lecture 1 part two economy management lectures

lecture 1 part two economy management lectures

1. Chapter 2
The Firm
and Its Goals

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Chapter Outline
•The firm and resource allocation
•Profit maximization-the economic goal of
the firm
•Goals other than profit
•Do companies maximize profits?
•Maximizing the wealth of stockholders
•Economic profit

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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
®

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The Firm
A firm
is a collection of resources that is transformed into
products demanded by consumers
•Profitis the difference between revenue received
and costs incurred
Price x Unit sold = Revenue –Costs = Gross Profit

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The Firm
Why does a firm perform certain functions
internally and others through the market?
Transaction costs
1.The time and effort spent in carrying out
transaction
2.are incurred when entering into a contract.
–Types of transaction costs:
•Investigation (to find the outside firm)
•negotiation
•enforcing contracts

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The Firm
•Transaction costs are incurred when
entering into a contract
–Influences
•uncertainty
•frequency of recurrence
•asset specificity

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The Firm
Examples of transaction costs
Off shoringto source consumer products
(e.g. retail stores)
Manufacturing components overseas (e.g.
the automotive industry)
Logistics services (e.g. warehousing,
delivery, etc.)
Offshoringisthetransferringactivitiesorownershipofacomplete
businessprocesstoadifferentcountryfromthecountry(orcountries)
wherethecompanyreceivingtheservicesislocated

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The Firm
•Reshoring: Operations returning to the
country where the offshoring occurred
(Example -United States)
•Signs of Reshoring
–Wages in developing countries have been rising.
–The decrease in the value of the dollar has
increased the cost of importing.
–Increases in energy costs have made it more
expensive to ship products
–Manufacturing firms have significantly increased
productivity making firms production more
competitive.

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Economic Goal of the Firm and
Optimal Decision Making
•Profit maximization hypothesis : the primary
objective of the firm (to economists) is to maximize
profits.
–Other goals include market share, revenue growth, and
shareholder value
•Optimal decision is the one that brings the firm
closest to its goal
–It is crucial to be preciselyaware of a firm’s goals.
Different goals can lead to very different managerial
decisions given the same, limited amount of resources.

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Goals other than Profit
•Economic/financial objectives
–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 for employees
–Quality products and services for customers
–Good corporate citizenship and social
responsibility

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Do Companies Maximize Profit?
Assignment 1
Read carefully and summarize the argument
about companies maximize or not the profit ?

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Maximizing the Wealth
of Stockholders
Some Measurements of Wealth :
–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:
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.

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Maximizing the Wealth
of Stockholders
Future cash flows (D
i) must be ‘discounted’
to find their present equivalent value
The discount rate (k) is affected by risk
The discount rate is the interest rate used to determine the present
value of future cash flows in a discounted cash flow (DCF) analysis
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. (interest rate , inflation rate , GDP per
capita…..)
All firms face business risk to varying degrees.

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Maximizing the Wealth
of Stockholders
•Financial riskconcerns the variation in
returns that is induced by ‘leverage’
Leverageis the proportion of a company financed
by debt (debt to asset )
•Thehigher the leverage, thegreater 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 yearsn
n
k
D
k
D
k
D
k
D
P
)1()1()1()1(
3
3
2
21

 

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Maximizing the Wealth
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

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Maximizing the Wealth
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 = D
1/(k-g)
where D
1is the dividend to be paid during the
coming year
–Multiplying Pby the number of shares
outstanding gives the total value of the firm’s
common equity (‘market capitalization’).

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Maximizing the Wealth
of Stockholders
•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 alignedwith stockholder
objectives.

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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
•Basically, MVA is a forward-looking measure

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•The market value of the company includes
= the value of both equity and debt.
The capital includes =
1. the book value of debt
+
2.equity on the company’s balance sheet
+
3.a number of adjustments that increase the
basic number.(R&D)

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Maximizing the Wealth of Stockholders
•While the market value of the company will always
be positive,
•MVAmay be positive or negative depending on
whether the market value of the company is
greaterthan the capital that investors contributed.
Where a corporation’s MVis < contributed capital, investors’
wealth has actually been “destroyed

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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

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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
Return on capital =profit / capital
estimated cost of capital

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Maximizing the Wealth
of Stockholders
if EVA > 0 shareholder wealth rising
if EVA < 0 shareholder wealth falling
EVA Momentum
measures the growth rate of EVA by dividing
the change in EVA for a given period by the
company’s sales at the beginning of the
period
Growth rate of EVA / company’s sales at beginning

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Economic Profits
•Economic profits and accounting profits are
typically different
–accountants measure explicit incurred costs, as
allowed by GAAP (Generally accepted accounting principles)
–accountants use historical cost

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Accounting profit
measures =
actualmoney inflowsversus money outflows
and is part of the required financial reporting
and transparency of a company
•Accountant profit = revenues -explicit costs

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Economicprofit
not recorded on a company’s financial statements,
it is not required to be disclosed to regulators,
investors, or financial institutions
Economic profit can be used in a "what if" analysis
Companies and individuals may choose to consider
economic profit when they are facedwith choices
involving production levels or other business
alternatives.
Economic profit can provide a proxyfor foregone profit
considerations.

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Economic Profits
•Economists are concerned with implicit
costs.
Economic profits =
total revenue -all the economic costs.
Economic profit =
totalrevenues -explicit costs -opportunity costs

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Example of an implicit cost
•Whenacompanyhiresanewemployee,
thereareimplicitcoststotrainthat
employee.
•Ifamanagerallocateseighthoursofan
existingemployee'sdaytoteachthisnew
teammember,theimplicitcostswouldbe
theexistingemployee'shourlywage,
multipliedbyeight.Thisisbecausethe
hourscouldhavebeenallocatedtowardthe
employee'scurrentrole.

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Another example of an implicit cost
•Another example of an implicit cost involves
small business owners who may decide to
pass on taking a salary in the early stages
of operations to reduce costs and increase
revenue.
•They provide the business with their skill in
lieu of a salary, which becomes an implicit
cost.

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Global Application
•When doing business in other countries and other
cultures, business decision-making becomes more
complicated due to:
•foreign currencies
•legal differences
•language
•attitudes
•role of government

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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