operate the facility when the revenue will exceed the variable costs associating with operating the facility. When a recession hits, the market price of crude oil falls to $50 per barrel, exceeding $40 so Daewoo should continue to run the mine. Daewoo won’t make enough to cover their overhead costs but should continue to operate. Capital intesive companys must be able to take losses at times like recession to make significant profits in the good times.

In industries that are no so capital intensive, new capacity can be added quickly. With Daewoo being capital intensive, new capacity cannot be easily added. It may take years for a capital intensive company like Daewoo to add new capacity so leaders like Daewoo should build new capacity when times are good. The market price significantly increased so Daewoo should not add new capacity because they would not be considered in good times. Daewoo should start to add new capacity when the market is strong.