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p A R T
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 C H A p T E R

19 Profit Maxiinization
over Tirn.e

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11
, ,::
I
.
' I::.' I.
d
rr=Tl] n this and the follow ing chapter, we will analyze the decision-mak ing
. t,11.1 process of a firm with a time horizon of not just one period but several periods into
1 1.

'
1; the future. Furthermore, the firm under consideration is owned by many shareho
L lde rs rathe r than by a single owner who also manages the firm . Sl ;ch :; f:r r:1. ·,-.•c
!.ild. se e m 1·0 be a radical departnre from thP owner-mamiged firm with a

,.;:
1· single-period horizon that we have i:ousidered throug hou t most ot the
I·
l·ri
'.! text.

I
i !n a sense, lhis change in assumpti0n!.'; does represent a substantial depar
ture, and th analysis of such a firm i1ppears to be a la rge order for only two
'
, chapters . G!ven this space limi tation_. we wi!l merely scratch the surface o [
<'
!!l r,1 I

number M issuc's . However, for someone ,<rh J underst ;inds the pr incip les of
e­
,i '' optimization set forth i.n Chapter 4 and the optimization analysi::. alread y d
. I! I scribed in a lc:rge part of the text, th is ma te rial should be nvthing new. V\lhat y,ch
!< have seen in the theories of the firms described thus far are applications of the
marginal beneW equals ma rg ina l cost rule, and that is what you will also se e in
l ; the remainder of the text.

ti
Before we proceed w ith the analysis of a firm's multi-period decisi o n making
process we want to reassure you that we have not cheated you by devoting so much
space to profit niaximization by a firm with a singl1::? - per io d tim e horizon. Most
firm and managerial decision making can be analyzed and understood just as fruitfully
within the single-period framework without adding the complexity of th e time
dimension. For some firms' decisions, however, th<' addi tional time dimension is
not only useful but necessary. S0me importcn t examples of this are the firm·s
investment decisions and profit-maxiuuzation

6.42
 CH AP r ER 19 l' rnlil M,,ximization owr Time 643

decisions, when such decisions made in one period affect decisions made in
futun: periods.
After ir,troducing the concepts of present value and maximization of the
vr,luc of the firm, we will ana lyze the profit-max imiz ation decision when deci
sions i-n one period affect decisions in future periods. We will demonstrate that
in a lllrgc nwn ber of cases, multi-pe: iod optimization is iden tical to sing le period
maximizat ion. We will also demonstrnte that lhe ru le of marg inal bene fit equals
marginal cos t still applies even though the time horizon has been ex tended. In the
following chapter, we will w e the multi-p e riod framework to address the firms
investment decision. In all of the examples to folJow, you will see that the re is one
simple rule for the p rofit-maximiz ing firm to fo!low: Maxi
mize Ifie prcsl'llt vnh1e of 1he firm.

19.1 NET PRESENT VALUE

Multi-period decision mc1king is based upon the concepts of pr esen t value and
present ,·olue (.OV) net presen t value. Present value is the value at the present time of i\ payment or
Tl,e volue c:I lhe p'o 111
stream of paymeuts to be received some time in the future . Net present value is
lime
ul C 1e1wn ro ht: le?et.:i;,_,orJ l
the difference between the oresent value of a future return or stream of returns
Ji from nn asse t or project a1;d the cost of that asset or project. Before using the
!t,;t:1e l1111e in i he lur u1e. concept of net present value to analyze c1 firm's decision maki.ng, we w ill de
net prese nt value INPV) scribe how net present value is cak:ulated.
I t l,_' dJHt"E!l1CE! b el wtH.W In
1 eso>n l value of the nel cv h
Present Value of a Single Payment in the Future
llowf5I from on osse1 ond
1h,; cosl of the a sset First consider how much someone would pay today for a project that will return
$,r:Q in onP. YP"lr. There i1' 11'J ,.isk or 1.1:,cer t:-!inty , s0 th '3 s;lQO reh!.:-n is a
sl.ll"e thing. An alternative to this r isk-free project is investing in other riskless
activi ties, the best P.xample of which is US government secur iti.es. Suppose that
one year gcvP.rrunent bonds are paying 6 percent annually. How much would
have to be in\'ested in these bonds to get $100 at the end ot the year? Investing $X
today at an interest c&te of 6 percent will return $X(l.06) in one year. If th.is
investment is vvorth $100 al the e11cl of one year,

$X(l.06) = $100
1l follows that the amount one must invest tod y is $94.34(=$100/1.06). That
is, the present value of $100 in one year with an interest rate- a discount rate-
of 6 percent is $94.34.
Now suppose that the project wouid return the $100 not in one year, but in two
years. Again, suppose that the annual interest rate on two-year US govern ment
bonds is 6 percen t. Investing $X at 6 percent would yield $X(l.06) at the end of
year one and, at theend of year two, [$X(l.06)](1.06) = $X(l .06)2. Th us, for an
investment to be worth $100 in two years,
$ X(1.06)2 =
$100
Thus, the amow1t that must be invested today is $89.00[=$100/ (1.06)2]. The pres ent
value of $100 i.t1 two years \·:ith a discount rate of 6 pe rcen t is $89.00.

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 ---
644 P A R T VII Decision Making ov,•r TimP

Clearly a pattern is eme rg ing : The present value of $100 in one ye.1r at 6
percent is
.
$100
PV =_(
) = $9 4.34
06
Th2 present value of $100 in two years at 6 percent is
$100
PV = (10. 6) 2 _ = $89.00

T h e refore, the presen t value of $100 to be received in t years (t being any number
of years) with a discount rate of 6 percent is
$100
PV = (1.06)'
Thi:, relation can be made cv .:1. inore general to determine the present value of
some net cash flow (NCF) to be rece ived in t years at a prevailing interes t rnte
of r. 13y net cnsh flow, we obvio us ly m ea., the cash received in time period r,
net of any costs or expenses that must be paid out of the cash inflow. Also note
that if
th e in te res t rat e is 6 perce n t, for example, r is expressed as 0.LJ6.

[BJ Relation The pr2sent vcl ue jPV) o f $NCF to be received :n I years al o discount ,ate of 1 1s

$NU
PV=(f+,r

As illustrated abuve, the p rese nt value of a cash flow declin s the further in
thz future it is t0 b.: rec,:fr,ed--k>r exrun ple, the present va: ue of $100 at 6 pe
rce1·,t was $94.34 i n one year and only $89.00 in two years. As should be evident
from the more generai statement oi prese nt value, the present value of a cash
flow is inversely related le the discount rate-for example, the present value of
$100 to be receivt!d in tw o ye<1rs is $89.00 w ith z d iscc tmt rate of 6 percent,
II
but only
Ir $85.73[=$100/ (1.08)2] with a discount rate pf 8 percent. Obviously the present
valL,e of a cast, flow increases a the size of the cash flow increa:;es - fc t·example,
! using one year to maturity and a discount rate of 6 pe rce nt the present value of
$200 is $188.68, rather than the $94.34 for a $100 cash flow. These relations are
summari2.e d in the fo ll owin g n la tio n, the first two parts of which are illustrated
graphically in Figure 19.1.
@l Relation There is an inverse rela tion between the present valu ofc, cosh flow and the tim& to
rnoturrly- the present value of cosh flow $NCF to be received in I years is greeter than tha t for the
some cash llow lo be received in I + i yeors.
There is on inverse relation be twe en the present volue of o cash flow ond the discount
rote the present value of cash flow $NCF discoun ted ol r is greote1 than that for the some
cash flow discounted of r + j.
There is o direct relation between the present value of o cosh flow ond tr.e $i Ze of the cash
flow- usingthe some times lo mcturity ond discountroies, the voluf! of co sh flew $NCF is less bt
n that for cosh flow $INC' + k).

j
 CH A P TER 19 l'rnfit Max i,nl2 tion over T imi! 645

FIG UR E 19.1
The Present Va!ue of
$100:Chonges in the
Dhcounl Rote and Time
to Moturity 100

80

3 % discount rate

0 5 10 IS 20 25
Years

Present Value of a Stream of Payments

So far we ha'le consider!'d the present value of a project that returns a single
payment. We now extend the anaiysis lo consiqer the value of an investment that
makes a nu mbe1 of paymen ts in the futurt': for example, the value of a
ris!.<less pro jec t that pays $100 in one year and $100 in two years. As you
know, the present value ot each of these payments depends on the relevant
discount rates; and, since the project is riskless, the discount rate is the interest
rate for govern ment sec urities. Suppose that the annual interest rate for a one-
year government security is 6 percent and the rate for a two-year security is 7
percent. The present value of the first payment would thei1 be
$100
(1.06) = $94.34

and the p.csent value of the second payrnent would be

$100
(1.07)2 = $87.34
 646 P A RT VII Decision M,1k111i; m•t•r Tinw

T h 1s, tlw prcs(•nt value of llw p m jl' CI i s

) - s100
{ V- $1()(1- c.,1 8 1 )8
(1.06)+ <1.ll7f- "' .t
From the preceding, you should be able to see that the present value of a

I
project lh l has,l m1mber of c.1sh flow;; is equal to the sum ,f tlw prese nt
v.1lucs of the net cash flo ws. Let, , s put ti1is c1 littll' more precisely: The present
v,'llue of
a s t re<1111 of cnsh flow , where S,.NCF, is lh1.• c,,sh flow n.:ceivcd 11r pa id u1 pcriud t
is givL•n by

w he re r, i:, the d isco unt rnlc for period f, and T is the life span of the stream of
cash flows.
Once the presen t ,·:1luc of a project has lwe11 caic 11l c1tcd it is n s imple ma t te
r In find the net present value of the project. The 111:I / ln' Sl'!I I v11l11t' (NP\/) is the
present value oi th1.• re t ur ns iro n, the pn,jecl 1Pmus lhe current rnst uf the p roj
ec t. T he net prese nt value of a projt:ct (asset) i the diffe re no .' b.:tween the p
res ent value of the net cash flows of t·he project nnd its curre n t cost:
NPV = PV - Cost of pro ject

Cokulai;un of e l Pras t Vc.!:.:e : /'. Er.:-: p lc

Al the end of 1994, the mnnagcm c,11 of l\1c tro plex Properties •v11s ot f ered il 1111e- '! ,1
third share in a six-year lirr.itt:!<l p ar tne rship un a new dfi.:e build in g. Construe-
tion was to begin cm January 1, 1995, \vith completion on December 31, 1995.
Th pr ice of the one - th ird pa r tne r!>h ip to Metroplex Properlil•,; \A.'?.S $-150,000.
Sc h ed uled l)C( t1pa nc:, total r(•n tnl income, and total expen!-l' :\'<.:rt' as f, llows:

Occuponcy role
Year ( rcent)
Ren tal Exeenses Net cmh flow
income
(9<;6 t':.: 32:, OQIJ $200('IXJ + 1 L5 ' -'
1997 80 4)5 000 250 1)()0 $
1998 ,r I) ) :15 000 2:)('IOCO +
+
1., 5 I-.:
7:'5 '·',J
1999 (X) )/'.) 00L :•uOOGO + 2,::, JO
:woo 100 :>25.000 325 ,000 + 200 < ,)0
Nole: Fo, s •m.,l,c,1 we a>>ume 1h01paymon1s and 1ec1?,pls occur a l 11,e end al the yea, .

Al the end of 2000, the val ue of the b uilding would be $1,000,000. These cash
flows arc knov,•n with certainty.
Clearly, the management of Mctrnplex needed to deten ninc tht:- \'alue ol the
project. They fou:,d the an nual intere t rates fo cme -, two........, six-year gov
ernment securit ies to be
I CHAPTER 19 l' rofil Ma imizmi(1n ove:- '1'1111 647

Interest rate
Maturity Ipercent)
! .1,,, I ><1' :,,/)
I.>,, , 1 ' N <i (,.00
Dw 19 9 7 6 25
D,!< 1998 650
[),., 1999 (ii.)
I,'I ,ooo /.00

Using these rnlcs, c1nd the ;ibuve net cc1sh flows, they calculc1ted the present
value of the prnjecl ,1s

1,11 _ $1 25_,o oQ g 0o _o ?25,ooo1 22s,g_o.9 90,000 $1,000,000

- (1.06)1 + (1.0625)'+ (J.065) + (1.0675t+ (l. 07)'' + (1.07)'
= $11,1 250 5145,8()1.J + $ 174,898 + $162,309 + $133,268 + $666,342
= $1,393,966

Since the nrnrn:gen,ent of M;:,tro plex Properties had been offered a 33 percent sh?
11c u( the s ix-year partn;_-rshiJJ for il price of $450,000, the ne t present val ue of the
deal to Mctro plex Properties is -:alculnted ilS

NJ>V = (0.33)($'1,393,966) - $450,000

= $10,009

19.2 MAXIMIZING THE VALUE OF THE FIRM-ANOTHER MARGINAL RULE

/\ shu;.n 1 i!1 he J-ll CLec..!i 1g ect jon, p14..:::;ent ,::due 1:.; 2dditi·.,1e. For x n,p! ,
the present value of a project returning $100 after one year and $125 <1fter two years
is equivalen t to th s u:11 of th tc present values of a project returning $100 in one
year and ar,other project returning $125 in two years. In more general terms, the
present value of the por tfolio of rwo p,ojects, A und B, is equal to the sum of the
present values of Projects A and B: P\l(A + B) = PV(A) + PV(B).
Going a . tcp f ur th e r, a [i rill is rl',illy no(hing n,ore th.:;n a portfolio of p•·uj
worthor o firm ec ts (assets). The wnrth of a firm is the price the fiTm wo uld bring if it were
A iwn presen: value sold, and is, thereiore, simply its present value. The present value of this por t folio
of projects is the s11m of the present values of the individual projects.
If the objective is to maxim i ze th e present value of the firm, what behavior is
required? Think about the firm as a po rtfolio of 11 p rojects . Now consider
whe the r it should grow by ncql tiri ng c1n additiona l (margin.:il ) pro jec t, the 11 +
1 project. From the principles of optimization, you know that the present value of
the firm will increase if the marginal benefit (the present value of the addit ion al
project) exceeds the marginal cost (the cost of the additional project). Put another
way, an additional project wiJl irn:rease the value 0f the firm if the present value
of the additional projec t is greate r than the cost of the project (i.e., if tlw net
present value of the project i positive ).
Now consider whether a firm would be better off by shrin.'<ing. That is,
would the value of a firm mcrease by s lling off a project? Using the optimization
 PART VII i)c•(1s1on M lc.111i-; over 1'11111·
,. J 1 .
l
:
.I prindpk•.;, the valul' of tl1s' fi r m would risl' as" result of selling off a project if t!
ll' preSL'nt ,·,1l ue of tlw divl'Sll'd project w.is kss th,111 its m,irket vnlul' (thL• pri ce

I the firm co uid i-;el for it}. Tll,1t is, the v,1luL' of !hL· firm will risv if it sells projects
that l1e1vc ne ga tive net present values . For example, suppose one of the fi rm s
assets hns a pn!scnt value of $1 million, and it could sell this asset for $1.5
m illio n. Tiw net pre cnt vnlul.'d the asset is -$500,000. Consl'q11ently, the value
of th e fi rm would incrL•asc $500,000 if it sold the nssct. Thus, thL· v alue of the firm
\\'ill increase if it di, l'Sts projects or ,1sscb, for which the nl't present value i.,
negative.
II
Although this principle seems correct in theory, it may sOLand a little strange.
You might wonder why somt.:one else would be willing to pay more for ari asset/
project/subsidiary thiln it is wo r th to the firm i•self? The rc.ison has to be that the
pn>JCCt fits betkr with thl! por tfolio of p rojects nf the acquiring firm thn11
with the divesting firm, mus t likely becaus1! of pn,d uct compll'mentarities such
.I ;is those discuss:!d in ChaplL' r 18.
In the previous example of Metropkx Properties, the price for the i,westment
pr0jec t was $450,000, and the net present vcJuc for the project was $10,009.
Clearly, Metroplcx should acct!pl th;s project, because it will increase the va lue
l of the tirin. H o we ve r, if the price Metroplcx had to pay for the 33 percent ,;hare
in the nffice building ;m,ject \\ n:; S-!70,000, !Ill' netpresent , illuc of the
. project
wou:d bl' nega tive: NPV = (0.33)($1,393,%6) - -i? u,000 ==- - $,9 991. In U,is ins tnnce ,
the management of Metro plex should reject the project. Accepti:1g a project
with a negative net present value ·would reduce the val.ue of the firm, for the
same
I,
I reason as sel!ing a project with a negative net present value would increase the
v;,lue <'( the fir n1.
Co n1i.,in; .-1 th.: t\, ·,; p rc:c c j :ng prin c : p !e s r r0 d \•c,_•s a r>n Pr;,l rlllt: f,1r th e
behavior of a ,·clue-maximizing firm:
@) Pr:nciple The l'Je; Prese nt Value Rvle for mo xim1z1ng the volve of the firm is to occepl p 10 1ec t
(ocqu·,e oss<?rs) lo,r ,,l,,ch Ir e ne1 nres,, nl va lue ,s pos1l1v e a n d re jecl projecIs fo,, ...,l,icli th,"' e t
pr <!, er • .,ofve is" "::' J' "l-'i• - The ',rm should d i-.·esl pr-:,IecIs for wh,ch the net0 Ie sen1value is r egul,vE:
'
19.3 MAXIMIZING THE VALUE OF THE FIRM
VERSUS SING LE·P RIOD PROFIT MAXIMIZATION
In this chapter we have c1ddcd a time dimension to :-nanagerial decision m, g,
anj we have argued that the pioper objective of the firm is to maximiz it,- \ ,11 uc.
But, most of the space in this text is devoted to th(? principles of maximi z.in g the
profit of the firm. We must now pause to show you how the two see mingly
different objectives compare. As it turns out, single-period profit maximi a tio n
is consistent with maximizing the value of the firm in most, but not all, cases.
Recall that the present value of a firm is defined as the sum of the disco unte d net
cash Ovws ove1 the relevant time horizon:

T
NCF,
PV = Li (1 + ,.,)'
I: I

'l I I l'
 CH APTER 19 l'n>lil \l,\Xim11,1litm ll\ W T,nw 649

1-j
.u -
1 .
,. J LL US•T,R A TI O N 19,1
!I!. "'

f,
What Is the Value of a Firm? ·
pcinteli out that Exxon stock at the time was selling
for $46, and, therefore, by this measure was over
The previous discussion of the value of a firm may priced. nut the model is sensitive to the estimated
have Sl!ems?d a bit abst ract, more suited for discus values of discount and growth rates used in the
sions in economic theory than for the use of sophisti calcu lation. A small change in the discount or
cated investors. Not so, as a column "Smart M ol} y" growth rate r.roduces a big dlfference in the present
s in Busi11es5 W ek illustra te , · ; ' '•., • ,.,,., · value of Ex- '(f.,.
.;
,• ,xonstJcI<. . .
T his column begins by noting thalinvesfm nt TheDOM allows investors to ask, " What if?"
ana
. lysts use a vast collection of tools to select stocks and
ques tions. For example, as the author points out, "If
you think interest rates will fall, lower your
' one of their handie r devices is the dividend discount
discou:1t rate by, s y, a percentaee point. That would
model, or DDM. "The DOM works Ci\ tile premise value Exxon at
that a11 investment is worth the ores t value of its $52, signa ling a buy." Or, the column went on to say,
fu ture cash flows. So to value a stock, yo1..'ll need. "if the disccunt rate is raised a point, that would val!:!
llte current annual dividend!a p ected growth,rate, 1
f- )Qeon at $35, indicating you should wait for tha
a 'dis oun t raLe'. j:.· price to fall." ,
1
' .- "'I '•

1
The Rusi11ess Week co lumn used Exxon to illustrate According to the author, some pros recast th
! the ecei:sary calculation. At the time, the annual div DDM by dividir.g the divideJ1d by the stock price to
idQnd was $2.20, which can be obtained from d news• get the current yield. Then they add the growth rate
paper. It was expected to grow at a 7 perc'711t annual to get the stock's implied rate of return. (It was 11.8
rate, according o Value Line Jn7:r:stment Su v y.: Thl percent for Exxon at -the time.) The implied rates of
information c-o uld also be obtained·n'Qµ:i a p roke r. To return forseveralstocks caP L'.en be ranked by poten
c:.kulate the discount rate, th BtlSii]e s Week r.ohu:nn tial return, and only the growth rnte must be esti-
used the current' rate on
long-term government
bonds. al the time about 9.2 percent. The column sug
mated.
Before you plunge deeply into the mitrket. we must
I
ti'. Il gested adding an equity ris-k premium to CO! warnlimitcticns.
has· you that the columns
"It works pointed
i.>zst outgrowing,
c>n slow that the ma
ODM ,
flpensate rb ... uf uwnul :;iock;i: T.ht:;.-prt:mill-!11

!1
[01 d11: ,..JJ,::J
was sc1id to ran"e between 2can;:I .'l.J>_¥rc-ent, dep turt 1cc(mp anies
th ·e ccmsisten; ividc d payers."
end

r
'I ing un the risk;c:-s of the s tt>l:k F6•r a1.ilu ip' s ut h
as Exx:>n, the author suggested about 3 percent, yi.e!d
Themodel tioesa't work well on high-flyulg btotech
stocks, and it may make asset-rich sto,;ks arpear
I ing a 122 pP.rcent discount factor. over priced when takeover artists are wilLlng tc r.:y
- ! fo c-:1lc:1lclt£: the effective discount rate, s:ilitract the
7 percent growth rare of the Exx:>n dividend from the much more.

lj ·

t
discount rate of 12.2 p rce!]!;:l<?;o,p , .5.,.fi;fP rc i1t. · >,;t.
Then convert 5.2 percen in!_?., d hli.aJ for..m (0:9§2) Source: This lustratio, nis baSed on Jeffrey
Laderman, and divide the deci:na! value into the $2.20 dividend »smart Money:Fast Figuring for Stock
Handicappers," to obtain a present value of $42 30. T h e column Busit1ess Week, August 1, 1938, p. 103.

A demonstrated in the preceding section, the net cash flow in period t can be
decomposed into the difference between the revenue in that period (R,) and the
costs in period / (C,). Hence, we can write present value as
T
R,-C,
PV= 4 (1+ r,)'
I =1

- - - - - - - - --- ·- -- ·
11
..,
I
650 p ART Vil l) ,, , • i:,,tl' ll :-Sl.1J..111;; .,,,., I
ttlh'

i•
n
i1h 1' • /\. I i:- 11n11d i1, l h ' ri,,d I , l ill' 111.1,i111u111f ' l'l'S1·11l 1,1IL1v 11 i l l bv .111.1i111•d
b\' 111. 1, i 1111 / it )> ; , r,it"il 1 11 , · ,1< I, f'" r i,,d . I 11.,1 i:-, tlw p rl', 1·d111g 1111li,,·. 1v....
 ,1
n lli.11 ...i11g ·le - 1w ri11d 1 1111lil 111.i:-.i 111i/ .1l iP11 .111d 1n, 1, 11n1/ .i11g lhL', 1· 1l11v ltl llw
, .Il ai1:
i'ir111 ,1r1· 1•q ui1·,1lcn t llll',ll)S lo llw , s rnw t•nd : m,1\1111i1.inf ; p rofit i n L',1Ch 1w r
illd w i ll rl'!-llll in the 111.1,-.:imum 1·,1lm· uf thl' fir111 ,md 1:1,1i-i111i1.i11g llw 1·,1luv of
J: till' fir m l'l"q uin •,_; 111,H:i mi,.ing prniil i n c;,ch pl' r i(1d.
1 lw 1 •q11i1·,1IL' !1t'L'd ..,ing lL·- 11vr i11d profit 111,1, i111i1. tl i1111 ,111d 111.1,i111i1i11g lhl'
lill : 1·,liu,· 1111111' lirin lw kb , mi · 1,·b,·1: ti,,• r1•1·t•nu L' .111d Uh l 1·111Hiili\l11" in 1111t
• tinH! pl' r iud .ir,·ind q >t·n, ll-111 n l r v1·11·rnv <1m i 1·\l:-sts in f ul url' tin w pL'rind.-..
ll 11 1
;\s 11t·· s hall discus,, in tlw 11'LXl S'L1: lio n, \\'lll'n Pt d ,1y's d ec is i,111!- ,tffL•l°t net

I!.,!!; c,1sh flln1·,, in f utu re

linw pl·r·illd:;,f1 rin · t11· ,> ut pu l dl'Li!-otllns lh<1l rn,1,xi 11i1.1· pro fit in c•,ic h (sing ll·)
timL• f 1L'l'i11d ll' ill 1H1t 111,1 xi111izt· thl' 1·,1l11t• nf tlw firm.

Ji: :iii
, ;: I
Ii i ill11:-tr ,\lt· hi,, p11i111 fur llw r, rL'c·,111 111,11 p n. dit 111,l),i111i1.1li1111 i n ,111_1· f' n i n
d,
":.i p t •1 i11d /, n·q uir't !-o th.i t t\! /,. = Al ('. ., " h id , ..1L- t,·rn 1i nc•:-. tlw p rn(il-111,1 :-- imi /..ing
Ii ,I) 1n il p u ! i11 th,1l p1·1·i11d ((.];,. ,\ l ( ]"', l!w cl1ff1•r1"11, l' bd1,H·11 / , .:nd l· i!-o ,lt its
111,1xim u:11. T hus lT· = NCF, = /•;, - C. is 111;:i-, imizl'd . ·1 111.: pr l 'SL·n ,t -.1IL1L' o f the
11i :(I -,t rc,1111 nf 11111.r i1: 111111 p rut'ils , ,1· nl'l .::., h fl,11,·s m us! bl' hig hl' r t-h ,111 i hv present
1·.1111l' of ,1111· othn strl',1•11 11f lct;, •a ,wt 1·,1:,h tl ,111 s . r h u-,, 111.1:-. imi/ in g, : i11g
'11 ,. le
: i)i:'1 p1•ri ud ,rnlil. und L•1· lh'c" L' c irc um,,[,111c·1",. 111,1:-. i111i / i..':-- t ill' .ilu,· -,f thl!
p rL'"L'

, l il,l
fi rm.

@l Principl e 11 . :,· rn.. I 1 -, .,,,,,= , , !.c, ,, .111. : ,.,. , •(-: ::•:. 1·1, /,! ,.,·, !;, , I : 1 - i -r •·-", r •. 1r '."Jr,e in
..rhe, 1•111,- 1 ·.. , r • ·J t1 •· c11 lil •' J ·.·, ,!11 111' •1111,.:- · 11t....nb. I•.. ,., /rl,.. ,, , --,..1,1 , n:.,,.· ! l,11n) by
,P,
•1•:- ,1 l :, - ·h o! ·,1 , .· ri i··,-: 1 • 1· 1f't , , t· •., . • • 1 ,1; •· •I

JI )9.4 SOME CASES WHt:N v',i.LlJi: AND FROriT /v' 1A Xl:'vilZ A IG N

,, :
ARE NOT EQUIVALENT
As 11·t: discussed, m,1;,...i11117.111g IIK' 1·.:i l u l' llf ,1 firm c,1n Li e ,10.:ornfdis hl'd th ro ugh
s i11 /p - 1n i11d m ,1:..i111i1.,1ti1ln o f pn,ti t, i11 11,:11. I t'd,,1' . UndL'r LL·r t,1i11 cn nd itio ns , ill
! 111·v,·L'1·, inc ,111!-i!-oll' llci,•-- b,:t\\'L'l'll ,;i11 iv-JJL'l'it1d, 1 1-.1fil m,1'i111i/ ,l l1t111 ,rnd
pres- 'L 11 l 1.1lut· 111.1, im i1..1tn111L ·,, n ,,, .. ·111·. <-;u c h i11C11i1:-:i...1,·11c iL· dv11•Jpp ,,: /w n
rl'l'l'11LlCS
'' ,rnd or Ltl!-ob in lllW f, L·ri11d ,1rl' 111,t i11 dq, e 11dl' 11l nl thl' r,1k tll o u tp ut 111 o th er
ii. f Wr itids. 1t11l' 1::,, 1mp les might il! us tr,11l- Lhi svl'mingly C\tmplicalt.:d po in t.
. ,I!

i!r I
' ll
: "
:· I. earning By Doing
lear ning by d o ing
vVhen o firm's employees, bf (1,w L':-.,1111p lv 11'11L' r'L 1 .1l ul' ,rnd J'l'lli'1l 111,1\ i111i 1..1li, 111 .irt· nut 1·q ui1 ,1k111 i..; l
produc i ng i n the earn i ng b y doing. .-\ f i rm's em p lt1 -L'l'!-o bt•..:\1n1e mt,rL' p rod uL·t i,·1·, 1111,rL'd fic
presen,t become more
produclive
i1·11l, in fu t u re pe r io d s by pr tK1ucing more t1utpc1t in t',H lie r pc rinds. In
or m0re efficienl in future such casl'S, Lh L' m o re a firm pmduCL' S in th e pres en t, the lowe r its cost, .md he nce
periods, the1ebv 111;-ir inal cost, will be in the fut L•re. Tlwrcfort•, c ur rt·nt ou tp ut \\'ill h,Wl' ,1 p,1siti
lowering fulUlt: Cv, 15. l'l.' cffl'ct on future ou1 1ut ,ind prnfit, ,111d t h e firn1'!- 111,111.igL'ITil' lll -,hn uld t.1k1·
thi s fl! tt1l'L' d iL·ct i nto
,Kcoun t ll'hL·n pl,111nin1-; c u rrl'lll prud w, .: io n. T he l' U IT l' n l nu tpu l 1, uu ld the
n dif fer from (be l;:irg e r th an ) tl1L' output that tht: firni would choosl' if the only
objcct i1·e is to maximize the profit in tht! c:urn: ul ptri.od.
 CHAPTER 19 l'mfit M,1\ imiznti1in m •1·rTinw 651

Tb ill usi rnte tlw effl'ct 011 op tim,11 dc ci.sion mnking und l' r llil' above C(lnd i
tions, suppose tiw firm\ pl,rnning- hor i:10. 11 extends only O\'t•r tw11 pe rilld s .
Tlw cost IL11K l ions in pe riod s · 1 ,rnd 2 ,ll'l'

where q, and q, are out-pu t levels in pe riods l and 2 Cost in per iod 1 depl.'nds
only upon o utp ut in period 1, but cost in perio d 2 cit-pe nds upon outpl1t in
period 2 c1nd output in pl'rilld I. The cust cif p rod uci ng n pl l·al of t]r + qi unils is
t'qunl to the sum of the cos ts in the two period s:·

The margiml cost of production in periods l m1d 2 is

..\.C ,K
- - = -·

Ikc,1use p rod uctit111 in p1.:r iod 1 lm, ·,•rs etis l in period 2. J.C:/.:l'1/ is neg at i, ·L•, so
that ..\.C /t:,.q, < 6C,/ t>q,. If the firm maximizes single -pe riod profit only, it would
choose the outp ut in period 1 at which marginal revenue equals t:,.C ,/ t1q1• If
it maximi ze s the value of the firm , it would set MR equal to (t.Cr/ q, + tlC,lilq ,),
which is lower th,m iJ.C,/ 6.q,.Therefore. the firm would produce morP in period
1 u:1der the latter co.iditi.ms .
1 he situation in period I i:c: illustrc1h,•d in Figur e 19.2, in whic h M l? , i the
firm S; marginal revenue curve in period 1 and MC, is the period 1 marginal C"OSt
c u r ve. conside ri ng on ly the effect of current production on current cost. If the
fir m is in teres ted only in s ing le - pe riod profits, it would p rod uce q,, where MR, =
MC:. If the firm maximizes present vc1l ue and hence considers the effect cu rren
t output has on futur cost, MC1 is the re lL·\·ant mmgina) cost cur\'l' ( M R1
would not be affected); MC, is below MC because current production lowers
future cost: that is, !!.Ci,'t:,.q, < 0. In this case, the firm would proJ uce ij1 if it
maximiLes present value, and current output would be higher.1
Altern atively, if current production hc1s the effect of increasing cost in the
fu tu re, maximizing present \'alue would result in a lower current output than
maximizing single- period profit. fn such cases, maximizing single-per iod p rof it
also is not equivalent to maxim izing present value. One exam ple of higher cu rren
t production raising fu tu re cost would occur if higher rates of output in thepresent
cause capital eguipment to depreciate faster and become less productive in the fu tm
e. AnothE::, relatively important example occurs in extractive industries

'Note that the effect of q, on C, would have to he discOL, nted by the relevant in:erest ratP fur
comple te accuracy. We did not discount because we were intr,rested only in showing that period 1
production is affected, ann not how r,nocn 1i i, a ff,,c ied. Thus the v.'as no re3son to iurthcr
I'
complicate the analys b.
 652PART VIIkl .-"i i" n 1.1l..111g 1l\ '1• r I 1111'.'

F I G U R E 19.2
Single-Period Profit Maximization versus Pre sen t Value
Motimization

QJ
:,
C
g,>

0
C
OJ
0

l
E
11
08
V
0
C
Ell
0

Ouonl1ly

such ,15 mining ;ind oil production. The higher the ,atP of extr:ict-ion 0r pt1mping
in the prL·scnt l i ml' period, the more costlv it is, in ge ne ra l, to extract ore from a
min•' m !11111111 nil rrnm ., 11·t ll in i!w f ut url' . 1\1 i,1er:.. tvpic,11lv mus t t1ig deeper
the nwre that h. s been pre1·iuusly 1.·xtr<1eted. -'\s llil i:, punipci.1 ir l\ 111 ,1 wdl, the
well lnse :; pressure, ,,nd pumping additionc1I uil u >·'.s mon:, somclimcs because
ot the diffe re n t techniques that must be used. Jn ,,ny case, present production
.iffccts future costs.
Des 1itc tlw:;1•1•. xam plcs of inco ns is tenc ies lw t,w• e n tht' two type:.. of rn, a : imi
- ;1tiP11, it is / ' l'IK' r,1lly tiw rn -;t• tha: then: is little diffL'JTJKl' bei1,·t·en tlw , nnc lu
,;in ns of si , !,;:P-p cr iod p m (i m <1x i m i zntill n ( t ile topic nf mu l of th i'.: text) and
present \'a!ue ma>.imization (the topic u£ this ch,1pter). Thus, sin g le- pe r iod profit
ma,.,i111ization is ge nera lly the most useful approach to the ant1iysis of rnax imi7a tinn
<n·er time .

Entry Limit Strategies over Tim e

The d isc uss io n thus far has concerned situn:ions in which a firms costs are not
independent over time. Another sit uation in which present 1·alue maximization is
not equi'.'alent to single -period maximization occur5 when firms practice en try
limit pricing or use excess capacity as a barrie r to the entry of new fir,ns into the
market These strnteg ics were discussed in Chapter 16, btil we did not ana lyze
these strategies in a mult i pe riod frnmewor k. Rather than dis,ussing the effect
over time, we limited the discussion to single-period aniilysis, while not
ing that we would add a time dimension later. w now turn to this task.
 CH APTER 19 l' ro1i1 M,1x1i11i zn 1io11 Ol't'r Timl' 653

As noted in Chapter lh, en try limit pricmg ,md excess cnpac ity arc two
possible strntegies ,iv,1il,1blc to ,111 cst,1blished firm th..it w is hes to prevent or
discourage the entry of 1ww iirrns into the mnrket. As we just mentioned, these
str,1tegics involve decision n1<1k ing over time and, therefore, might cause a
diver gence between the maxuniz,,tion of prnfit in each period and maximiza t ion of
present vnl cJc. We w i ll now p1esl ' nl n hy po th eti cal exa mple s ho w ing how a
mnn agcr can determinl' whl'lher entry limit pricing is a better str,1tq;y than maxi
mi7.ing p ro fit in c,i-:h period .ind leLt; n g entry occur. We wi ll postpone
d iscussion of capacity ns ,m entry-blocking. strntegy, in order to simplify the
exc1mple by considering only ; wo choices.
Zephyr Produr ts- a firm providing ind us t ria l serviccs-w3s the fi rs t firm
to enter a new market nnd therdore enjoys tlw po s it ion of bt•ing the estab lis
hed fir m. The manngl'I ,if 7.l'phyr h,1s dl'tl'rminl:'d the single - pe riod p rofi t m
axim iz ing price tn be $2,tl00. With this price, annual profit is $80,000.
Howe ver, the man age!· kno ws that, if p rice is set at $2,000, ad d itio nal
firms will ente r the mnrkct. Entry would gr;idualiy drive price to $1,200 and,
over time, Zephyr 's an nual profit would fall to $30,000. Using experience in other
markets, the manag r belie ves Zephyr'..:: profits over its five -yc,u plnnning hori zon
would be:

Yeo,
Prcfil
I
$80,000
1.
$!>0 000 $40,000 "
$30 .0(
5
$30 .00 0
)()

Alte rn ative ly, Zephyr om pr.ictice entry lim;t pric i11g. T he manager of
7.l'phyr he lif'\ 'e thilt ;f prirL' is •'t :-it '£1,-!00, !10 fir! T.'S wot!ld er:ter the r:,a:.-kc t.
With thi price, Zephyr's anmnil profit wm1ld be $50,000 in each year over the five-
year pla!"ning hurizon.
Hence, the manager of Zephyr is faced with a choice of two strategie!:>- - two
inco me s tre ;:ims . The manager wi!I o b,·im 1s ly se lec t lhM stream of income that
, h1s the !1ighcr prcsen \'all 1L' . Using the p;·l•,.·:il in g US Trc,1sury rates provided
e,1rUer in tl1is cha pte r, the P"L'Sl'nt ,·aiL:es of the two possible s reams are as
follows:
Maximize si.".\gle -per iod profit and permit entry:

-- --

= $75,650 + $-1-4,SOU + $33,348 + $23,320 + $21,641

= $198,459

Entry limit price:

PV _ $50,000 .._ _$50,000 $50,000 $50,000 $50,000

- (1.0575) (1.06)l + (1.0625) 3 (1.065)-1+ (1.0675)5
= $47,281 + $44,500 + $41,685 + $38,866 + $36,069
= $208,401
 6 54 p ART VII I )L'L '' '" " l.i h.111g ll\ l'I I1111t•

In lh i:-. L'\.llllf)k, llw , ,1luL' 11f /.1: p hy r l'n1duct-- j., m,1,im1z1•d by t·ntry limit
pric ing. WL• h,l\'L', u l n1ur:--1•, 111,1de :-.1•,·cr,11 ,1ss u111 pl io11s l h,1t ,illu w I. L'p h y r t
o be
,1b lc I ll p rac t iL"L' this sl r,llt•gy. Firs t, ,1s wn:; J isc ussl'd nt l1•ngth in Chnptcr 16, the
lim it p r icl' must be bl'low the minimu m po in t o n t hl' lo ng- run ,wer,,gL·" cost
curve of .ill pok•nti.11 1·n t r.111ts . /\lso, lwc,n1se /. L'p hy r l'onlinm·d m,,king profits
,ll lht: li mit p r icl', l. t•phy r s lu ng- run ,ivt•r ;ige cos t must lw bl' l1)w llw li mi t
prirl' ove r il
r.mgt· of nutput. l' hu, , l.l'ph_\ r mu ...t h,l\'t' ., l'o:-.1 ,1th ·,rn t.1gl' ml'r po1en l i<1l l'll ·
lr, rn ts, n p o in t t•mphasized in Cha pll' r 16.
One final .,ssumption is implicit in this <'Xantple: Zephyr mus t hnve the ca p,1cit
y to in cr t"ns e its o u t p u t in o rd e r to sel l the increc1sed qua ntity d e m nnd forthcoming ,
11 tlw l owL •r price. Thus Zephyr m.iy hilvc.· bt•t•n ,1b1L• to use this excess 'L,l p,11:it y ,
1lrl',l d \0 i11 p lan • ,1s ,111 entry dl'il'rrl'nt witlH1ut h,n·ini-; to nctu.illy l,,,,·er its
pric1•. l\itl'nti.11 l'J1tr,111b, 1-.nm, ing ,1bo ul thi!-> L'\Ct•.,:,, L",1p.ic i t y, would plissib ly be d
is..:1iu r,1gL•d fr(im t•11te1 ing the m.uket Lwcaw,t• thev l-.m1\, that if the y prepared to en:
•r, Lephvr would h,we the c;ipacity to inc n..'a;,c o u tp u t by d c
c reasin its p r ice•. If the firm does not ,,lrcady have th rnpacity to in::rease salt's,
tlw cnst or ,1dding this extra capacity during L',1rly periods would h nvc to bt:
..:onsidt·rl'd ll'hl'n L'l1111p,1ri11g prL·scnt vnlu..:s undl'r s111g lc -p e rin d m,1ximi1:atwn,
t•ntr) li mit p n Ling , ,md L,1p, 1Li l y dd t•r1L'llCl'. The co mp ut,1til111 Wll t ild be th Q
same ,ls thc1t ll'-L'd in the nbme comp:iristln ot prcst•nt , ,1lul':-. In any ca .e, whl!n
an en tr y-limit in i,; ,;trnt..:gy is emplnrcd, single -per iud profit mnximiz.ition mny
not be the sc1mt• as vc1lue maximization.
11

19 .5 CONFLICTS BETWEEN SHAREHO LDERS (O WN ERS) AND MAI-JAGERS 9

pn nc1pol·c1gcnl problem
:I e 9" J I m OIIO:JH1lu'; l11
lrhe c ::ie111do nol ,101ch
d
lhe goofs 1'1-: ONner (1he
r.11incipol)
Ir, l ht: :,impic firms dcsr rib ed thrnu hout mo,t 0t t11is tP x t thl' •.'1lt n'1' re r.e!.!r w; s
both the owner (sharehc:ld e r) a nd the rnanagP.r; what was good for the ow•1er
" as, by definition, good fN the mnnilgcr. If this owner-manc1gu iden tity does
nnt l'Xist, cn nfli1:t!: arc Ii kcly bct\\'ccn shareholders ;ind the managers they h&ve
birl'd to op•·r,,tt• the i1rm In g:mt•rnl, tht'SL' n111flict:-. ;iris!! lwc,n, t• of d iHcren
Cf'5
bl'l wl'e n tlw 11b j1•ctin,
.ijl
nl the :-h,1rl' h,1ld l' rS nnd th m;,nagL•rs. i\Ji,rr specifically,
th e ..:onflicr:, c .111 n,nsi oftt'n be tracl'd to tht' contrncts betwl'en the shareh0
lcicrs and the m a nagc me!1l lc an ,s. Such COl'll1icts , fr(:quently referred to ns the
p,h,c - pr.l-ngc11t problc'm or simply the ngt?11c y J Jl'oblr m, :lrl' curre11tly rece iving
m n1
a g r eat
d e a l of a t tvn tion frnm ,·cnnnmists ,rnd cnrpor,ltL' ana!ysh .
A prin1ip,11 111 ,111 ,1grl' L'll1L'n t •:ur,tr.,ct., \\'1th ,111 .1g1:11t ti, fWrforPl t,,sks de
!'-igned to f ur lbL•r thL· p r i•1L"ip,1l s ubjl'cth·c!->. The pr inc ip a i- agen l p ro b le m a
r is es when the ager.ts hm·c objectives that diffor from those (I( the principa l; th e
prin cipal has diffic ulty enforcing the contrnct with the agent; or the princip:it fin d
s it d ifficu lt to learn whether or not the agent is actually carr ymg out the
agreement
and fu r the r ing the p r inc ipa ls o bjec t ives. Altho ugh there are a multitude of ex
,,mples of the princip,11- age n t p ro ble m- whene ver one party contrnr t:; w it h nn-

' If entry was de te rred at !he p rice cf in!,1 -pcriod profit maximi;r,a tion- -if the minlmum
av rage cost of potenli:it en! rz ts was above $2,000-we would say e n t ry is blockaded: Zephyr
-:ould maxim: '-<! sing le-pe riod p rofit witho ut att racting e nt ra nts.

. ...,.,...
 CH APTER 19 l' rofit M ximizatio11 owr Tim<" 65 5

othl'r, p1rt y to f)L'l"ll\rlll ,1 i'unr th1n- wt' arc cc:,cerncd here with the shnn:ho ldc r
m.111.igt'r probiL•m. Tlw sh,1rc holders are nbviously the principals and the mam,g
crs nrt· the agt•nb . T ill ' n c ncy p rob lem occurs because of the existence of
111uml
/wzord.

Moral liozard
Moral hc,zord Moral hazard l'Xisls whc11 e ither party to an agree men t has an incentive not to
I . ·,I . I,,' •ill,• I'' " '·, , nbide by all provisions of the <1g r eeme n t, and_ one party finds it difficult,
:r d ' jl ' • fl j+ •ljf 110• I 1/ 1
I• I • f l• ! I,, . ,l1i1J1· I ,, 1 11!
per haps impossib le, to find out if tlw o ther party is abiding by the agreemen t, or
I1 • r,, !1 1, • t i• 11• , •111• to actuc1Uy enforce the ngreement even when the information is available. Moral
·rd hc17..ird a ris es in a lnrgc number of princi p,1l-agent agrcemems. Workl' rs 1rn1y
s hir k on the job, la w •l' rs may not put forth their best pffort for their clients, nnd n
firm mig ht sell gtiods or scr \'ices that a re be low s tandard with deficiencies that
I
l arc difficult to de tec t. Here, however, we are concerned only with moral hazard
in the ccise Clf firm mcin agement working for shareholders.
We have tr ied to d:?m o nstrnte that shareholde rs have a single, s tr aigh t
for ward objecti,·c: mnxim ize the \'alue of the fir m. Mnnagc rs may or mny not
sh n re this objective. They could desire to attain other goals and may be wil li ng to
sacrificl' some of the firm s value in order to pursue these other objectives. Sev eral
conflictin g m,mag:.!rinl objectives have been proposed. For exam ple, manag ers
ma y want nmenities that cut into the firms profit: luxurious office bui ldin gs in
prestig ious loc;it ions, elegdnt dining and enter tainment facilities, c-orporate
l'lt1tomobiles an<l ;iirplnnes, business trips to exotic locations. Manage rs m,1y
wish to use more of the firm':; income for charita ble, civic, or political contribu
ti, n 5-. , !,: r1trd ut,i1 ! c •: C! hr nce- l"e e1:1 1ager's ta t-_i;-e i the i:!ty, the stJtc\
5 h,,,:-
or the nation.
Sometimes managers are \; illing to sacrifice some of the firm'.$ pr o fit for
increased revenue. How much business a firm does or its sha;:e of the m <1r ket is
frequen tly a so urce of prest ige to a firm's CEO. As you know, profit is m,1ximized
by producing ll'hen: rnncg imi l re•;en ue equals margini'il cosl. Revenue can be
i1,cre ased by producing beyond the proFit-maximizing equ ilib, ium 3S long as
marginal re\'C:r, ue is positive- that is, de mand is elas tic. Beyond the equilibr ium,
marginal reven c1e is less than marginal cost ;:md, as you know, profit is not being
maxim ized becaL! e the firm is prod ucing too much. During the slump of the
l'ilr l_v 1990s, firm s thrit \\'ere expenc ncmg a drastic decline in business freqt!'L ntl}
tried to remedy the problem by downsiz ing. These iirms were simply too large.
All of tht: con flicting goals we have mentioned, as well as some others, pose
agency problems.
You may be wondering why the sha reholders don' t simply tell the
managers to begin maximizing the value of the firm, and, if they don't comply,
repla ce them with new managers. This process is a lot morP complex and
diffic ult than it would ap pear at first glance . The large modern corporation is
,m extremely complicated ins titution. The upper management of a firm is much
more fam ili a r with the fun ct ic rung of the corpora tion than most or even all
of the stockholders are. Stockholders would not even know, in man y cases,
whether management 1s
656 PART VII U,•cis iun M,,1-.ing m•,•r I rlllt'

or is not.ittemp ting to mc1ximizc the va lue uf the firm or ih profits, e pecinlly

when business is good and the prke of the stock is risin g. They gel their infor
mation about thl' firm primarily from that snme management.
In the case of large co rporatio ns, nny given shareholder typicaily holds a
rcbtiveiy sm ll proportion of the total outs tnnding stock. The stockhold e rs nre
gl•nernlly brnad ly d ive rs i fiL•d .ind would hn,'l' d i ffic u ll"v o rg, rn izi ng into a
group thnt could actually affect the fir m po licie s . Furthermore, ,in individunl stock
holder would probably not have the ince ntive to find the necessary information
about the firm, and then attempt to monitor management. The cost of obtaining
and processing the required informal ion wo uld be huge, while the benefits to an
in div id unl shnreho ld e r would be small, cv n if the monito r in g were success fu l.
Sha nc:ho lde rs tt!'t1,1ily hnvl' d iversif ied po r tfolios in which nu imli,·idua l
stock lo1>ms par tic ularly iargc, rclc1th c tl> their tot.ii holdings. rlwy in.•quL·n tly d o
n' t have much of an in terest in one particular stock. Tlv reforc, the owners of la
rge co rporations have a difficult t ime p o lic ing the managers.

Some Solution !> le the Agency Problem

J\.11 of this discussion of moral haza rd 1s n o t meant to imply thnt shn rd , old ers
arc comp le tely help l:?ss in the face of managers who aren't doing what the
shareholders expect them to do. Obviously, if sh areholde rs are unhappy about
a firm's performance, they can sell their stock in the firm and buy equity in other
corporations. Such action, if ta ken by a re latively la rge numb er of stock holders,
would te nd to de press the price of a company's stock. This would 0" r.e:-J ll}' be
detrimer,t-11 to thE> m:in;1 ers, who tvpically own stork in th e firm
themselves. This possibility would tend to limit egregwus, confiictmg behav
ior by the managers. However, if the price of th e stock has been falling because
of poor rerfor,nance, stn, kholde rs wnuld abo experience some decline in
wealth.
Stockhoklt!rs often try to so!ve th:: ,1scncy problem by t ing man:igers'
income to fu:filling the go;ils of the s tockholde rs. As n e:-:nmple of a poo r com
pens ation plan, suppose stockholders want to guara ntee a firm's lonf;·term
growth i,1 the industry; they might set UiJ a m,magerial compensation plan based
on net operating income, g rowth in sales, and the relative rank of the firm in the
industry. Tlwn if income is avail;ible af ter paying dividend . ma nage me nt would
be motivated to reinves t these cash flow:; Ill new pwject::;. Jf the firm ge ts larger,
managemen t gets be tter bonuses. Such a plan could work •"ell for th!! stoc kh old
ers if the market continues to grow. Dividends would continue to be high, as the
price of the s toc k is driven up by the growth of the comp any.
Howeve r, if bus ines s beg ins to decline, the net present value of new
inves tment projects would decline. Beca 11st' of the bonus arrangement, ma nage
ment might even invest free cash flows into projec ts for which the net present
value is negative. The mandgement woulri be happy,!)ul thP c;h:ireholders would
be unhappy dS the vaiue of the stock declineJ . The problem is that the share-

' I

iI ;, !
 CH APTER 19 Profit MJximization ovur Tim(• 657

holders gave mnn::igement a compensation plan based on the goal of sales or size
maximization rather than value maximization.
Resolving the conflict between mam1gerial c1nd s.tockholder objectives re
quires a compensation plan that induces management to maximize the valu e ot
the firm. Tl'ie simplest approach is to change the compensation plan from one
based on accounting revenuc;s to one based on economic profitability. In such
cases, management bonuses would be directly linked to increases in dividends
and the value of the stock. Managers would then have the s::ime objectivt?s as
shareholders.
It's easy to propose a sweeping change in compensation plans as a soll!tion
to the agency problem. In the real world of cor po ra te politics, it may not be so
easy to implement this type of change. It could well be the case that a manage ment
team likes the compensation system they have, and have enough clout with the
board of directors to keep it in place. Furthermore, any attempts by share holders to
alter the method of compe ns ation runs squarely into the previously discu ss ed
problems of sha reholders attem pting lo police the firm ::ind convince management
lo change its policies. Shareholders are small, numerous, and diver sified, and an
individual shareholder would not have m;,,ich incentive or the capability of
changing compensation policies.
Corporate takeovers are an important possible solution to the conflict be tv1een
shareholders and managers who do not maximize the value of the firm. 1f the vaiue
of th e firm is Less with the present set of manageri:; than it would be with another,
there is a profit incentive for others to acquire the firm and replace the managemP.n
t team with a new set of m anagers . For example, in the above example of the poor
compensation scheme, anoll--ier company, or group of corpo
:-::::.t::! rnidcrs, bclie·..-a g its ;:;:-.-a: ,agemer.t co i..ld do a better joL1, mig11l lake v\<!r
Ute fir m by purchasing enr:iugh shares to take control. When the acquisition plan
is an:i.ounced, the firms stock would probabl.y increase 111 value, and the
sharehold ers woukl once again be happy.
ln this exm-iple, the new owners would. benefit from the takeover. How':!ver,
it sho uld also be made clear that, in any takeover motivated by maximizing the
present value of the firm, the shareholders of the' target furn will also ben€fit.
Ind eed, it has beer. estimated that in merger anri acquisition deals during the
1980s, the shareholders of the target firms realized huge increases in the values of
the ir holdings. It is not sur pris ing to see articles in business publications, such as
Tlic Wn!I Street Journal, telling of s ubstan tial increases in the price of a firm's
stock after a takeover bid has been announced. Even though most of the media,
many politicians, and certainly the managers of the takeover targets were
outraged, such takeovers; frequently called "hostile," act as a check on the powers
of in com pe tent managers to create inefficiency, and also on managers who are
less interested in maximizing profits, since they are not major owners, than they
are in expanding their corporate domain. Thus, takeovers can sometimes resolve to
some extent the conflict between managers and shareholders. (Fer further dis
cus::,ion of hostile takeovers, see Illustration 19.2).

.J
 I LL U S TR A T I O N 19.2
T
\IVhat's Wrong with Hostile Takeovers? These companies arc the potential takeover targets. f
He also argues, that even the distant threat of a_ take
\/Ve briefly alluded to corporate tnkeov'?rs as a possi- over can be therapeutic. ''Companies are funous!y
1:,le s .:ilution to tl,e conflict between shareholders anJ selling unw,mted divisions and ubsidiaries."
r(lamgers who do not maximize the corpora tion's Accord ing to these argulflents, c0rporate r;iidPrs
present w1lue. During the 1980s, and to c1 somewhat keep man agers much more in- line wiih the
lesser extent in the 1990s, there was a wave of mergers wishes of stockholders, and, to the extent that they
and hostile takeove1s (hostile at least to the managers
improve cl)mpanies' efficiency, they benefit
involved) along with a certain amount of illegal in sider consumers and the pubiic as well.
trading. The media and !Tiany politicians were ou In a lilt r co!umn, Samuelson reiterates the advan
traged over this seeming affront to entrenched cor tages or benefits of co rp o rate takeovers but points out
porate managers. Two columns by Newsweek colum nist why illegal inside r trading, particularly by the mo_st
·Roc ::-rt J. Samuelson, published in 1985 and 1986, pl1t prominent insider at tt1e time who allegedly made bil
the takeover rnovem'?nt in perspective, show h:iw the lions illegally, gave beneficial takltove rs a bad name.
takeo,·er movement was related to the conflict Clf According to Sam uelson, "Ma ny companies are exces
s h ;;rel ic,lders and managers, anci explain some of the sively bureaucratic or exces:,i,·ely divers ified. They
insider trading that was taking place. would operate morP efficien tly if broken up into thcir
According to Samuelson, corporate raiders were constituent business ... or put under better man3ge ment.
parodied as c,1pitalism' s juvenile delinCJue n ts, en ... Fragmen ted sharehold ers arc passive; di rectors are
gaged in hostile takeovers financed l>y junk bond . complacent.·' And, "sliort of bankruptcy, top
" [ n fact, hostile takeovE:rs ... rep rese n t a crude executives h«ve enjoyed huge job security....
checl-. 0n the rower of corpcrate managers to waste Hostile takeovers shatter this security."
wealth and create inefficiency. I doubt that those in Samuelson notes that the resulting st0c1< m ark et
Cong1ess who rondemn [T. Boone] Pickens [a promi n-:?nt specu la!ion over possible takE>over ca ndidates really
c c-rp :)!·ate :-::ti::!er :::t tlte U.:r:ej .:nd i·.-an t to ,.::gu late reflects mi m.-r,;igt>mPnt. Sup::-ose ". companyt tnck
takeove ,mderstand [this]." sells at $10, ar.d someone plans c1 tdkeovcr a: $13 (take
He went on to point out that, whe.., corporate man over prerniurns average bctwee:-, 25 and 50 per, ent).
agers are not the major owners of their rn n1panies - as The takeover group think" c-etter manageme1 t can
most are not-their loyalti<!S become confused. "They raise the stock's value to $17. 'i'\t a crude level, the gap
may be less inte rest-:?d in maximizing profits than <Jetweer, $10 and $17 (if attained) is misman.agement."
in prese rving a.'1d expa.'1di11g their corporate domain." Then there enter t,aders with illegal ins id e infor
This was the point of our discussior. in thE' text. mation, such as Ivan 13oesky, the prominent trader
No:·1 rer:ill the discussion in the text of the hy po referred to above. With a tip about the takeover, an
thetical corporation. Samuelson says, · s long as a ins id er trad er can buy the stock at $10 and sell it at
comp,rny s prima ry business is thriving, thf: conflict $13. Samuelson argues, however, "Nothing in
may lie dormant. Managers can 1naxirr.ize p rofits Boesky's scar:, dimi111shes th e real gains possible
a.ad expand simulta neous ly. But this happy from replacing bad management with good." He also
marriage rarely lasts forever.'' Then as the business ar gues that even though the number of actual hostile
matu res, management may diversify into a new takeovers is small, even the threat of a takeover spurs
business, where the company may have no special many managers to improve their efficiency. As noted
knowledge or talen t. And, "Hostile takeovers arise in the text, takeovers can resolve to some extent the
mainly to ex ploit profit oppor tunities created conflict between managers and shareholders.
when corporations cannot cop2 with their growth
dilemma." Samuelson emphasized thnt todays Source: This illustration L based on Robert J. Samuelson,
hostile takeovers represen t a corrective for ' '!n ?raise of B0one," Newswee.'c, May 6, 1985, p, 59, and

J
yesierday'.s abuses, and lhal many cor poratiOil5 "The S\!per Bow! of Sc:mda!, H Ncr:moe€k, Dec. l, 1986,
have become cumbersome empire and canr,ot i'· 64.
motiva te workers or be managed efficiently.
 C H A PTER 19 l'ni fi tr vt xirniz alio•1<\\'l ' r l 'irne 659

19.6 SUMMARY
The \ '.l i L1e tod,1y of a c,1sh llo w tu bl' n..'.C:L'ivcd in
th e futurc is its prc;;ent vnlue. Thl'1m·,1•11/ v11lu1 • (l'V) oh,
net cn h fl o w ($NCf) to be recl'i\'l'd 1Vith certainty in I pc r i
,1,b i::
l'V= SNCT:
(I + rJ'
whL·rL·r is t h e r isk less int• rest rate in time period 1- nlso
k11llwn ,is thL' discount r,1tc. The present value in c, ca sci :
,\ ( I) ThL• s iL.L' of tl w c a s h flow incrt• st•s, (2) 1·11e t:me
to
rc•ct·ip t decn·.ises, ur (Ji Tht· di:..n a mt ri1tt' dec n: m,es.
For a p rojec t or a:;s ct with ;is tream of c,1sh flow s
over T periods of time, the p rese nt value is
'I $NCF,
PV= Z, (I +,·,)'
/I
where NCF, is the net cash fl l>I\' n•.n •ived in pe r iod /, and
r, is
th e I-period disco un t r,1tc. The 11,•t µ n· sen / vah1e
(NPV) of a project or asset 1s the difference between it
prest'11t va lue and its cost,
N/1V = P\I - C,is t of the projec t or ,1ss\!l
·----- - ----- -- - - - ·- - - -
A firm can be thought of as a port folio of project or
nssets. Conscqucnlly, the value o ( the firm is the sum of
tht• present values of all of its projects or assets. In order
to maxim ize the value of the firm, the m11nage; · need
only follow the Net Presc11t Vr.Jue Rule for maxim iz ing
the value of the firm:
Accept projects (acquire assets) for which the net present
value i:, positive and rejc I projects for which the 11d pres em
Vi1lue is negative. The manager should divest the firm of
any projects for which the NPV is negati ve.
As long as revenues and costs are inde pendent over
time, single-period profit rnaximiza tio1, is equivalent l·o
maxim izing the value of the fir m. lnco nsis te ncies o, c
lJ, when the firms output decis iun in one period aff1:cts
cos ts or revenu es in s ubs eq ue nt time periods.
A principal- age nt problem arises when managers
have incentives that are differe nt from those of share
holders. If the re are many relatively s mall s ha re hold e
ts, as is the case for most large corporations, sha rehold ers
have a difficul t time forcing managers to maximize the
firm's value. Possible sulutious are tying man age rs '
income t0 profit, and takecvers that replace old manag ers
with new r:,anagers.

TECHNICAL PROBLEMS

In the follmving fi\"C! pr oblems, use the term s tr ucture of US Treas ur y se.:urities
fer the r is klt:ss in te res t rates below:

Time lo 111ol urity lntere, I role

lyeors) (percent)
l 5 75
2 6.00
3 6.25
.j 6.50
5 6.75

• 1. Calculate the present value of $1,000 to be rece ived in

n. One year .
b. Two years.
c. Three years.
d. Four V<?ars .
e. Five years.
 W&iEiki-

660 PA RT VII D cisiun Makin rnw 'l iml'

2. What i thl.' prl.' cnt v,1lue of the follow ing incoml' stream from a project? (Trea t 11!!
c,1sh flows .,s paid or l"l'cl'ivcd at year-end.)

Year Net cash flow

I
- $ 10,000
2
$ 20.()(_'()
J
$50,000
L! $15,000
5 $50,000

• 3. If the purchase pricl' of the projl'Ct described in problem '} is $' 125, 00 0, what is the
projl.'c ts net pn:s rm t value? What is thl' projects net present value if its purcha e
price is $150,000?
4 If the purehast.• price of the project ou tlined abow is $125,000, should the firm
un fortake the proi•·ct? What if the price is 5150,000? What is the m aximum amount
thl! firm shnu Jd pay for this project?
5. Look again ,11 the discussion dealir.g with Zephyr Products's decision abt1ut whether
to limit price. Reevalu,1te this decision if
n. Entr y occurred slower than orig inally presu!l1cd- that is:

Year '} 3 4 5
Pro, f, 80 ,000 $60,000 $50.000 $40,000 $30.000

/>. Thi' limit pr ire ann ual profits we re $45,000 rather than $50,000.
c Tlui US Treasury i1iter" SI ratt,,; we re l pen;en t higl,E,- t h.it i:;:

""-OtS f") fr1Q l 1., 11

lr·· 0
re \ l rul-a

6. Fini:ncial a sets (e.g.,shares of stock) Me said to b7 z.:ro nC't present valu., p rojec ts.
Why? If an asset like a share of st->ck i::; a lcro NP\' proj,ect noninteres t-bearing
t!1ecking accounts look like nEgativ NPV proj••cts. However, firms do hold such as!
>ets . Why?
7. What types of firms would you expect to b•• able to use entry limit pricing? What
types dthe: could nl•t .>r "'ould nut u 1.: thi t ratcs y? l'rcl\' icl'? sonw l.'xamp les of
ind ustries in which yo11 might expect ent ry limit pricing and some for which such
II
pricing would not be expected.
,j
S. An oil de pos it is d iscovered in your backyard. Your s tream of royalty inco:ne will be
as follows (aii payments arc: made at year-end):
'
I

1; I
Yeor Roi::oh;t: po i::menl
i• 'i
II
1 $20,000
·I
2 $20,000
3 $15 , 000
fI t 4
5
$10,000
$ 2,000
l-1
r

J
1• 1 t!

'I
P\= $80,000 $50,()00 $.J.0,000 $30,000 $30,000
+ + +- - - - + - - - -
I