The Firm and Its Goals
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The Firm
Economic Goal of the Firm
Goals Other Than Profit
Do Companies Maximize Profits?
Maximizing the Wealth of
Stockholders
• Economic Profits
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.
Economic vs. Accounting
Profits
• Accounting Profits
– Total revenue (sales) minus dollar cost of
producing goods or services.
– Reported on the firm’s income
statement.
• Economic Profits
– Total revenue minus total opportunity
cost.
Cost
• Accounting Costs
– The explicit costs of the resources
needed to produce produce goods or
services.
– Reported on the firm’s income
statement.
• Opportunity Cost
– The cost of the explicit and implicit
resources that are foregone when a
decision is made.
• Economic Profits
– Total revenue minus total opportunity
cost.
Economic Goal of the
Firm
• Primary objective of the firm (to
economists) is to maximize profits.
– Profit maximization hypothesis
– Other goals include market share,
revenue growth, and shareholder value
• Optimal decision is the one that
brings the firm closest to its goal.
• Short-run vs. 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
Goals Other Than Profit
– Market share maximization (as
measured by sales revenue or proportion
of quantity sold to total market
– Growth rate maximization (increasing
size of the firm over time. Higher rates
of growth in other variables than profit)
– Profit margin
– Return on investment, Return on assets
– Shareholder value
– Technological advancement
– Customer satisfaction
– Maximization of managerial returns
(manager’s own interest subject to
generating sufficient profits to keep
their jobs)
• Non-economic Objectives
– Good work environment
– Quality products and services
– Corporate citizenship, social
responsibility
Do Companies Maximize
Profit?
• Criticism: Companies do not maximize
profits but instead their aim is to
“satisfice.”
– “Satisfice” is to achieve a set goal, even though
that goal may not require the firm to “do its
best.”
– Two components to “satisficing”:
• Position and power of stockholders
• Position and power of professional
management
• Position and power of stockholders
– Medium-sized or large corporations are owned
by thousands of shareholders
– Shareholders own only minute interests in the
firm
– Shareholders diversify holdings in many firms
– Shareholders are concerned with performance
of entire portfolio and not individual stocks.
– Most stockholders are not well informed
on how well a corporation can do and
thus are not capable of determining the
effectiveness of management.
– Not likely to take any action as long as
they are earning a “satisfactory” return
on their investment.
• Position and power of professional
management
– High-level managers who are responsible
for major decision making may own very
little of the company’s stock.
– Managers tend to be more conservative
because jobs will likely be safe if
performance is steady, not spectacular.
– Management incentives may be
misaligned
• E.g. incentive for revenue growth, not
profits
• Managers may be more interested in
maximizing own income and perks
– Divergence of objectives is known as
“principal-agent” problem or “agency
problem”
• Counter-arguments which support the profit
maximization hypothesis.
– Large number of shares is owned by
institutions (mutual funds, banks, etc.) utilizing
analysts to judge the prospects of a company.
– Stock prices are a reflection of a company’s
profitability. If managers do not seek to
maximize profits, stock prices fall and firms
are subject to takeover bids and proxy fights.
– The compensation of many executives is tied to
stock price.
• 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, management
objectives tend to be more aligned with
stockholder objectives.
Maximizing the Wealth
of 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 time value
of money.
– Dollars earned in the future are worth less
than dollars earned today.
• Future cash flows must be
discounted to the present.
• The discount rate is affected by
risk.
• Two major types of risk:
•Business Risk
•Financial Risk
• 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.
• 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.
Timing
2 types of models
1. Static model:– describe the
behaviour at a single point in time.
Disregards differences in the
sequence of actions and payments
2. Dynamic models:- focus on the
timing and sequence of actions and
payments
The Time Value of Money
• Present value (PV) of a lump-sum
amount (FV) to be received at the
end of “n” periods when the perperiod interest rate is “i”:
PV 
• .
FV
1  i 
n
• Examples:
– Lotto winner choosing between a single lumpsum payout of $104 million or $198 million over
25 years.
– Determining damages in a patent infringement
case
Present Value of a Series
• Present value of a stream of future
amounts (FVt) received at the end of
each period for “n” periods:
PV 
FV1
1  i 
1

FV2
1  i 
2
 ...
FVn
1  i 
n
Net Present Value
• Suppose a manager can purchase a stream
of future receipts (FVt ) by spending “C0”
dollars today. The NPV of such a decision
Is
NPV 
FV1
1  i 
If
1

FV2
1  i 
2
 ...
FVn
1  i 
Decision Rule:
NPV < 0: Reject project
NPV > 0: Accept project
n
 C0
Present Value of a
Perpetuity
• An asset that perpetually generates a stream of
cash flows (CF) at the end of each period is called a
perpetuity.
• The present value (PV) of a perpetuity of cash
flows paying the same amount at the end of each
period is
CF
CF
CF
PVPerpetuity 


 ...
2
3
1  i  1  i  1  i 
CF

i
Firm Valuation
• The value of a firm equals the
present value of current and future
profits.
– PV = S pt / (1 + i)t
• If profits grow at a constant rate (g < i)
and current period profits are po:
1 i
PVFirm  p 0
before current profits have been paid out as dividends;
ig
1 g
Ex  Dividend
PVFirm
 p0
immediately after current profits are paid out as dividends.
ig
• If the growth rate in profits <
interest rate and both remain
constant, maximizing the present
value of all future profits is the same
as maximizing current profits.
Marginal (Incremental)
Analysis
• Control Variables
–
–
–
–
–
Output
Price
Product Quality
Advertising
R&D
Net Benefits
• Basic Managerial Question: How much of
the control variable should be used to
maximize net benefits?
• Net Benefits = Total Benefits - Total
Costs
• Profits = Revenue - Costs
Marginal Benefit (MB)
• Change in total benefits arising from a
change in the control variable, Q:
B
MB 
Q
• Slope (calculus derivative) of the total
benefit curve.
Marginal Cost (MC)
• Change in total costs arising from a
change in the control variable, Q:
C
MC 
Q
• Slope (calculus derivative) of the total
cost curve
Marginal Principle
• To maximize net benefits, the
managerial control variable should be
increased up to the point where MB =
MC.
• MB > MC means the last unit of the
control variable increased benefits
more than it increased costs.
• MB < MC means the last unit of the
control variable increased costs more
than it increased benefits.
The Geometry of
Optimization
Total Benefits
& Total Costs
Costs
Slope =MB
Benefits
B
Slope = MC
C
Q*
Q
Conclusion
• Make sure you include all costs and
benefits when making decisions
(opportunity cost).
• When decisions span time, make sure
you are comparing apples to apples
(PV analysis).
• Optimal economic decisions are made
at the margin (marginal analysis).
Maximizing the Wealth
of Stockholders
• Another measure of the wealth of
stockholders is called Market Value
Added (MVA)®.
• MVA represents the difference
between the market value of the
company and the capital that the
investors have paid into the company.
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.
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 is positive then shareholder wealth
is increasing. If EVA is negative, then
shareholder wealth is being destroyed.