Chapter 2 The Firm and Its Goals

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 Emphasize that it is the total costs are minimized for a given level of output-minimizing costs from a single operation could increase costs for another sector of the business.

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. Some firms have brought operations back to the US due to the changing costs, technology advances, or productivity changes.

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 Mention that these goals are interconnected and are often part of the goal of profit maximization.

Goals other than Profit Non-economic objectives Good work environment for employees Quality products and services for customers Good corporate citizenship and social responsibility Although these goals do not directly mention profit maximization-they may be part of achieving that goal.

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’.

Do Companies Maximize Profit? Two forces leading to satisficing position and power of stockholders position and power of management

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

Do Companies Maximize Profit? 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.

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

Do Companies Maximize Profit? 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 Unfortunately there have been several well publicized instances of corporate managers who pursued their own benefits instead of their responsibility to shareholders.

Do Companies Maximize Profit? 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

Do Companies Maximize Profit? 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.

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

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.

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 Examples from the financial crisis and the risk introduced by leverage can be used to illustrate this concept.

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 = present price of the stock D = dividends received per year k = discount rate n = life of firm in years

Maximizing the Wealth of Stockholders 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

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

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.

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

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 > 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 Students who have traveled outside the US may be able to provide some examples of these differences.

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