What Should the Firm Do? Why would a consumer be willing to pay extra for a name brand product?
mrtssmktwg
Chapter11WhatShouldtheFirmDo.pptPowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University
What Should the Firm Do?
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
CHAPTER 11
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stakeholders and Shareholders
- Firm’s objectives
Maximize shareholder value
May ignore important social issues
Other objectives?
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Business Insight
Who Does the Company Exist for,
the Shareholders or the Stakeholders?
- Companies should maintain dividend payments to stockholders
Even if it means the company has to lay off workers
Japan, 3% of managers agree
Germany, 41% agree
France, 40% agree
U.S. and U.K., 89% of managers agree
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Business Insight
Who Does the Company Exist for,
the Shareholders or the Stakeholders?
- A company exists for all stakeholders
Japan, 97% agree
Germany, 83% agree
France, 78% agree
U.S., 76% agree
U.K., 71% agree
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Maximizing the Power of the Firm
- Value maximization
Manager should make all decisions
To increase the long-run market value of the firm
Maximize the sum of the value of all financial claims on the firm
- Adding value
Produce an output
That is valued by customers
At more than the value of the inputs
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Maximizing the Power of the Firm
- Value maximization
Benefits society - voluntary transactions
Inputs
Owners of inputs value them less than or equal to the price at which the firm buys them
Opportunity cost to society of those inputs
Is no higher than the total cost to the firm
Goods and services produced by the firm
Their value is at least as great as the price the firm receives from their sale
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stakeholder Theory
- Has to Be to Maximize Profit
- A firm most benefits society
By focusing on maximizing shareholder value or profit
Counterintuitive
- Firm has to maximize value to all stakeholders
Firm maximizing profit - will not care if it harms employees, consumers, communities, or the environment
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stakeholder Theory
- CSR
Make firms responsible for the social costs and benefits of economic change
Encourage corporations to be more employee-sensitive
Reward: reduction of corporate taxes
Punishment: extra taxes
Problems: trade-off
Maximize current profits, market share, future growth in profits, employee health and safety, and benefits for the local community
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Stakeholder Theory
- Firm - must maximize the value it adds to resources
Maximizing: shareholder value, profit, value added
Objective of business: create value
Managers - respond to all stakeholders:
Spend an additional dollar of resources
To satisfy the desires of each constituency
As long as consumers value the result at more than a dollar
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
An Illustration of Profit Maximization
- Maximize profit: MR = MC
- Marginal cost (MC)
Additional cost of producing one more unit of output
Value of resources needed to produce one more unit
- Marginal revenue (MR)
Additional revenue obtained from selling one more unit of output
Value society places on one more unit
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
An Illustration of Profit Maximization
- If MR>MC
Producing and selling more will increase profit
- If MR<MC
Producing and selling more will lower profit
- Maximize profit
When the quantity offered for sale creates MR = MC
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Table 11.1
Profit Maximization
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
An Illustration of Profit Maximization
- Problems
MR and MC are typically not known
Managers do not even think of marginal costs and revenues
Accountants do not provide marginal cost information
Executives say they pay no attention to marginal cost or marginal revenue
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
An Illustration of Profit Maximization
- MR and MC
Come into play in the managers’ decisions
Spend an additional dollar on any activity as long as consumers value the result at more than a dollar
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Competition and Price
- Competition
Search for profit
Drives out inefficiency
Ensures that resources are allocated to their highest valued uses
To make and sustain profit
Build a better product; continually improve it
Learning process
Come up with the next great thing, the next innovation or technological change
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Competition and Price
- Market power
Higher profits
- Monopoly – single supplier
Rent seeking – government
Created and sustained by the government
Patents
Licenses
Cost conditions – natural monopoly
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Competition and Price
- Differentiation and Market power
Higher profits
- Product differentiation
Create a special attribute
Brand name or reputation
Promotion, placement, and packaging
Guarantees and warranties
Reduce the consumers’ costs of gathering information
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exit
- Negative economic profit
Firm - inefficient decisions
Firm - fails to match the efficiencies of other firms
In short-run
Continue operating until it is able to liquidate
Temporarily close down
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exit
- Monopolist - negative economic profit
Government subsidy
Temporarily shut down
Go out of business entirely
- Fixed costs
Costs that do not vary as output changes
- Variable costs
Costs that vary as output varies
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Table 11.2
Temporary Closures
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Value over Time
- Maximize profit
Allocate resources to an activity
Only if the value society places on the activity exceeds the costs
Continue to expand purchases of inputs and sell the resulting outputs
As long as an additional dollar of inputs generates sales of at least a dollar
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Value over Time
- Future value = $1 × (1 + r)
Value one year from now
Of a dollar saved today
For use one year from now
where r is the interest rate
- Present value = $1/(1 + r)
Value today
Of a dollar of resources
To be received one year from now
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Value over Time
- Firm
Maximize the present value of its expected profits
- Risk
Financial markets - buy and sell risk at a given price
Risk adjusted interest rate
To calculate the present value of risky claims
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Normal profit
Zero economic profit
Revenue = total opportunity cost
- Abnormal profit
Positive economic profit
Revenue > total opportunity cost
Positive economic profit above normal profit
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- The abnormal net income model
The market value of a firm
Is its book value (the current stockholder’s equity)
Plus the present value of economic profits expected to be earned in the future
- P0 = current book value + present value of expected economic profits
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Expected economic profits
Next year’s expected accounting profit in excess of the cost of capital
- Abnormal net income next year
Next year’s expected accounting profit in excess of the cost of capital
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- The Value of a Firm
Amount that owners would pay to keep ownership
Amount that new owners would pay to acquire ownership
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Value of a Publicly held firm
Its market capitalization
Value per share
Multiplied by the number of shares of stock that are outstanding
- Value of a Privately held company
At minimum: its liquidation value
Value of a firm’s assets when they are dismantled and sold
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Economic profit & stock price performance – relationship?
Yes - Abnormal Net Income model
No - stock prices
- Stock prices gains in one given year
Above the market average
Or below the market average
Snapshot at that year’s profits
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Economic profit over several years
Great picture of performance
Present value of all expected future economic profits
Whether a company creates or destroys wealth
- “Maximizing shareholder value”
Focus on short-term profits even at the expense of long-run losses
Incorrect!
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Short Termism
Focusing on short-term results at the expense of long-term results
Drive the shareholder value down, not up
Short-term stock performance would be low
Reflecting the long-term prospects of the firm
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Shareholder value
Reflection of the current and expected future economic profits of a firm
Stock price reflects the expected economic profit stream
Maximizing shareholder value = maximizing economic profit
Focus on long-term performance
Attempt to maximize the difference between net earnings and the cost of capital
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Stock price
Demand for and supply of shares of that stock
Valuation of the price of the stock – based on expectations of future firm performance
Demanders and suppliers
Different viewpoints about the movement of the stock price
Different objectives for owning stock
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Changes in stock price
Revisions of expectations
Expectations of future net income rise
When expectations of future net income rise
Market value declines
When the cost of capital, r, rises
Stock price rises
When expectations are revised upward
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Abnormal Net Income Model
- Abnormal profits
How long can they be maintained?
Depends on how fast competitors come on line to drive economic profit to zero
- Decay rate
Speed at which abnormal net income is driven to zero
Rate at which entrepreneurs are able to innovate or otherwise compete with the firm
Defined by the competitive conditions
*
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
