goal of firm
Transcript of goal of firm
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Chapter 2 Chapter 2 The Firm and Its
Goals
Managerial Economics: Economic Tools for Todays Decision Makers, 5/e
By Paul Keat and Philip Young
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The Firm and Its Goals
The FirmEconomic Goal of the Firm
Goals Other Than ProfitDo Companies Maximize Profits?Maximizing the Wealth of StockholdersEconomic Profits
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L earning Objectives
Understand the reasons for existence of firms andmeaning of transaction costsExplain economic goals and optimal decision
makingDescribe meaning of principal-agent problemDistinguish between profit maximization andshareholder wealth maximizationDemonstrate usefulness of Market Value Addedand Economic Value Added
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The Firm
A f irm is a collection of resources thatis transformed into products demanded
by consumers.What is wrong with this definition?Pro f it is the difference betweenrevenue received and costs incurred(explicit and implicit).
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The Firm
Transaction costs are incurred whenentering into a contract.
Types of transaction costs
InvestigationNegotiationEnforcing contract and coordinating transactions
InfluencesUncertaintyFrequency of recurrenceAsset specificity
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Internet
What is the effect on transaction costs?Bigger or smaller firms?
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The Firm
Limits to Firm Sizetradeoff betweenexternal transactionsand the cost of internaloperationsCompany chooses toallocate resources sototal cost is minimum
Outsourcing of peripheral, non-coreactivities
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E conomic Goal o f the Firm
Primary objective of the firm (toeconomists) is to maximize profits.
Profit maximization hypothesisOther goals include market share,revenue growth, and shareholder value
Optimal decision is the one that bringsthe firm closest to its goal.
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E conomic Goal o f the Firm
Short-run vs. Long-runNothing to do directly with calendar time
Short-run: firm can vary amount of someresources but not othersLong-run: firm can vary amount of allresourcesAt times short-run profitability will besacrificed for long-run purposes
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Goals Other Than Pro f it
Economic GoalsMarket share, Growth rate
Profit marginReturn on investment, Return on assetsTechnological advancement
Customer satisfactionShareholder value
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Goals Other Than Pro f it
Non-economic ObjectivesGood work environment
Quality products and servicesCorporate citizenship, socialresponsibility
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D o Companies Maximize Pro f it?
Criticism: Companies do not maximize profits but instead their aim is to satisfice.
Satisfice is to achieve a set goal, even thoughthat goal may not require the firm to do its best.Two components to satisficing:
Position and power of stockholdersPosition and power of professional management
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D o Companies Maximize Pro f it?
Position and power of stockholdersMedium-sized or large corporations are owned
by thousands of shareholdersShareholders own only minute interests in thefirmShareholders diversify holdings in many firms
Shareholders are concerned with performanceof entire portfolio and not individual stocks.
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D o Companies Maximize Pro f it?
Position and power of stockholdersMost stockholders are not well informed
on how well a corporation can do andthus are not capable of determining theeffectiveness of management.
Not likely to take any action as long asthey are earning a satisfactory return ontheir investment.
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D o Companies Maximize Pro f it?
Position and power of professionalmanagement
High-level managers who are responsiblefor major decision making may own verylittle of the companys stock.Managers tend to be more conservative
because jobs will likely be safe if performance is steady, not spectacular.
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D o Companies Maximize Pro f it?
Position and power of professionalmanagement
Management incentives may be misalignedE.g. incentive for revenue growth, not profitsManagers may be more interested in maximizingown income and perks
Divergence of objectives is known asprincipal-agent problem or agency problem
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D o Companies Maximize Pro f it?
Counter-arguments which support the profitmaximization hypothesis.
Large number of shares is owned by institutions(mutual funds, banks, etc.) utilizing analysts to judgethe prospects of a company.Stock prices are a reflection of a companys
profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject totakeover bids and proxy fights.
The compensation of many executives is tied tostock price.
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Maximizing the Wealthof Stockholders
Views the firm from the perspective of a stream of earnings over time, i.e., a
cash flow.Must include the concept of the timevalue of money.
Dollars earned in the future are worth lessthan dollars earned today.
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Maximizing the Wealthof Stockholders
Bu siness risk involves variation inreturns due to the ups and downs of the
economy, the industry, and the firm.All firms face business risk to varyingdegrees.
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Maximizing the Wealthof Stockholders
Financial Risk concerns the variation inreturns that is induced by leverage.L everage is the proportion of a companyfinanced by debt.The higher the leverage, the greater the
potential fluctuations in stockholder earnings.
Financial risk is directly related to thedegree of leverage.
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Maximizing the Wealthof Stockholders
The present price of a firms stock should reflectthe discounted value of the expected future cashflows to shareholders (dividends).
P = present price of the stock D = dividends received per year K = discount rateN = life of firm in years
n
n
k
D
k
D
k
D
k
D P
)1()1()1()1( 33
221! .
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Maximizing the Wealthof Stockholders
If the firm is assumed to have aninfinitely long life, the price of a share
of stock which earns a dividend D per year is determined by the equation:
P = D/k
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Maximizing the Wealthof Stockholders
Company tries to manage its business insuch a way that the dividends over time
paid from its earnings and the risk incurred
to bring about the stream of dividendsalways create the highest price for thecompanys stock.When stock options are substantial part of
executive compensation, managementobjectives tend to be more aligned withstockholder objectives.
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Maximizing the Wealthof Stockholders
Another measure of the wealth of stockholders is called Market Val u e
Added (MVA).MVA represents the difference
between the market value of the
company and the capital that theinvestors have paid into the company.
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Maximizing the Wealthof Stockholders
Market value includes value of both equityand debt.Capital includes book value of equity anddebt 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 positiveor negative.
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Maximizing the Wealthof Stockholders
Another measure of the wealth of stockholders is called E conomic Val u eAdded ( E VA).
EVA=(Return on Total Capital Cost of Capital) x Total Capital
If EVA is positive then shareholder wealthis increasing. If EVA is negative, thenshareholder wealth is being destroyed.
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E conomic Pro f its
Economic profits and accounting profits are typically different.
Accounting treatments allowed by GAAPAccountants report cost on historical
basis.
Economists are more concerned withopportunity costs or alternative costs.
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E conomic Pro f its
Historical costs vs. replacement costsImplicit costs and normal profits
Return required by scarce resources to remaincommitted to a particular firm
Economic costs include historical andexplicit costs (accounting) as well asreplacement and implicit costs
Economic profits is total revenue minus alleconomic costs