Managerial Economics Week 1
Chapter Two
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Chapter 2
The Firm and its Goals
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Chapter Two
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Overview
- The firm
- Economic goal of the firm
- Goals other than profit
- Do companies maximize profits?
- Maximizing the wealth of stockholders
- Economic profit
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Chapter Two
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Learning objectives
- understand the rationale for existence of firms
- explain economic goals and optimal decision making
- describe the ‘principal-agent’ problem
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Chapter Two
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Learning objectives
- distinguish between profit maximization and shareholder wealth maximization
- apply Market Value Added and Economic Value Added
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Chapter Two
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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
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Chapter Two
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The Firm
- Transaction costs are incurred when entering into a contract
- types of transaction costs
- investigation
- negotiation
- enforcing contracts
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Chapter Two
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The Firm
- Transaction costs are incurred when entering into a contract
- influences
- uncertainty
- frequency of recurrence
- asset specificity
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Chapter Two
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The Firm
- Examples
- Kodak – uses offshoring to source cameras
- IBM – manufacturing computers overseas
- Exult – third party services used in human resources
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Chapter Two
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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 minimum
- outsourcing of peripheral, non-core activities
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Chapter Two
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Economic goal of the firm
- 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
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Chapter Two
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Economic goal of the firm
- Short-run versus Long-run
- nothing to do directly with calendar time
- short-run: firm can vary amount of some resources but not others
- long-run: firm can vary amount of all resources
- at times short-run profitability will be sacrificed for long-run purposes
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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Goals other than profit
- Economic goals
- market share, growth rate
- profit margin
- return on investment, return on assets
- technological advancement
- customer satisfaction
- shareholder value
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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Goals other than profit
- Non-economic objectives
- good work environment
- quality products and services
- corporate citizenship, social responsibility
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Chapter Two
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Do companies maximize profit?
- Criticism: companies do not maximize profits but instead merely aim to satisfice, which means to achieve a satisfactory goal, one that may not require the firm to ‘do its best’
- two forces affect satisficing:
- position and power of stockholders
- position and power of management
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Do companies maximize profit?
- Position and power of stockholders
- larger firms are owned by thousands of shareholders
- shareholders own only minute interests in the firm ... and hold diversified holdings in many other firms
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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Do companies maximize profit?
- Position and power of stockholders
- shareholders are concerned with performance of entire portfolio and not individual stocks
- less informed about the firm than management
stockholders not likely to take any action if earning a ‘satisfactory’ return
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 because jobs will likely be safe if performance is steady, not spectacular
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Do companies maximize profit?
- Position and power of management
- managers may be more interested in maximizing own income and perks
- management incentives may be misaligned (eg. revenue not profits)
divergence of objectives is known as ‘principal-agent’ problem
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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Do companies maximize profit?
- Counter-arguments which support the profit maximization hypothesis
- large stockholdings held by institutions (mutual funds, banks, etc.) scrutiny by professional analysts
- stockmarket discipline if managers do not seek to maximize profits, firms face threat of takeover
- incentive effect the compensation of many executives is tied to stock price
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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Maximizing the wealth
of stockholders
- 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: says a dollar earned in the future is worth less than a dollar earned today
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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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
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Chapter Two
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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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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’)
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Maximizing the wealth
of stockholders
- 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 substantial part of executive compensation, management objectives tend to be more aligned with stockholder objective
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
*
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
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
Chapter Two
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Economic profits
- Economic profits and accounting profits are typically different
- accountants measure explicit incurred costs, as allowed by GAAP
- accountants use historical cost of machines
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Chapter Two
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Economic profits
- Economists are concerned with implicit costs, called opportunity costs
Accordingly, economists use replacement cost of machines
economic costs include historical and explicit (accounting) costs as well as replacement and implicit (economic) costs
economic profit is total revenue minus all economic costs
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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