LECTURE 1 : Organizations and the Economic Environment

Chapter 1

Introduction

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Economics and managerial
decision making
• Questions that managers must
answer:

– What are the economic conditions in our
particular market?
– Should our firm be in this business?
– How can we maintain a competitive
advantage over other firms?
– What are the risks involved?

Copyright 2011 Pearson Education,
Chapter One 2
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Economics of a business
• Change: the four-stage model

– Stage I (the ‘good old days’)
• market dominance
• high profit margin
• cost plus pricing

… changes in technology, competition,
customers force firm into Stage II ..
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. Chapter One 4 Inc. Economics of a business • Change: the four-stage model – Stage II (crisis) • cost management • downsizing • restructuring … ‘re-engineering’ to deal with changes and move firm into Stage III . Copyright 2011 Pearson Education. Publishing as Prentice Hall..

. Economics of a business • Change: the four-stage model – Stage III (reform) • revenue management • cost cutting has limited benefit … focus on ‘top-line’ growth . Publishing as Prentice Hall. Chapter One 5 Inc. . Copyright 2011 Pearson Education.

Economics of a business • Change: the four-stage model – Stage IV (recovery) • revenue plus … revenue grows profitably Copyright 2011 Pearson Education. Publishing as Prentice Hall. Chapter One 6 Inc. .

Chapter One 7 Inc. Publishing as Prentice Hall. Review of economic terms • Allocation decisions must be made because of scarcity. . Three choices: What should be produced? How should it be produced? For whom should be produced? Copyright 2011 Pearson Education.

Publishing as Prentice Hall.begin or stop providing goods/services (production) How . Chapter One 8 Inc.hiring. . Review of economic terms • Economic decisions of the Firm What . capital budgeting (resourcing) For whom – target the customers most likely to purchase (marketing) Copyright 2011 Pearson Education. staffing.

Publishing as Prentice Hall. . Three ways to answer three questions • Market process • Command process • Traditional process • Mixed process Copyright 2011 Pearson Education. Chapter One 9 Inc.

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11 Inc. . Chapter 2 The Firm and its Goals Copyright 2011 Pearson Education. Publishing as Prentice Hall.

. 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 Copyright 2011 Pearson Education. Publishing as Prentice Hall. Chapter Two 12 Inc.

The Firm • Transaction costs are incurred when entering into a contract – types of transaction costs • Investigation/search • negotiation • Enforcing/coordinating contracts Copyright 2011 Pearson Education. Publishing as Prentice Hall. Chapter Two 13 Inc. .

Publishing as Prentice Hall. The Firm • Transaction costs are incurred when entering into a contract – Influenced by • uncertainty • frequency of recurrence • asset specificity Copyright 2011 Pearson Education. . Chapter Two 14 Inc.

. that creates its own costs – Hiring workers – Monitoring and supervising – incentives Copyright 2011 Pearson Education. Publishing as Prentice Hall. The Firm • When transactions cost is high. a firm may choose to provide the service or product itself. • However. Chapter Two 15 Inc.

Chapter Two 16 Inc. 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. . Publishing as Prentice Hall. non-core activities Copyright 2011 Pearson Education.

Publishing as Prentice Hall. revenue growth. Chapter Two 17 Inc. . 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. and shareholder value • Optimal decision is the one that brings the firm closest to its goal Copyright 2011 Pearson Education.

Publishing as Prentice Hall. 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 Copyright 2011 Pearson Education. Chapter Two 18 Inc. .

Chapter Two 19 Inc. Goals other than profit • Economic goals – market share. Return on assets – technological advancement – customer satisfaction – shareholder value Copyright 2011 Pearson Education. Publishing as Prentice Hall. . growth rate – profit margin – return on investment.

Chapter Two 20 Inc. Publishing as Prentice Hall. social responsibility Do not interfere with profit maximization. . Copyright 2011 Pearson Education. Goals other than profit • Non-economic objectives – good work environment – quality products and services – corporate citizenship.

which means to achieve a satisfactory goal. Chapter Two 21 Inc.Do companies maximize profit? • Criticism: companies do not maximize profits but instead merely aim to satisfice. . Publishing as Prentice Hall. 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 Copyright 2011 Pearson Education.

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 ... . Publishing as Prentice Hall. and hold diversified holdings in many other firms Copyright 2011 Pearson Education. Chapter Two 22 Inc.

. Chapter Two 23 Inc.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 Copyright 2011 Pearson Education. Publishing as Prentice Hall.

Publishing as Prentice Hall. . Chapter Two 24 Inc. not spectacular Copyright 2011 Pearson Education.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.

Chapter Two 25 Inc. Publishing as Prentice Hall. . revenue not profits)  divergence of objectives is known as ‘principal-agent’ problem Copyright 2011 Pearson Education.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.

What would you do? .

etc. Do companies maximize profit? • Counter-arguments which support the profit maximization hypothesis – large stockholdings held by institutions (mutual funds. banks. . Publishing as Prentice Hall.)  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 Copyright 2011 Pearson Education. Chapter Two 27 Inc.

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 Copyright 2011 Pearson Education. . Publishing as Prentice Hall. Chapter Two 28 Inc.

Chapter Two 29 Inc. 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 Copyright 2011 Pearson Education. Publishing as Prentice Hall. .

Chapter Two 30 Inc. the industry. Maximizing the wealth of stockholders • Business risk involves variation in returns due to the ups and downs of the economy. and the firm All firms face business risk to varying degrees Copyright 2011 Pearson Education. Publishing as Prentice Hall. .

the greater the potential fluctuations in stockholder earnings  financial risk is directly related to the degree of leverage Copyright 2011 Pearson Education. Chapter Two 31 Inc. 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. . Publishing as Prentice Hall.

Chapter Two 32 Inc. 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) 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 Copyright 2011 Pearson Education. . Publishing as Prentice Hall.

Publishing as Prentice Hall. . Maximizing the wealth of stockholders • If the firm is assumed to have an infinitely long life. Chapter Two 33 Inc. the price of a unit of stock which earns a dividend D per year is given by the equation: P = D/k Copyright 2011 Pearson Education.

management objectives tend to be more aligned with stockholder objective Copyright 2011 Pearson Education. Publishing as Prentice Hall. Chapter Two 34 Inc. . 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.

. Publishing as Prentice Hall. MVA may be positive or negative Copyright 2011 Pearson Education. Chapter Two 35 Inc. 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 While the market value of the company will always be positive.

Chapter Two 36 Inc. Publishing as Prentice Hall. . 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 Copyright 2011 Pearson Education.