Chapter 2

Chapter 2
The Firm
and Its Goals
Chapter Outline
• A firm
• The economic goal of the firm and optimal decision making
• Goals other than profit
• Do companies maximize profits?
• Maximizing the wealth of stockholders
• Economic profits.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-2

Learning Objectives
• Understand the reasons for the existence of firms

and the meaning of transaction costs
• Explain the economic goals of the firm and optimal

decision making
• Describe the ‘principal-agent’ problem
• Distinguish between “profit maximization” and the

“maximization of the wealth of shareholders”
• Demonstrate the usefulness of 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.
Profit = Price x Unit sold = Revenue –Costs

The Firm
Why does a firm perform certain functions

internally and others through the market?
Transaction costs
•Transaction costs are incurred when entering
into a contract.
•Types of transaction costs:

 Investigation to find the outside firm
 Negotiation of the contract
 Enforcing the contract

The Firm
• Transaction costs influenced by:

 Uncertainty: the inability to know the future
perfectly (+)
 Frequency of recurrence of the transactions

(+)
 Asset specificity (+)

The Firm
• Examples of transaction costs:
 Offshoring to source consumer products

(e.g. retail stores)
 Manufacturing components overseas (e.g.

the automotive industry)
 Logistics services (e.g. warehousing,

delivery, etc.).

The Firm
• Tradeoff between external transactions and the cost
of internal operations
Cost External Transaction
Internal Operations
Total
 Company chooses to
120
100
80
60
allocate resources so
40
20
total cost is
minimized (for a
given level of
output)
 Outsourcing of
peripheral, non-core
activities.
20 40 60 80 100
Internal
Operations
The Firm
• Reshoring: Operations returning to the

country where the offshoring occurred
(Example - United States).
• Reasons of Reshoring:
 Wages in developing countries have been rising.
 The decrease in the value of the dollar has

increased the cost of importing.

The Firm
• Reasons of Reshoring:
 Increases in energy costs have made it more
expensive to ship products.
 Communications and quality control have been

instrumental in increasing costs.
 Manufacturing firms have significantly increased

productivity making firms production more
competitive.

Economic Goal of the Firm and
Optimal Decision Making
• Profit maximization hypothesis: the primary
objective of the firm, to economists, is to maximize
profits.
• Optimal decision is the one that brings the firm

closest to its goal; because
 It is crucial to be precisely aware of a firm’s goals.
 Different goals can lead to very different
managerial decisions given the same, limited
amount of resources.

Goals other than Profit
• Economic/financial objectives:
 Market share
 Revenue growth
 Profit margin
 Return on investment, return on assets
 Technological advancement
 Customer satisfaction
 Shareholder value (i.e., maximizing the price of
its stock).

Goals other than Profit
• Non-economic objectives:
 Good work environment for employees
 Quality products and services for customers
 Good corporate citizenship and social

responsibility.

Do Companies Maximize Profit?
• Argument against companies today is that
companies are not maximizing profits but instead
merely aim to satisfice, which means firms seek
to achieve a satisfactory goal, one that may not
require the firm to ‘do its best’.
• To understand the above argument, we consider

two parts of this idea:
 The position and power of stockholders in today’s
corporation
 The position and power of professional management
in today’s corporation.

• Position and power of stockholders:
 Large firms are owned by thousands of shareholders.
 Stockholders generally own only minute interests in

the firm and hold diversified holdings in many other
firms.
 Stockholders are not well informed on how well a

corporation can do.
 They will be satisfied with an adequate dividend and

some reasonable growth.

• Position and power of stockholders:

 Stockholders are concerned with performance of
their entire portfolio and not individual stocks.
 Stockholders are much less informed about the

firm than management.
 Thus, stockholders are not likely to take

any action if earning a ‘satisfactory’ return.

• Position and power of management:
 High-level managers may own very little of the

firm’s stock.
 Managers tend to be more conservative (that is,

risk averse) than stockholders would be, because
their jobs will most likely be safer if they turn in
a competent and steady, if unspectacular,
performance.

• Position and power of management:
 Managers may be more interested in

maximizing their own income and perks.
 Management incentives may be misaligned

(e.g. revenue /income goal for compensations
and not profits).
Divergence of objectives between owners and

management is known as the ‘principal-agent’
problem.
• Arguments supporting the profit maximization
hypothesis:
 large stockholdings held by institutions (mutual funds,

banks, etc.)  scrutiny by professional analysts.
 Stock market discipline and competition  if
managers do not seek to maximize profits, then firms
face the threat of takeover or changes in
management.
 Incentives effect  the compensation of many
executives is tied to stock price.

• Other influences:
 The Sarbanes-Oxley Act was passed in 2002 in
response to a number of corporate scandals. The
Act sets stricter standards on the behavior of
public corporations and more transparency of
corporate information.
 Within the labor market for financial managers,

superior performance is rewarded.

Maximizing the Wealth
of Stockholders
• Measurement of Wealth (MoW):
 MoW 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.
 MoW requires the concept of the time value of

money: a dollar earned in the future is worth
less than a dollar earned today.
There is an opportunity cost of getting a dollar in
the future instead of today.
of Stockholders
• How do we obtain a measure of

stockholders’ wealth?
 Future cash flows (Di) must be ‘discounted’ to
find their present equivalent value
 The discount rate (k) is affected by two major

types of risk:
o Business risk
o Financial risk

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.

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
 Thus, financial risk is directly related to the

degree of leverage

of Stockholders
• Stockholder wealth measure:
• 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
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

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’.

of Stockholders
Example:
A company expects to pay a dividend of $4 in the
coming year and expects dividends to grow at 5 percent
each year.
The rate of return is 12 percent.
We would expect the price of stock to be:
P = 4/(0.12-0.05) = 4/0.07 = $57.14 million

 The value of the company’s stock would be $57.14
million

of Stockholders
As a result:
•A 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 a substantial part of

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

of Stockholders
• Market Value Added and Economic

Value Added: are another measures of the
wealth of stockholders
 Market Value Added (MVA) (A forward-
looking method)
MVA = difference between the market value of

the company and the capital that the investors
have paid into the company.

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.
 Since the market value of the company will

always be positive, then MVA may be positive
or negative.

of Stockholders
 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 generally accepted
accounting principles (GAAP) .
 Accountants use historical cost.

Economic Profits
• Economists are concerned with implicit

costs also.
 Accordingly, economic costs include not only the
historical costs and explicit costs recorded by
the accountants, but also the replacement costs
and implicit costs (normal profits) that must be
earned on the owners’ resources.
• Economic profits are total revenue minus

all the economic costs.

Global Application
• When doing business in other countries and other cultures,

business decision-making becomes more complicated due to:
 Foreign currencies and their exchange rate
 Legal differences
 Language
 Differences in culture and attitudes
 Role of government in defining roles
 Transferring corporate resources out of the country.

Summary
• A firm’s objective is the maximization of its profit or the
minimization of its loss.
• There are other important non-economic goals of the firm.
• Understanding risk and the time value of money are

essential for managing a business.
• Economic profits for a firm are total revenue minus all

economic costs.

Chapter 2 - The Firm and Its Goals (ECON 610)

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• The economic goal of the firm and optimal decision making

• Goals other than profit

• Do companies maximize profits?

• Maximizing the wealth of stockholders

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-2

• Understand the reasons for the existence of firms

• Explain the economic goals of the firm and optimal

• Describe the ‘principal-agent’ problem

• Distinguish between “profit maximization” and the

• Demonstrate the usefulness of Market Value Added

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-3

• A firm is a collection of resources that is

• Profit is the difference between revenue

Profit = Price x Unit sold = Revenue –Costs

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-4

Why does a firm perform certain functions

•Types of transaction costs:

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-5

• Transaction costs influenced by:

 Frequency of recurrence of the transactions

 Asset specificity (+)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-6

• Examples of transaction costs:

 Offshoring to source consumer products

 Manufacturing components overseas (e.g.

 Logistics services (e.g. warehousing,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-7

• Reshoring: Operations returning to the

 The decrease in the value of the dollar has

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-9

 Communications and quality control have been

 Manufacturing firms have significantly increased

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-10

• Optimal decision is the one that brings the firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-11

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-12

 Good work environment for employees

 Quality products and services for customers

 Good corporate citizenship and social

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-13

• To understand the above argument, we consider

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-14

• Position and power of stockholders:

 Large firms are owned by thousands of shareholders.

 Stockholders generally own only minute interests in

 Stockholders are not well informed on how well a

 They will be satisfied with an adequate dividend and

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-15

• Position and power of stockholders:

 Stockholders are much less informed about the

 Thus, stockholders are not likely to take

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-16

• Position and power of management:

 High-level managers may own very little of the

 Managers tend to be more conservative (that is,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-17

 Managers may be more interested in

 Management incentives may be misaligned

Divergence of objectives between owners and

 large stockholdings held by institutions (mutual funds,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-19

 Within the labor market for financial managers,