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Chapter 2:

The Firm and Its Goals

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The Firm and Its Goals

• The Firm• Economic Goal of the Firm• Goals Other Than Profit• Do Companies Maximize Profits?• Maximizing the Wealth of Stockholders• Economic Profits

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Learning Objectives

• Understand reasons for existence of firms and meaning of transaction costs

• Explain economic goals and optimal decision making• Describe meaning of “principal-agent” problem• Distinguish between “profit maximization” and

“shareholder wealth maximization”• Demonstrate usefulness of 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 contract and coordinating transactions

– Influences• Uncertainty• Frequency of recurrence• Asset specificity

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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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Economic Goal of the Firm

• Primary objective of the firm (to economists) is to maximize profits.– Profit maximization hypothesis

• Optimal decision is the one that brings the firm closest to its goal.

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Economic Goal of the Firm

• 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

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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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Goals Other Than Profit

• Non-economic Objectives– Good work environment– Quality products and services– Corporate citizenship, social responsibility

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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

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Do Companies Maximize Profit?

• Position and power of stockholders

– Medium-sized or large corporations are owned by thousands of shareholders

– Shareholders own only minute interests in the firm and diversify holdings in many firms

– Shareholders are concerned with performance of entire portfolio and not individual stocks.

– Not likely to take any action as long as they are earning a “satisfactory” return on their investment.

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Do Companies Maximize Profit?

• 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”

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Do Companies Maximize Profit?• 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.

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Wealth Maximization

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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.

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Maximizing the Wealth of Stockholders

• The discount rate is affected by risk.• Two major types of risk:

• Business Risk• Financial Risk

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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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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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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).

• P = present price of the stock• D = dividends received per year• K = discount rate• N = life of firm in years

nn

k

D

k

D

k

DkDP

)1()1()1()1( 33

221

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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.

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Economic Profits

• Economic profits and accounting profits are typically different.

– Economists are more concerned with opportunity costs or alternative costs

– Accounting treatments allowed by GAAP

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Economic Profits• Historical costs vs. replacement costs

• Implicit costs and normal profits– Return required by scarce resources to remain

committed to a particular firm

• Economic costs include historical and explicit costs (accounting) as well as replacement and implicit costs

• Economic profits is total revenue minus all economic costs

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Copyrights “Keat and Young”