3. 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
4. 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®
5. 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
- 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
6. The Firm
Transaction costs are incurred when entering into a contract
- Influences
- uncertainty
- frequency of recurrence
- asset specificity
- 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.)
7. 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
to attract new employees. Such employees will, of course, benefit when the company is
profitable and its stock increases in value. However, incentives come with a price tag.
The trade-off between external transaction costs and the cost of internal opera-
tions can be shown on the simple graph in Figure 2.1. When a company operates at
the vertical axis, all its operations are conducted with the outside. As we move to the
right on this graph, the firm substitutes internal for external operations. The cost of
external transactions decreases, while the cost of internal operations increases. The
total cost is the vertical summation of the two costs, and it decreases at first as the
company finds that internalizing some operations is efficient. However, as more of
the operations are internalized, some efficiency is lost, and the total cost begins to rise
again. The company will choose to allocate its resources between external transactions
and internal operations so the total cost is at a minimum, which in this case will occur
about midway between the two extremes.
If transaction costs for a specific product or service are higher than the costs
of carrying on the activity internally, then a company benefits from performing this
particular task in-house. An independent firm may not find it profitable to produce a
product if only a few customers demand it. However, as markets expand, the demand
for a product or service, which may have been limited in the past, now expands. This
will permit new firms to specialize in activities that previously had to be performed
by the firm that needed this task to be performed. Thus new companies and indus-
tries come into existence. This is true not only in the case of products, but also for
services that at one time were performed by the firm itself and are now produced by
120
100
20
0
80
60
40
20
40 60 80 100 Internal
Operations (%)
0
Cost External transactions
Internal operations
Total
Figure 2.1
Trade-off Between
Transaction Costs and
Internal Operating Costs
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 to ship products
- Manufacturing firms have significantly increased productivity making firms production more
competitive.
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 improving efficiency.
10. 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.
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
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
13. 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
14. Do Companies Maximize Profit?
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
- 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.
15. Do Companies Maximize Profit?
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
- 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
16. 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
17. 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.
18. Maximizing the Wealth of Stockholders
- 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
19. 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
20. Maximizing the Wealth of Stockholders
- The present price of a firm’s stock should reflect the discounted value of the
expected future cash flows to shareholders (dividends)
P =
D1
(1 + k)
+
D2
(1 + k)2
+
D3
(1 + k)3
+ ..... +
Dn
(1 + k)n
(1)
- P = present price of the stock
- D = dividends received per year
- k = discount rate
- n = life of firm in years
- 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
21. 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) (2)
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’).
22. Maximizing the Wealth of Stockholders
- 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.
23. 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.
24. 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
25. Economic Value Added
- 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
26. Economic Profits
- Economic profits and accounting profits are typically different
- accountants measure explicit incurred costs
- accountants use historical cost
- 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.
27. 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
28. 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
29. Thank You Very Much
Our economic methodology
is full of fine epistemology.
But when we come to problems practical
our theories are too didactical.
If economics is a science,
it needs to foster the alliance
of theorist and statistician,
with manager and prognostician;
To tie the work of mathematicist
to problems of the market strategist.
–Herman Southworth
