Chapter 2

The Firm
and Its Goals

The Firm
Limits to firm size

tradeoff between
external
t
l
transactions and the
cost of internal
p
operations
company chooses to
allocate resources
so total cost is
minimized
i i i d (for
(f a
given level of
output)
outsourcing of
peripheral, non-core
activities

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-8

The Firm
Reshoring: Operations returning to the
country where the offshoring occurred
(Example - United States)
Signs of Reshoring
Wages in developing countries have been rising.
The decrease in the value of the dollar has
increased the cost of importing.
Increases in energy costs have made it more
expensive
i
tto ship
hi products
d t
Manufacturing firms have significantly increased
productivity making firms production more
competitive.
Copyright 2014 Pearson Education, Inc. All rights reserved.

2-9

The Firm
Illustration: Coase and the Internet
Ronald Coase wrote in 1937, pre-internet,
but his ideas are still relevant today.
He discussed tradeoff between internal
costs and external transactions.
Technology has reduced search costs
i
improving
i
efficiency.
ffi i

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-10

Economic Goal of the Firm and

Optimal
Op
a Decision
ec s o Making
a
g
Profit maximization hypothesis: the primary
objective of the firm (to economists) is to maximize
profits
Other goals include market share, revenue growth, and
shareholder value

Optimal decision is the one that brings the firm

closest to its goal
It is crucial to be precisely aware of a firms goals.
Diff
Different
goals
l can lead
l d to very different
diff
managerial
i l
decisions given the same, limited amount of resources.

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-11

Goals other than Profit

Economic/financial objectives

market share, growth rate

profit margin
return on investment, return on assets
technological advancement
customer satisfaction
shareholder value

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-12

Goals other than Profit

Non-economic objectives
Good work environment for employees
Quality products and services for customers
Good corporate citizenship and social
responsibility
p
y

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-13

Do Companies Maximize Profit?

Argument against companies not
maximizing profits
f
but
b instead
d merely
l aim
to satisfice, which means firms seek to

Maximizing the Wealth

of Stockholders
o
S oc o de s
Measurements of Wealth
Views the firm from the perspective of a stream
of profits (cash flows) over time. The value of
the stream depends on when cash flows occur.
occur
Requires the concept of the time value of
money: a dollar earned in the future is worth
less than a dollar earned today. There is an
opportunity cost of getting a dollar in the
future instead of today.
y

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-22

Maximizing the Wealth

of Stockholders
o
S oc o de s
Future cash flows (Di) must be discounted
to find
f d their
h
present equivalent
l
value
l
The discount rate (k) is affected by risk
Two major types of risk:
business risk
financial risk

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-23

Maximizing the Wealth

of Stockholders
o
S oc o de s
Business risk involves variation in returns
d
due
to the
h ups and
d downs
d
off the
h economy,
the industry, and the firm.
All firms face business risk to varying degrees.

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-24

Do Companies Maximize Profit?

Other influences
The Sarbanes-Oxley Act was passed in 2002 in
response to a number of corporate scandals. The
Act sets stricter standards on the behavior of
public corporations and more transparency of
corporate information.
Within the labor market for financial managers,
superior performance is rewarded.

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-21

Maximizing the Wealth

of Stockholders
o
S oc o de s
Measurements of Wealth
Views the firm from the perspective of a stream
of profits (cash flows) over time. The value of
the stream depends on when cash flows occur.
occur
Requires the concept of the time value of
money: a dollar earned in the future is worth
less than a dollar earned today. There is an
opportunity cost of getting a dollar in the
future instead of today.
y

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-22

Maximizing the Wealth

of Stockholders
o
S oc o de s
Future cash flows (Di) must be discounted
to find
f d their
h
present equivalent
l
value
l
The discount rate (k) is affected by risk
Two major types of risk:
business risk
financial risk

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-23

Maximizing the Wealth

of Stockholders
o
S oc o de s
Business risk involves variation in returns
d
due
to the
h ups and
d downs
d
off the
h economy,
the industry, and the firm.
All firms face business risk to varying degrees.

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-24

Maximizing the Wealth

of Stockholders
o
S oc o de s
Financial risk concerns the variation in
returns that
h is induced
d
d by
b leverage
l

Leverage is the proportion of a company

financed by debt
the higher the leverage, the greater the potential
fluctuations in stockholder earnings
financial risk is directly related to the degree of leverage

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-25

Maximizing the Wealth

of Stockholders
o
S oc o de s
The present price of a firms stock should
reflect
fl
the
h discounted
d
d value
l
off the
h expected
d
future cash flows to shareholders
(dividends)

P=

D1
(1+ k )

+ (1+k )2 + (1+ k )3 + L+ (1+ k )n

D2

D3

Dn

P = present price of the stock

D = dividends received per year
k = discount rate
e of
o firm in years
yea s
n = life
Copyright 2014 Pearson Education, Inc. All rights reserved.

2-26

Maximizing the Wealth

of Stockholders
o
S oc o de s
If the firm is assumed to have an infinitely
l
long
llife,
f the
h price off a unit off stock
k which
h h
earns a dividend D per year is given by the
equation:
P = D/k

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-27

Maximizing the Wealth

of Stockholders
o
S oc o de s
Given an infinitely lived firm whose
d d d grow at a constant rate ((g)) each
dividends
h
year, the equation for the stock price
becomes:
P = D1/(k-g)
where D1 is the dividend to be paid during
the coming year
Multiplying P by the number of shares
outstanding
gg
gives total value of firms common
equity (market capitalization).
Copyright 2014 Pearson Education, Inc. All rights reserved.

2-28

Maximizing the Wealth

of Stockholders
o
S oc o de s
A company tries to manage its business in such a
way that the dividends over time paid from its
earnings and the risk incurred to bring about the
stream of dividends always create the highest price
for the companys stock.
Wh
When stock
t k options
ti
are a substantial
b t ti l partt off
executive compensation, management objectives
tend to be more aligned with stockholder objective.

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-29

Maximizing the Wealth

of Stockholders
Another measure of the wealth of stockholders is
called Market Value Added (MVA)
MVA = difference between the market value of
the company and the capital that the investors
have paid into the company

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-30

Maximizing the Wealth

of Stockholders
o
S oc o de s
Market value includes value of both equity and
debt
Capital
Capital includes book value of equity and debt as
well as certain adjustments
e.g. accumulated R&D and goodwill

While the market value of the company will always

be positive,
pos t e, MVA may
ay be positive
pos t e or
o negative
egat e

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-31

Maximizing the Wealth

of Stockholders
o
S oc o de s
Another measure of the wealth of
stockholders
kh ld
is called
ll d Economic
i Value
l
Added (EVA)
EVA=(Return on total capital Cost of capital) x
Total capital

if EVA > 0 shareholder wealth rising

if EVA < 0 shareholder wealth falling

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-32

Economic Profits
Economic profits and accounting profits are
typically
ll d
different
ff
accountants measure explicit incurred costs, as
allowed by GAAP
accountants use historical cost

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-33

Economic Profits
Economists are concerned with implicit
costs.
Accordingly, economic costs include not only
the historical costs and explicit costs recorded by
the accountants, but also the replacement costs
and implicit costs (normal profits) that must be
earned on the owners resources.
Economic profits are total revenue minus all
the economic costs.
Copyright 2014 Pearson Education, Inc. All rights reserved.

2-34

Global Application
When doing business in other countries and other
cultures business decision
cultures,
decision-making
making becomes more
complicated due to:

foreign currencies
legal differences
language
attitudes
role of government

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-35

Summary
A firms objective is the maximization of its profit or
the minimization of its loss.
loss
There are other important non economic goals of
the firm
Understanding risk and the time value of money
are essential for managing a business.
Economic profits for a firm are total revenue minus
all economic costs

Copyright 2014 Pearson Education, Inc. All rights reserved.

2-36