Chapter 2
The Firm and its Goals
Overview
The firm
Economic goal of the firm
Goals other than profit
Do companies maximize profits?
Maximizing the wealth of
stockholders
Economic profit
Learning objectives
understand the rationale for existence of
firms
explain economic goals and optimal decision
making
describe the ‘principal-agent’ problem
distinguish between profit maximization and
shareholder wealth maximization
apply Market Value Added and Economic
Value Added
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
The Firm
Transaction costs are incurred when
entering into a contract
types of transaction costs
investigation
negotiation
enforcing contracts
The Firm
Transaction costs are incurred when
entering into a contract
influences
uncertainty
frequency of recurrence
asset specificity
The Firm
Examples
Kodak – uses offshoring to source
cameras
IBM – manufacturing computers
overseas
Exult – third party services used in
human resources
The Firm
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
The Firm
Illustration: Coase and the Internet
Ronald Coase wrote in 1937, pre-
internet
but his ideas are still relevant today
tradeoff between internal costs and
external transactions
search costs
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
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
Goals other than profit
Economic goals
market share, growth rate
profit margin
return on investment, Return on assets
technological advancement
customer satisfaction
shareholder value
Goals other than profit
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 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
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
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
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
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
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
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
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
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
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
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)
D1 D2 D3 Dn
P (1 k ) (1 k ) 2 (1 k )3 (1 k ) n
P = present price of the stock
D = dividends received per year
k = discount rate
n = life of firm in years
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
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’)
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
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
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 > 0 shareholder wealth rising
if EVA < 0 shareholder wealth falling
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
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
Economic profits
Other countries, other cultures
foreign currencies
legal differences
language
attitudes
role of government