goal of firm

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Chapter 2 Chapter 2 The Firm and Its

Goals

Managerial Economics: Economic Tools for Todays Decision Makers, 5/e

By Paul Keat and Philip Young


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2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

The Firm and Its Goals

The FirmEconomic Goal of the Firm

Goals Other Than ProfitDo Companies Maximize Profits?Maximizing the Wealth of StockholdersEconomic Profits


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L earning Objectives

Understand the reasons for existence of firms andmeaning of transaction costsExplain economic goals and optimal decision

makingDescribe meaning of principal-agent problemDistinguish between profit maximization andshareholder wealth maximizationDemonstrate usefulness of Market Value Addedand Economic Value Added


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The Firm

A f irm is a collection of resources thatis transformed into products demanded

by consumers.What is wrong with this definition?Pro f it is the difference betweenrevenue received and costs incurred(explicit and implicit).


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The Firm

Transaction costs are incurred whenentering into a contract.

Types of transaction costs

InvestigationNegotiationEnforcing contract and coordinating transactions

InfluencesUncertaintyFrequency of recurrenceAsset specificity


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Internet

What is the effect on transaction costs?Bigger or smaller firms?


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The Firm

Limits to Firm Sizetradeoff betweenexternal transactionsand the cost of internaloperationsCompany chooses toallocate resources sototal cost is minimum

Outsourcing of peripheral, non-coreactivities


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E conomic Goal o f the Firm

Primary objective of the firm (toeconomists) is to maximize profits.

Profit maximization hypothesisOther goals include market share,revenue growth, and shareholder value

Optimal decision is the one that bringsthe firm closest to its goal.


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E conomic Goal o f the Firm

Short-run vs. Long-runNothing to do directly with calendar time

Short-run: firm can vary amount of someresources but not othersLong-run: firm can vary amount of allresourcesAt times short-run profitability will besacrificed for long-run purposes


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Goals Other Than Pro f it

Economic GoalsMarket share, Growth rate

Profit marginReturn on investment, Return on assetsTechnological advancement

Customer satisfactionShareholder value


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Goals Other Than Pro f it

Non-economic ObjectivesGood work environment

Quality products and servicesCorporate citizenship, socialresponsibility


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D o Companies Maximize Pro f it?

Criticism: Companies do not maximize profits but instead their aim is to satisfice.

Satisfice is to achieve a set goal, even thoughthat goal may not require the firm to do its best.Two components to satisficing:

Position and power of stockholdersPosition and power of professional management


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Position and power of stockholdersMedium-sized or large corporations are owned

by thousands of shareholdersShareholders own only minute interests in thefirmShareholders diversify holdings in many firms

Shareholders are concerned with performanceof entire portfolio and not individual stocks.


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Position and power of stockholdersMost stockholders are not well informed

on how well a corporation can do andthus are not capable of determining theeffectiveness of management.

Not likely to take any action as long asthey are earning a satisfactory return ontheir investment.


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Position and power of professionalmanagement

High-level managers who are responsiblefor major decision making may own verylittle of the companys stock.Managers tend to be more conservative

because jobs will likely be safe if performance is steady, not spectacular.


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Position and power of professionalmanagement

Management incentives may be misalignedE.g. incentive for revenue growth, not profitsManagers may be more interested in maximizingown income and perks

Divergence of objectives is known asprincipal-agent problem or agency problem


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Counter-arguments which support the profitmaximization hypothesis.

Large number of shares is owned by institutions(mutual funds, banks, etc.) utilizing analysts to judgethe prospects of a company.Stock prices are a reflection of a companys

profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject totakeover bids and proxy fights.

The compensation of many executives is tied tostock price.


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Maximizing the Wealthof 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 timevalue of money.

Dollars earned in the future are worth lessthan dollars earned today.


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Bu siness risk involves variation inreturns due to the ups and downs of the

economy, the industry, and the firm.All firms face business risk to varyingdegrees.


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Financial Risk concerns the variation inreturns that is induced by leverage.L everage is the proportion of a companyfinanced by debt.The higher the leverage, the greater the

potential fluctuations in stockholder earnings.

Financial risk is directly related to thedegree of leverage.


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The present price of a firms stock should reflectthe discounted value of the expected future cashflows to shareholders (dividends).

P = present price of the stock D = dividends received per year K = discount rateN = life of firm in years

n

n

k

D

k

D

k

D

k

D P

)1()1()1()1( 33

221! .


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If the firm is assumed to have aninfinitely long life, the price of a share

of stock which earns a dividend D per year is determined by the equation:

P = D/k


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Company tries to manage its business insuch a way that the dividends over time

paid from its earnings and the risk incurred

to bring about the stream of dividendsalways create the highest price for thecompanys stock.When stock options are substantial part of

executive compensation, managementobjectives tend to be more aligned withstockholder objectives.


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Another measure of the wealth of stockholders is called Market Val u e

Added (MVA).MVA represents the difference

between the market value of the

company and the capital that theinvestors have paid into the company.


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Market value includes value of both equityand debt.Capital includes book value of equity anddebt 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 positiveor negative.


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Another measure of the wealth of stockholders is called E conomic Val u eAdded ( E VA).

EVA=(Return on Total Capital Cost of Capital) x Total Capital

If EVA is positive then shareholder wealthis increasing. If EVA is negative, thenshareholder wealth is being destroyed.


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E conomic Pro f its

Economic profits and accounting profits are typically different.

Accounting treatments allowed by GAAPAccountants report cost on historical

basis.

Economists are more concerned withopportunity costs or alternative costs.


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E conomic Pro f its

Historical costs vs. replacement costsImplicit costs and normal profits

Return required by scarce resources to remaincommitted to a particular firm

Economic costs include historical andexplicit costs (accounting) as well asreplacement and implicit costs

Economic profits is total revenue minus alleconomic costs

goal of firm

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