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Chapter 2

The Firm and its Goals

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cation, Inc. Publishing as
Overview
The firm
Economic goal of the firm
Goals other than profit
Do companies maximize profits?
Maximizing the wealth of
stockholders
Economic profit
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cation, Inc. Publishing as
Learning objectives

understand the rationale for existence of


firms

explain economic goals and optimal


decision making

describe the principal-agent problem

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cation, Inc. Publishing as
Learning objectives

distinguish between profit maximization


and shareholder wealth maximization

apply Market Value Added and Economic


Value Added

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The Firm

A firm is a collection of resources that is


transformed into products demanded by
consumers

Profit is the difference between revenue


received and costs incurred

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The Firm

Transaction costs are incurred when


entering into a contract

types of transaction costs


investigation

negotiation

enforcing contracts

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The Firm

Transaction costs are incurred when


entering into a contract

influences
uncertainty

frequency of recurrence

asset specificity

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The Firm

Examples

Kodak uses offshoring to source


cameras
IBM manufacturing computers
overseas
Exult third party services used in
human resources

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cation, Inc. Publishing as
The Firm
Limits to firm size

tradeoff between
external transactions
and the cost of internal
operations

company chooses to
allocate resources so
total cost is minimum

outsourcing of
peripheral, non-core
activities

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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
Economic goal of the firm
Profit maximization hypothesis: the
primary objective of the firm (to
economists) is to maximize profits

Other goals include market share, revenue


growth, and shareholder value

Optimal decision is the one that brings


the firm closest to its goal

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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
Goals other than profit
Economic goals

market share, growth rate


profit margin
return on investment, Return on assets
technological advancement
customer satisfaction
shareholder value

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cation, Inc. Publishing as
Goals other than profit
Non-economic objectives

good work environment

quality products and services

corporate citizenship, social


responsibility

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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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
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cation, Inc. Publishing as
Do companies maximize
profit?
Position and power of management

high-level managers may own very little


of the firms stock
managers tend to be more conservative
because jobs will likely be safe if
performance is steady, not spectacular

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cation, Inc. Publishing as
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
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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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
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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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
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cation, Inc. Publishing as
Maximizing the wealth
of stockholders
The present price of a firms stock should
reflect the discounted value of the expected
future cash flows to shareholders (dividends)

D3 Dn
P D1
(1 k ) (1 k ) 2 (1 k )3 (1 k ) n
D2

P = present price of the stock


D = dividends received per year
k = discount rate
n = life of firm in years
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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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 firms common equity (market
capitalization)
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cation, Inc. Publishing as
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 companys stock

When stock options are substantial part of


executive compensation, management
objectives tend to be more aligned with
stockholder objective

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cation, Inc. Publishing as
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

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cation, Inc. Publishing as
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
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cation, Inc. Publishing as
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
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cation, Inc. Publishing as
Economic profits
Economic profits and accounting profits
are typically different

accountants measure explicit incurred


costs, as allowed by GAAP

accountants use historical cost of


machines

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cation, Inc. Publishing as
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

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Global application

Other countries, other cultures

foreign currencies
legal differences
language
attitudes
role of government

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cation, Inc. Publishing as