Profit and Shareholder Maximization Shareholder wealth (more commonly referred to as shareholder �value�) is talking about the value of the company generally expressed in the value of the stock. Profit maximization refers to how much dollar profit the company makes. It might seem like making as much profit as possible would yield the highest value for the stock but that is not always the case. When investors look at a company they not only look at dollar profit but also profit margins, return on capital and other indicators of efficiency. Say there are two companies doing the same thing. Company A had sales of $100 million and profit of $10 million. Company B had sales of $200 million and profit of $12 million. Wall Street could look at Company B and say they are less valuable because they clearly do no operate as efficiently as Company A. So even though Company B had more profit Company A will have more shareholder value. And to answer the next question, yes companies often decide to forgo marginal increases in profit if they feel the lower margins on the incremental gains in profit will have a negative impact share price. They actually increase shareholder value by NOT making more profit. . PART I - INTRODUCTION Chapter 1 Introduction and Goals of the Firm This chapter shows that managerial economics is that part of economics applied to the decisions that managers must make. When managers make decisions that maximize firm profits, they simultaneously maximize shareholder wealth and promote efficient allocation of resources. Sometimes managers aim at objectives other than profit, such as their own security. To avoid non-profit maximizing behavior, a growing number of firms are structuring compensation plans for managers that promote long-term profitability. A. Shareholder Wealth Maximization 1. To align the interests of the shareholders of Salomon Brothers with the interests of its chairman, Deryck Maughn, most of the chairman's compensation is based on the performance of the company relative to its five major competitors. 2. Executive compensation is based
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Profit and Shareholder MaximizationShareholder wealth (more commonly referred to as shareholder �value�) is talking about the value of the company generally expressed in the value of the stock. Profit maximization refers to how much dollar profit the company makes. It might seem like making as much profit as possible would yield the highest value for the stock but that is not always the case.When investors look at a company they not only look at dollar profit but also profit margins, return on capital and other indicators of efficiency. Say there are two companies doing the same thing. Company A had sales of $100 million and profit of $10 million. Company B had sales of $200 million and profit of $12 million. Wall Street could look at Company B and say they are less valuable because they clearly do no operate as efficiently as Company A. So even though Company B had more profit Company A will have more shareholder value.And to answer the next question, yes companies often decide to forgo marginal increases in profit if they feel the lower margins on the incremental gains in profit will have a negative impact share price. They actually increase shareholder value by NOT making more profit.
. PART I - INTRODUCTION Chapter 1 Introduction and Goals of the Firm
This chapter shows that managerial economics is that part of economics
applied to the decisions that managers must make. When managers make
decisions that maximize firm profits, they simultaneously maximize
shareholder wealth and promote efficient allocation of resources.
Sometimes managers aim at objectives other than profit, such as their own
security. To avoid non-profit maximizing behavior, a growing number of
firms are structuring compensation plans for managers that promote long-
term profitability. A. Shareholder Wealth Maximization 1. To align the
interests of the shareholders of Salomon Brothers with the interests of its
chairman, Deryck Maughn, most of the chairman's compensation is based
on the performance of the company relative to its five major competitors. 2.
Executive compensation is based on Salomon Brothers' return on equity
and return on equity of their competitors. The bonus can be as large as
$24 million. B. Managerial Economics and Economic Theory 1. Managerial
Economics extracts the parts of economics, particularly microeconomics,
useful for making decisions faced by managers: pricing, production, cost
analysis, market structure, and strategy. 2. Microeconomics--deals with
economics of micro units: individuals, households, firms or industries. 3.
Macroeconomics--studies market aggregates, such as whole countries, the
market for all labor, inflation, business cycles, and unemployment. 4. The
traditional definition of economics: "The science of allocating scarce
resources among competing ends." For-profit firms as well as NFP
organizations face a variety of trade-offs. 6
7. Chapter 1 Introduction and Firm Goals 7 5. Steps in decision making
include: Establish and identify objectives, define the problem, find possible
alternative solutions, select the best solution, and implement that choice.
C. The Role of Profits 1. Economic Cost (or opportunity cost) is the highest
valued benefit that must be sacrificed as a result of choosing an
alternative. 2. Economic profit is the difference between revenues and total
economic cost (including the economic or opportunity cost of owner
supplied resources such as time and capital. 3. Theories of why profit
varies across industries: a. RISK-BEARING THEORY. A compensation for
investing in riskier endeavors. Example: investing in the stock of Circus
Circus. b. DYNAMIC EQUILIBRIUM (OR FRICTIONAL) THEORY OF
PROFIT. Industries earning above the normal long run profits at one point
of time will eventually find more competition. Added competition will tend to
bring profits back to normal over time. Competition directs resources to
industries with the greatest profit. c. MONOPOLY THEORY OF PROFIT.
Barriers, such as governmental regulations, are the source of higher than
normal profits. d. INNOVATION THEORY OF PROFIT. There is a reward
for developing new ideas, new construction technologies, and for finding
new markets. e. MANAGERIAL EFFICIENCY THEORY OF PROFIT.
Exceptional managerial skills can produce abnormal profits. 4. Circus
Circus, a Las Vegas casino and hotel earned exceptionally high returns in
1994, but a similar firm, Bally's, earned rather low returns. High average
returns tend to occur in industries with high risk. D. Objective of the Firm 1.
Profit maximization as a goal implies that decisions that raise revenues
more than costs or lower costs more than reduce revenues should be
selected. This goal does not incorporate the long time horizon of investors.
8. 2. Shareholder wealth maximization as a goal implies that decisions that
increase the present value of expected future profits SHOULD be selected.
Even decisions that reduce today's profits, yet substantially raise future
profits, may be appropriate decisions. 3. The price of a share of stock can
be thought of as the present value of expected future cash flows. Since
profits and cash flows are treated in this chapter as if they were identical,
then maximizing profits also maximizes the price of shares of stock. In this
way, profit maximization and shareholder wealth maximization can be
viewed as complementary concepts. 4. The value of the firm, V, is the
present value of expected future profits (π) or cash flows, discounted at the
shareholders required rate of return, ke, ignoring taxes. ∞ V = Σ π t /(1+ke)
t t=1 5. Profit, π, is total revenue minus total cost (TR - TC). Total revenue
for a single product firm is price times quantity, P·Q. Total cost (TC) is total
variable cost plus fixed cost, F. Total variable cost is the variable cost per
unit, V, times the number of units, Q. Hence, π = P·Q - V·Q - F. ∞ 6.
Through substitution: V = Σ [ Pt·Qt - Vt·Qt - Ft ]/(1+ke) t t=1 Determinants
of Firm Value 7. Business decisions affect the amount and timing of
revenues, costs, and the discount rate used by investors. For example,
selecting a capital-intensive technology may raise fixed costs, F, but lower
variable costs per unit, V. 8. The equation above is a simple model that
helps us organize our thinking about economic decisions that managers
must make. If firm decisions reduce the perceived risk of the firm, then a
reduction in required rate of return, ke, raises the value of the firm. 9.
Expected future profits are not the same as accounting profits. Accounting
profits do not consider the opportunity cost of capital invested by owners or
actual cash flows collected or paid by the company. In practice, managers
who base their decisions on 8
9. Chapter 1 Introduction and Firm Goals 9 ways to maximize the present
value of cash flows, will make decisions that maximize the wealth of
shareholders. 10. Profit maximization is the primary goal of William Buffett,
CEO of Berkshire Hathaway. Higher profits mean higher share values.
Buffett owns a sizeable stake in his company. E. Managerial Actions to
Influence Shareholder Wealth 1. Some determinants of profits are outside
the direct control of managers. Economic Environment Factors include the
level of economic activity (recession or boom), tax rates, competition,
governmental regulations, unionization, and international economic
exposure. Also Conditions in Financial Markets such as interest rates,
investor sentiment, and anticipated inflation affect profitability. 2. Other
determinants of profits are within the direct control of managers. Major
Policy Decisions include product mix, production technology, marketing
network, investment strategies, employment policies and compensation,
form of organization, capital structure (use of debt versus equity), working
capital management, and dividend policies. F. Agency Problems, and
Alternative Objectives for the Firm 1. Modern corporations allow the
managers to have no, or limited, ownership participation in the profitability
of the firm. Shareholders may want profits, but managers may wish to
relax. The shareholders are principals, whereas the managers are agents.
Conflicting motivations between these groups are called agency problems.
2. Solutions to agency problems involve compensation that is based on the
performance of agents. Some firms are experimenting with compensation
plans by extending to all workers stock options, bonuses, and grants of
stock. This creates added incentives to help the company, because that
improves the value of stock options and bonuses. G. Implications of
Shareholder Wealth Maximization 1. Critics claim that aligning
compensation with shareholder interests leads to short run objectives. 2.
But maximization of the present value of expected cash flows works well if
the following conditions are met:
10. a. COMPLETE MARKETS -- liquid markets for firm's inputs and by-
products (including polluting by-products). b. NO SIGNIFICANT
ASYMMETRIC INFORMATION -- buyers and sellers all know the same
things. c. KNOWN RECONTRACTING COSTS -- future input costs are
part of the present value of expected cash flows. The existence of future
and forward markets in inputs can help lock-in future input costs. H. Goals
in the Public Sector and the Not-For-Profit (NFP) Enterprise 1. NFP
organizations such as performing arts groups, most hospitals and
universities, and volunteer organizations receive a substantial portion of
their financial support from contributions, and some support from "clients"
who use their services. 2. Instead of profit, NFP organizations may have as
their goals: a. Maximization of the quantity of output, subject to a
breakeven constraint. b. Maximization of the utility (happiness) of NFP
administrators. c. Maximization of cash flows. d. Maximization of the utility
of contributors to the NFP organization. 3. Which goal a NFP manager
selects affects the types of decisions made. A manager of a food shelter
may decide to maximize the utility of contributors or donors by selecting
only "healthy foods" to give to clients; or may decide that the objective is to
give out the greatest volume of food possible (not necessarily the most
nutritious). 4. Public sector managers are frequently monitored with regard
to how they perform their jobs. If reducing the cost per bed over a year
rewards a VA hospital administrator, then the administrator may become
quite efficient with respect to costs. However, the "friendliness" of the
hospital staff is harder to measure, so friendliness will tend not be a high
priority of the public sector manager. 5. In contrast, in the for-profit hotel
business, perceptions about the friendliness of the hotel staff may have a
direct effect on repeat business and profits. I. Managing a Globally
Competitive Economy 1. Managerial innovations, such as "just-in-time"
inventory methods, efficient transfer pricing, and total quality management
concepts can be learned by observing 10
11. Chapter 1 Introduction and Firm Goals 11 successful competitors in the
U.S. or abroad. Global managers need to be up-to-date with the tools of
managerial economics to compete and win in the world marketplace.
12. True and False Questions Agree or disagree with the following
statements, and correct the part that is erroneous. 1. The goal of
shareholder wealth maximization implies that managerial decisions
maximize this quarter's expected profits of the firm. 2. Macroeconomics
deals with large firms, big business deals, and huge deficits. 3. An example
of an agency problem is an employee who steals merchandise from the
place where he works. 4. If you owned and worked in your own card shop,
and if you did not pay yourself a wage, then you have ignored an economic
cost of running your business. 5. Decisions that do not affect the amount of
revenues and costs, but change the timing of receipts and disbursement
will not affect the value of the firm. 6. The amount of profits is entirely under
the control of the manager. 7. Not-for-profit organizations can't earn profits,
so they have no goals. 8. In the long run, all firms earn the same rate of
return. Answers 1. Disagree. Expected long run profits of the firm affects
firm value. 2. Disagree. Macroeconomics deals with market aggregates,
such as whole countries, the market for all labor, inflation, business cycles,
and unemployment. 3. True. 4. True. 5. Disagree. Timing affects the
present value of the firm. Monies received sooner are more valuable than
the same amount received later. 6. Disagree. Economic Environment
Factors and Conditions in Financial Markets are outside the control of
managers, and do affect profitability. 7. Disagree. The goals of NFP may
vary, such as maximizing number of clients served or maximizing the
happiness of the organization's management. But they do have goals. 8.
Disagree. Barriers to free trade, as in some kinds of governmental
regulations, can create monopoly. There may be differences in risk,
degrees of innovation, and there may be changes in technology and tastes
that create above normal, and below normal, profit rates in different