The Firm and Its Goals• The Firm• Economic Goal of the Firm• Goals Other Than Profit• Do Companies Maximize Profits?• Maximizing the Wealth of

Stockholders• Economic Profits

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.

Economic vs. Accounting Profits

• Accounting Profits– Total revenue (sales) minus dollar

cost of producing goods or services.– Reported on the firm’s income

statement.

• Economic Profits– Total revenue minus total opportunity

cost.

Cost• Accounting Costs

– The explicit costs of the resources needed to produce produce goods or services.

– Reported on the firm’s income statement.

• Opportunity Cost– The cost of the explicit and implicit

resources that are foregone when a decision is made.

• Economic Profits– Total revenue minus total opportunity

cost.

Economic Goal of the Firm

• Primary objective of the firm (to economists) is to maximize profits.– Profit maximization hypothesis– Other goals include market share,

revenue growth, and shareholder value

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

• Short-run vs. 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

Goals Other Than Profit– Market share maximization (as

measured by sales revenue or proportion of quantity sold to total market

– Growth rate maximization (increasing size of the firm over time. Higher rates of growth in other variables than profit)

– Profit margin

– Return on investment, Return on assets

– Shareholder value

– Technological advancement

– Customer satisfaction

– Maximization of managerial returns (manager’s own interest subject to generating sufficient profits to keep their jobs)

• Non-economic Objectives

– Good work environment

– Quality products and services

– Corporate citizenship, social responsibility

Do Companies Maximize Profit?

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

– “Satisfice” is to achieve a set goal, even though that goal may not require the firm to “do its best.”

– Two components to “satisficing”:• Position and power of stockholders• Position and power of professional

management

• Position and power of stockholders

– Medium-sized or large corporations are owned by thousands of shareholders

– Shareholders own only minute interests in the firm

– Shareholders diversify holdings in many firms

– Shareholders are concerned with performance of entire portfolio and not individual stocks.

– Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness of management.

– Not likely to take any action as long as they are earning a “satisfactory” return on their investment.

• Position and power of professional management

– High-level managers who are responsible for major decision making may own very little of the company’s stock.

– Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.

– Management incentives may be misaligned• E.g. incentive for revenue growth, not

profits• Managers may be more interested in

maximizing own income and perks

– Divergence of objectives is known as “principal-agent” problem or “agency problem”

• Counter-arguments which support the profit maximization hypothesis.

– Large number of shares is owned by institutions (mutual funds, banks, etc.) utilizing analysts to judge the prospects of a company.

– Stock prices are a reflection of a company’s profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject to takeover bids and proxy fights.

– The compensation of many executives is tied to stock price.

• 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 objectives.

Maximizing the Wealth of 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 time value of money.

– Dollars earned in the future are worth less than dollars earned today.

• Future cash flows must be discounted to the present.

• The discount rate is affected by risk.

• Two major types of risk:•Business Risk•Financial Risk

• 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.

• 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.

Timing

2 types of models1.Static model:– describe the

behaviour at a single point in time. Disregards differences in the sequence of actions and payments

2.Dynamic models:- focus on the timing and sequence of actions and payments

The Time Value of Money

• Present value (PV) of a lump-sum amount (FV) to be received at the end of “n” periods when the per-period interest rate is “i”:

PV

FV

i n1

• .

• Examples:– Lotto winner choosing between a single

lump-sum payout of $104 million or $198 million over 25 years.

– Determining damages in a patent infringement case

Present Value of a Series

• Present value of a stream of future amounts (FVt) received at the end of each period for “n” periods:

PV

FV

i

FV

i

FV

inn

1

12

21 1 1. . .

Net Present Value• Suppose a manager can purchase a stream of

future receipts (FVt ) by spending “C0” dollars today. The NPV of such a decision

Is

NPV

FV

i

FV

i

FV

iCn

n

11

22 01 1 1

. . .

Decision Rule:If NPV < 0: Reject project

NPV > 0: Accept project

Present Value of a Perpetuity

• An asset that perpetually generates a stream of cash flows (CF) at the end of each period is called a perpetuity.

• The present value (PV) of a perpetuity of cash flows paying the same amount at the end of each period is

i

CF

i

CF

i

CF

i

CFPVPerpetuity

...111 32

Firm Valuation

• The value of a firm equals the present value of current and future profits.– PV = t / (1 + i)t

• If profits grow at a constant rate (g < i) and current period profits are :

0

0

1 before current profits have been paid out as dividends;

1 immediately after current profits are paid out as dividends.

Firm

Ex DividendFirm

iPV

i g

gPV

i g

• If the growth rate in profits < interest rate and both remain constant, maximizing the present value of all future profits is the same as maximizing current profits.

• Control Variables– Output– Price– Product Quality– Advertising– R&D

Marginal (Incremental) Analysis

Net Benefits

• Basic Managerial Question: How much of the control variable should be used to maximize net benefits?

• Net Benefits = Total Benefits - Total Costs

• Profits = Revenue - Costs

Marginal Benefit (MB)

• Change in total benefits arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total benefit curve.

Q

BMB

Marginal Cost (MC)

• Change in total costs arising from a change in the control variable, Q:

• Slope (calculus derivative) of the total cost curve

Q

CMC

Marginal Principle• To maximize net benefits, the

managerial control variable should be increased up to the point where MB = MC.

• MB > MC means the last unit of the control variable increased benefits more than it increased costs.

• MB < MC means the last unit of the control variable increased costs more than it increased benefits.

The Geometry of Optimization

Q

Total Benefits & Total Costs

Benefits

Costs

Q*

B

CSlope = MC

Slope =MB

Conclusion• Make sure you include all costs and

benefits when making decisions (opportunity cost).

• When decisions span time, make sure you are comparing apples to apples (PV analysis).

• Optimal economic decisions are made at the margin (marginal analysis).

Maximizing the Wealth of Stockholders

• Another measure of the wealth of stockholders is called Market Value Added (MVA)®.

• MVA represents the 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 is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed.