Chapter The Firm and Its Goals 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-2 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 Addedđ Copyright â2014 Pearson Education, Inc All rights reserved 2-3 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 Price x Unit sold = Revenue –Costs = Profit Copyright ©2014 Pearson Education, Inc All rights reserved 2-4 The Firm • Why does a firm perform certain functions internally and others through the market? • Transaction costs are incurred when entering into a contract – Types of transaction costs: • investigation • negotiation • enforcing contracts Copyright ©2014 Pearson Education, Inc All rights reserved 2-5 The Firm • Transaction costs are incurred when entering into a contract – Influences • uncertainty • frequency of recurrence • asset specificity Copyright ©2014 Pearson Education, Inc All rights reserved 2-6 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.) Copyright ©2014 Pearson Education, Inc All rights reserved 2-7 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 minimized (for a given level of output) outsourcing of peripheral, non-core activities Copyright â2014 Pearson Education, Inc All rights reserved 2-8 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-9 The Firm • Illustration: Coase and the Internet – Ronald Coase wrote in 1937, pre-internet, but his ideas are still relevant today – He discussed tradeoff between internal costs and external transactions – Technology has reduced search costs improving efficiency Copyright ©2014 Pearson Education, Inc All rights reserved 2-10 Maximizing the Wealth of Stockholders • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-22 Maximizing the Wealth of Stockholders • Future cash flows (Di) must be ‘discounted’ to find their present equivalent value • The discount rate (k) is affected by risk • Two major types of risk: – business risk – financial risk Copyright ©2014 Pearson Education, Inc All rights reserved 2-23 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-24 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-25 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) D1 D2 P = present price of the stock (1+ k ) (1+ k ) P= + D3 Dn + (1+ k )3 +  + (1+ k ) n D = dividends received per year k = discount rate n = life of firm in years Copyright ©2014 Pearson Education, Inc All rights reserved 2-26 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-27 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 = 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’) Copyright ©2014 Pearson Education, Inc All rights reserved 2-28 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 aligned with stockholder objective Copyright ©2014 Pearson Education, Inc All rights reserved 2-29 Maximizing the Wealth of Stockholders • Another measure of the wealth of stockholders is called Market Value Added (MVA)đ MVA = difference between the market value of the company and the capital that the investors have paid into the company Copyright ©2014 Pearson Education, Inc All rights reserved 2-30 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-31 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 > shareholder wealth rising if EVA < shareholder wealth falling Copyright ©2014 Pearson Education, Inc All rights reserved 2-32 Economic Profits • Economic profits and accounting profits are typically different – accountants measure explicit incurred costs, as allowed by GAAP – accountants use historical cost Copyright ©2014 Pearson Education, Inc All rights reserved 2-33 Economic Profits • Economists are concerned with implicit costs – 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-34 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-35 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 Copyright ©2014 Pearson Education, Inc All rights reserved 2-36 ... Position and power of stockholders Reasons for satisficing by companies • larger firms are owned by thousands of shareholders • stockholders generally own only minute interests in the firm and hold... Goals other than Profit • Non -economic objectives – Good work environment for employees – Quality products and services for customers – Good corporate citizenship and social responsibility Copyright... Addedđ and Economic Value Addedđ Copyright â2014 Pearson Education, Inc All rights reserved 2-3 The Firm • A firm is a collection of resources that is transformed into products demanded by consumers