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PART 2: ECONOMICS OF FIRMS

THE NATURE OF THE FIRM AND ITS OBJECTIVES

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PURPOSE/ OBJECTIVES • The purpose of business organisation in

general is the creation of value. To add value to the resources employed.

• But the objective of an enterprise in particular is more problematic. Why?

• Firms are coalitions of individual factor owners and organising and managing the coalition to ensure it focuses on a particular objective is not easy.

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What determines objectives

• Extent to which individuals trust one another to co-operate rather than cheat.

• Extent to which co-operation is induced by external pressures, competition.

• Extent to which co-operation can be encouraged by appropriate design of incentive systems and corporate governance mechanisms.

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• Co-operation is necessary. Co-operation is valuable. But it is not always easy to achieve because it tends to be dominated by self-interest.

• Recall the Prisoner’s dilemma from P&M.

• Objectives therefore depend on several factors.

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• The capitalist entrepreneurial approach to enterprise has good motivational properties.

• Why? • Economic theory is largely based on the

profit maximising view of the world because it was first developed in an environment dominated by entrepreneurial capitalism. Small, competitive, organisationally simple, owner controlled business.

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But in the ‘real’ world? • The modern business corporation which

dominates today is characterised by:

• Oligopolistic environment, firms with some market power.

• Separation of ownership from control.

• Organisational complexity.

• QUESTION IS :: will such businesses necessarily be seeking to max. profits?

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• Will managerial control of the corporation make a difference to its objectives?

• Consensus is that ‘managers’ may be more interested in growth of the enterprise and their own salaries/ perks rather than maximising profit or its modern equivalent, SMV.

• Is there a conflict between growth and shareholder wealth?

• If there is why don’t owners exercise more control over managers?

• To examine these issues we develop the Marris model and its implications. (See Marris.doc)

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Some prelims

• The circular flow of of business diagram explained.

• The idea of shareholder wealth or stock market value explained.

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CIRCULAR FLOW DIAGRAM

P/Q DECISIONS============CUSTS/COSTS/COMPS/ CHANGE

EVADDED

DIVIDENDS

SMV=f(D, g)

RETENTIONSSTRATEGICINVESTMENTDECISIONS/r&d, e&t, markt,acqus, etc

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SMV

• Shareholder wealth, or SMV, is the present value of the firm’s dividend stream which can be expressed as follows:

• = D1 + D1 (1+g)/ (1+d) + D1 (1+g)2/ (1+d) + into the future

• So SMV = f(D,g,and d)

• And so to the Marris.doc

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Maximising SMV • Involves choosing a combination of current D and

future g because future growth depends on retention of profits a la CF diagram.

• What is the appropriate combination (D and g) ? • Depends on the return to reinvested income. That

is on the value of the investment growth. • If the NPV of the investment is positive than

growth is valuable. If NPV isn’t positive then growth is valueless! There will be an optimal level of reinvestment to max. SMV.

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The dividend growth trade off

• D

Growth (g)

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SMV growth trade off

• SMV

Growth (g)

NPV = +

NPV < 0

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Shareholder’s point of view • Key issue is, if the PV of extra divis in the

future (Dg) exceed the value of reduced divis this year then fine the managers should reinvest.

• In fact reinvest until the marginal benefit of reinvestment equals the marginal cost in the form of reduced divis.

• So there will be a firm g rate which maximises SMV.

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Consider also

• Why does it get harder for the firm to expand future divis fast enough to compensate for lower current divis?

• See my notes on this in the Marris doc.

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Owners v managers

• So a potential for conflict exists because owners only want valuable growth but managers might want growth even if it isn’t valuable to owners. So the key question is:

• Will managers DELIBERATELY choose poor investments and how far will they push their own preferences?

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This depends on

• 1. The ability of owners to DETECT managerial actions/ decisions.

• 2. The ability of owners to CONTROL managerial actions if they don’t like them. That is on governance mechanisms.

• See Perman/ Scouller on this issue.

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Ability to detect

• How can owners tell when managerial actions are not in their interests?

• Need good information but the cost of being well informed will be high.

• And even when owners can benefit from investment in monitoring managers they are not likely to invest enough.

• Why?

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• There is a co-operation dilemma as per the prisoner’s dilemma again.

• Self interest in terms of spending on monitoring dominates the collective interest so we get cheating.

• Individuals prefer to free ride if poss. and so valuable co-operation fails.

• Plus even if company is doing badly how do owners demonstrate that this is due to managerial failings? Legally problematic (ie expensive).

• Therefore detecting is costly and direct monitoring less than optimal.

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Ability to control

• Even if they have information can shareholders exercise much control?

• Write to complain about ‘fat cat’ salaries for example?

• Attend an AGM?• Help to organise a vote against the incumbent

managers? • Odds are stacked against you, in favour of

incumbents. There have been exceptions in the UK usually driven by US shareholders. (Saatchi)

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• But surely the big guys, the financial institutions, such as PFs, are powerful enough to make a stand.

• True, they are. They do some monitoring and sometimes they take action. But not a lot. Considering the amounts at stake.

• First, the embarrassment factor. Who governs them and their salaries?

• Second, it is easier for them to use info to sell up and walk away before the small guy catches on. FI’s are not geared up to fight battles with corporate managers. Too expensive.

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Market for corp. control • So does this mean there are no constraints at all? • The ultimate mechanism for owners is the take

over mechanism. The MCC. • If managers are failing to max. the value of a

business it is possible to replace them through the MCC. That is an acquirer makes a bid for the business, takes it over, and sacks the poor management team. Runs the business better, increases its value, makes a profit on the deal.

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Sounds easy, but ...• Acquisition can be profitable for acquirers

but need to remember there are costs and risks involved. Such as the takeover premium and its significance.

• The precise condition managers need to watch is this:

• SMV(current) must exceed SMV (potential in new hands) LESS the costs and risks of raiding.

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Risks?

• Such as making a mistake (firm performance can’t in fact be improved) or paying an excessive premium (winner’s curse) which lowers your own SMV and makes you vulnerable. Bad acquirers become targets.

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Sum up/ move on • Managers certainly have a degree of

freedom to indulge themselves …a window of opportunity provided by take-over risks and costs and the costs of detecting an controlling management behaviour.

• So what about indirect control and the possibility that owners might focus managerial actions on value indirectly? How might they do this?

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Indirect control of managers • Require a commitment from managers to be

good and to create max. shareholder value. No good, promises are cheap, not credible.

• Try to ensure a competitive market for managerial skills which will properly value managerial reputation for value creation. There are limits to this (see book) such as the fact that managers are chosen in practice by others managers rather than by owners.

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• Encourage/ insist managers to hold shares in the business. To make a commitment. Again there are problems. It is more rational for manager to invest elsewhere to diversify her wealth away from the business where her human capital is tied up. Plus insider trading becomes a worry.

• Performance related compensation schemes. Possibly, but again there are limits. Such as the essentially team nature of management. Can one person’s contribution to the actions of a complex organisation be well enough defined? Of course could make it a team based reward but then you face the free riding problem again.

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• Plus such schemes are often asymmetric. That is rewards increase if performance improves but do not decrease if it doesn’t. And this may in fact encourage managers to seek out high risk ventures. They can gamble with other people’s money.

• Finally even if good schemes can be designed (optimal incentive contracts) to suit owners can owners get them implemented. Would managers accept them?

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Summing up

• The ability of owners to govern effectively is limited by the costs involved, management control of info sources, unwillingness of FI’s, the costs of the MCC. The cost of designing and monitoring performance related pay schemes, etc.

• All of which raises the possibility that the desire to max. value will be compromised.

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• Certainly some evidence of this, for example some firms are over diversified, and some make value less acquisitions driven by managerial self aggrandisement. Book has the evidence.

• Also some managerial salaries look excessive and tend not to be correlated with performance. (Sunday Times league tables annually show this).

• And it often happens that raiders do find a lot of excess fat which can be cut out of businesses. (Hanson, Goldsmith made fortunes doing this).

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Internal organisation and motivation

• The issue of organisational complexity and motivation.

• Not developed in this class.