Chapter 2 The Firm and Its Goal

Chapter 2

The Firm and Its Goals

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-2

Chapter Outline

• The firm and resource allocation

• Profit maximization- the economic goal of the firm

• Goals other than profit

• Do companies maximize profits?

• Maximizing the wealth of stockholders

• Economic profit


Learning Objectives

• Understand the reasons for the existence of firms and the meaning of transaction costs

• Explain the economic goals of the firm and optimal decision making

• Describe the ‘principal-agent’ problem

• Distinguish between “profit maximization” and the “maximization of the wealth of shareholders”

• Demonstrate the usefulness of Market Value Added® and Economic Value Added®


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

Price x Unit sold = Revenue –Costs = Profit


The Firm

• Why does a firm perform certain functions internally and others through the market?

• Transaction costs are incurred when entering into a contract.

– Types of transaction costs:

• investigation

• negotiation

• enforcing contracts


The Firm

• Transaction costs are incurred when entering into a contract

– Influences

• uncertainty

• frequency of recurrence

• asset specificity


The Firm

• Examples of transaction costs

–Offshoring to source consumer products (e.g. retail stores)

–Manufacturing components overseas (e.g. the automotive industry)

– Logistics services (e.g. warehousing, delivery, etc.)


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 minimized (for a given level of output)

• outsourcing of peripheral, non-core activities


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 to ship products

– Manufacturing firms have significantly increased productivity making firms production more competitive.


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 improving efficiency.


Economic Goal of the Firm and Optimal Decision Making

• 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 firm’s goals. Different goals can lead to very different managerial decisions given the same, limited amount of resources.


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


Goals other than Profit

• Non-economic objectives

– Good work environment for employees

– Quality products and services for customers

– Good corporate citizenship and social responsibility


Do Companies Maximize Profit?

• Argument against companies not maximizing profits but instead merely aim to satisfice, which means firms seek to achieve a satisfactory goal--one that may not require the firm to ‘do its best’.



– Two forces leading to satisficing

• position and power of stockholders

• position and power of management



• Position and power of stockholders

Reasons for satisficing by companies• larger firms are owned by thousands of shareholders

• stockholders generally own only minute interests in the firm and hold diversified holdings in many other firms



• Position and power of stockholders

– Stockholders are concerned with performance of their entire portfolio and not individual stocks

– Stockholders are much less informed about the firm than management

Thus, stockholders are not likely to take any action if earning a ‘satisfactory’ return.



• Position and power of management

– high-level managers may own very little of the firm’s stock

– managers tend to be more conservative—that is, risk averse—than stockholders would be because their jobs will most likely be safer if they turn in a competent and steady, if unspectacular, performance



• Position and power of management

– managers may be more interested in maximizing their own income and perks

– management incentives may be misaligned (e.g. revenue goals for compensation and not profits)

– divergence of objectives is known as the ‘principal-agent’ problem



• Arguments supporting the profit maximization hypothesis

– large stockholdings held by institutions (mutual funds, banks, etc.) scrutiny by professional

analysts

– Stock market discipline and competition if

managers do not seek to maximize profits, firms face the threat of takeover or changes in management

– incentive effect the compensation of many

executives is tied to stock price



• 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.


Maximizing the Wealth of Stockholders

• 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.

– 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.



• Future cash flows (Di) must be ‘discounted’ to find their present equivalent value

• The discount rate (k) 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



• The present price of a firm’s stock should reflect the discounted value of the expected future cash flows to shareholders (dividends)

P = present price of the stock

D = dividends received per year

k = discount rate

n = life of firm in years

n

n

k

D

k

D

k

D

k

DP

)1()1()1()1( 3

3

2

21



• If the firm is assumed to have an infinitely long life, the price of a unit of stock which earns a dividend D per year is given by the equation:

P = D/k



• 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 firm’s common equity (‘market capitalization’).



• 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 company’s stock.

• When stock options are a substantial part of executive compensation, management objectives tend to be more aligned with stockholder objective.



• 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



• 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



• 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 > 0 shareholder wealth rising

if EVA < 0 shareholder wealth falling


Economic Profits

• Economic profits and accounting profits are typically different

– accountants measure explicit incurred costs, as allowed by GAAP

– accountants use historical cost


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.


Global Application

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

• foreign currencies

• legal differences

• language

• attitudes

• role of government


Summary

• A firm’s objective is the maximization of its profit or the minimization of its 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

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Chapter 2 The Firm and Its Goal

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