Chapter 2

The Firm and Its Goals

Managerial Economics: Economic Tools for Todays Decision Makers, 5/e By Paul Keat and Philip Young

The Firm and Its Goals The Firm Economic Goal of the Firm Goals Other Than Profit Do Companies Maximize Profits? Maximizing the Wealth of Stockholders Economic Profits
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Learning Objectives
Understand reasons for existence of firms and meaning of transaction costs Explain economic goals and optimal decision making Describe meaning of principal-agent problem Distinguish between profit maximization and shareholder wealth maximization Demonstrate usefulness of Market Value Added and Economic Value Added

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

The Firm A firm is a collection of resources that is transformed into products demanded by consumers. Profit is the difference between revenue received and costs incurred.

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

The Firm
Transaction costs are incurred when entering into a contract.
Types of transaction costs
Investigation Negotiation Enforcing contract and coordinating transactions

Influences
Uncertainty Frequency of recurrence Asset specificity

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

The Firm
Limits to Firm Size
tradeoff between external transactions and the cost of internal operations Company chooses to allocate resources so total cost is minimum Outsourcing of peripheral, non-core activities

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Managerial Economics, 5/e

Keat/Young

Economic Goal of the Firm Primary objective of the firm (to economists) is to maximize profits.
Profit maximization hypothesis Other goals include market share, revenue growth, and shareholder value

Optimal decision is the one that brings the firm closest to its goal.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Economic Goal of the Firm Short-run vs. Long-run

Nothing to do directly with calendar time Short-run: firm can vary amount of some resources but not others Long-run: firm can vary amount of all resources At times short-run profitability will be sacrificed for long-run purposes
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Goals Other Than Profit Economic Goals

Market share, Growth rate Profit margin Return on investment, Return on assets Technological advancement Customer satisfaction Shareholder value

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Managerial Economics, 5/e

Keat/Young

Goals Other Than Profit Non-economic Objectives

Good work environment Quality products and services Corporate citizenship, social responsibility

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Do Companies Maximize Profit?

Criticism: Companies do not maximize profits but instead their aim is to satisfice.
Satisfice is to achieve a set goal, even though that goal may not require the firm to do its best. Two components to satisficing:
Position and power of stockholders Position and power of professional management

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Managerial Economics, 5/e

Keat/Young

Do Companies Maximize Profit?

Position and power of stockholders
Medium-sized or large corporations are owned by thousands of shareholders Shareholders own only minute interests in the firm Shareholders diversify holdings in many firms Shareholders are concerned with performance of entire portfolio and not individual stocks.

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Do Companies Maximize Profit? Position and power of stockholders

Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness of management. Not likely to take any action as long as they are earning a satisfactory return on their investment.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Do Companies Maximize Profit? Position and power of professional management

High-level managers who are responsible for major decision making may own very little of the companys stock. Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Do Companies Maximize Profit?

Position and power of professional management
Management incentives may be misaligned
E.g. incentive for revenue growth, not profits Managers may be more interested in maximizing own income and perks

Divergence of objectives is known as principal-agent problem or agency problem

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Do Companies Maximize Profit?

Counter-arguments which support the profit maximization hypothesis.
Large number of shares is owned by institutions (mutual funds, banks, etc.) utilizing analysts to judge the prospects of a company. Stock prices are a reflection of a companys profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject to takeover bids and proxy fights.

The compensation of many executives is tied to stock price.

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Managerial Economics, 5/e

Keat/Young

Maximizing the Wealth of Stockholders Views the firm from the perspective of a stream of earnings over time, i.e., a cash flow. Must include the concept of the time value of money.
Dollars earned in the future are worth less than dollars earned today.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Maximizing the Wealth of Stockholders Future cash flows must be discounted to the present. The discount rate is affected by risk. Two major types of risk:
Business Risk Financial Risk

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Maximizing the Wealth of Stockholders Business risk involves variation in returns due to the ups and downs of the economy, the industry, and the firm. All firms face business risk to varying degrees.

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Maximizing the Wealth of Stockholders

Financial Risk concerns the variation in returns that is induced by leverage. 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.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Maximizing the Wealth of Stockholders

The present price of a firms stock should reflect the discounted value of the expected future cash flows to shareholders (dividends).

D1 (1 k )

(1 k )2 (1 k )3 (1 k )n
D2 D3 Dn

P = present price of the stock D = dividends received per year K = discount rate N = life of firm in years
Managerial Economics, 5/e Keat/Young

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Maximizing the Wealth of Stockholders If the firm is assumed to have an infinitely long life, the price of a share of stock which earns a dividend D per year is determined by the equation: P = D/k

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Maximizing the Wealth of Stockholders

Given an infinitely lived firm whose dividends grow at a constant rate (g) each 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 gives total value of firms common equity (market capitalization).

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Maximizing the Wealth of Stockholders

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. When stock options are substantial part of executive compensation, management objectives tend to be more aligned with stockholder objectives.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Maximizing the Wealth of Stockholders Another measure of the wealth of stockholders is called Market Value Added (MVA). MVA represents the difference between the market value of the company and the capital that the investors have paid into the company.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Maximizing the Wealth of Stockholders

Market value includes value of both equity and debt. 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, MVA may be positive or negative.

2006 Prentice Hall Business Publishing

Managerial Economics, 5/e

Keat/Young

Maximizing the Wealth of Stockholders

Another measure of the wealth of stockholders is called Economic Value Added (EVA).
EVA=(Return on Total Capital Cost of Capital) x Total Capital

If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Economic Profits Economic profits and accounting profits are typically different.
Accounting treatments allowed by GAAP Accountants report cost on historical basis. Economists are more concerned with opportunity costs or alternative costs.
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Economic Profits
Historical costs vs. replacement costs Implicit costs and normal profits
Return required by scarce resources to remain committed to a particular firm

Economic costs include historical and explicit costs (accounting) as well as replacement and implicit costs Economic profits is total revenue minus all economic costs
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young