Post on 21-Dec-2015
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
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.
Economic vs. Accounting Profits
• Accounting Profits– Total revenue (sales) minus dollar
cost of producing goods or services.– Reported on the firm’s income
statement.
• Economic Profits– Total revenue minus total opportunity
cost.
Cost• Accounting Costs
– The explicit costs of the resources needed to produce produce goods or services.
– Reported on the firm’s income statement.
• Opportunity Cost– The cost of the explicit and implicit
resources that are foregone when a decision is made.
• Economic Profits– Total revenue minus total opportunity
cost.
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.
• 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
Goals Other Than Profit– Market share maximization (as
measured by sales revenue or proportion of quantity sold to total market
– Growth rate maximization (increasing size of the firm over time. Higher rates of growth in other variables than profit)
– Profit margin
– Return on investment, Return on assets
– Shareholder value
– Technological advancement
– Customer satisfaction
– Maximization of managerial returns (manager’s own interest subject to generating sufficient profits to keep their jobs)
• Non-economic Objectives
– Good work environment
– Quality products and services
– Corporate citizenship, social responsibility
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
• 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.
– 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.
• Position and power of professional management
– High-level managers who are responsible for major decision making may own very little of the company’s stock.
– Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.
– 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”
• 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 company’s 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.
• 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 company’s stock.
• When stock options are substantial part of executive compensation, management objectives tend to be more aligned with stockholder objectives.
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.
• 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
• 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.
• 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.
Timing
2 types of models1.Static model:– describe the
behaviour at a single point in time. Disregards differences in the sequence of actions and payments
2.Dynamic models:- focus on the timing and sequence of actions and payments
The Time Value of Money
• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:
PV
FV
i n1
• .
• Examples:– Lotto winner choosing between a single
lump-sum payout of $104 million or $198 million over 25 years.
– Determining damages in a patent infringement case
Present Value of a Series
• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:
PV
FV
i
FV
i
FV
inn
1
12
21 1 1. . .
Net Present Value• Suppose a manager can purchase a stream of
future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision
Is
NPV
FV
i
FV
i
FV
iCn
n
11
22 01 1 1
. . .
Decision Rule:If NPV < 0: Reject project
NPV > 0: Accept project
Present Value of a Perpetuity
• An asset that perpetually generates a stream of cash flows (CF) at the end of each period is called a perpetuity.
• The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is
i
CF
i
CF
i
CF
i
CFPVPerpetuity
...111 32
Firm Valuation
• The value of a firm equals the present value of current and future profits.– PV = t / (1 + i)t
• If profits grow at a constant rate (g < i) and current period profits are :
0
0
1 before current profits have been paid out as dividends;
1 immediately after current profits are paid out as dividends.
Firm
Ex DividendFirm
iPV
i g
gPV
i g
• If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.
• Control Variables– Output– Price– Product Quality– Advertising– R&D
Marginal (Incremental) Analysis
Net Benefits
• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?
• Net Benefits = Total Benefits - Total Costs
• Profits = Revenue - Costs
Marginal Benefit (MB)
• Change in total benefits arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total benefit curve.
Q
BMB
Marginal Cost (MC)
• Change in total costs arising from a change in the control variable, Q:
• Slope (calculus derivative) of the total cost curve
Q
CMC
Marginal Principle• To maximize net benefits, the
managerial control variable should be increased up to the point where MB = MC.
• MB > MC means the last unit of the control variable increased benefits more than it increased costs.
• MB < MC means the last unit of the control variable increased costs more than it increased benefits.
The Geometry of Optimization
Q
Total Benefits & Total Costs
Benefits
Costs
Q*
B
CSlope = MC
Slope =MB
Conclusion• Make sure you include all costs and
benefits when making decisions (opportunity cost).
• When decisions span time, make sure you are comparing apples to apples (PV analysis).
• Optimal economic decisions are made at the margin (marginal analysis).
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.
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.
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.