Chapter 2

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

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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
Profit is the difference between revenue received
and costs incurred
Price x Unit sold = Revenue Costs = Profit

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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

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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
Offshoring to source consumer products
(e.g. retail stores)
Manufacturing components overseas (e.g.
the automotive industry)
Logistics services (e.g. warehousing,
delivery, etc.)

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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
minimized (for a
given level of
output)
outsourcing of
peripheral, non-core
activities

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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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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.

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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 precisely aware of a firms 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?

Argument against companies not
maximizing profits but instead merely aim
to satisfice, which means firms seek to
achieve a satisfactory goal--one that may
not require the firm to do its best.

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Do Companies Maximize Profit?

Two forces leading to satisficing
position and power of stockholders
position and power of management

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Do Companies Maximize Profit?

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 diversified holdings in many other firms

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Do Companies Maximize Profit?

Position and power of stockholders
Stockholders are concerned with performance of
their entire portfolio and not individual stocks
Stockholders are much less informed about the
firm than management
Thus, stockholders are not likely to take any action if
earning a satisfactory return.

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Do Companies Maximize Profit?

Position and power of management
high-level managers may own very little of the
firms stock
managers tend to be more conservativethat is,
risk aversethan stockholders would be because
their jobs will most likely be safer if they turn in
a competent and steady, if unspectacular,
performance

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Do Companies Maximize Profit?

Position and power of management
managers may be more interested in maximizing
their own income and perks
management incentives may be misaligned (e.g.
revenue goals for compensation and not profits)
divergence of objectives is known as the
principal-agent problem

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Do Companies Maximize Profit?

Arguments supporting the profit
maximization hypothesis
large stockholdings held by institutions (mutual
funds, banks, etc.) scrutiny by professional
analysts
Stock market discipline and competition if
managers do not seek to maximize profits, firms
face the threat of takeover or changes in
management
incentive effect the compensation of many
executives is tied to stock price
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Do Companies Maximize Profit?

Other influences
The Sarbanes-Oxley Act was passed in 2002 in
response to a number of corporate scandals. The
Act sets stricter standards on the behavior of
public corporations and more transparency of
corporate information.
Within the labor market for financial managers,
superior performance is rewarded.

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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.

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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

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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 firms stock should
reflect the discounted value of the expected
future cash flows to shareholders
(dividends)

D1
(1 k )

(1 k )2 (1 k )3 (1 k )n
D2

D3

Dn

P = present price of the stock

D = dividends received per year
k = discount rate
n = life of firm in years
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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 = 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 firms 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 companys stock.
When stock options are a substantial part of
executive compensation, management objectives
tend to be more aligned with stockholder objective.

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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

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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

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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

if EVA > 0 shareholder wealth rising

if EVA < 0 shareholder wealth falling

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Economic Profits
Economic profits and accounting profits are
typically different
accountants measure explicit incurred costs, as
allowed by GAAP
accountants use historical cost

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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.
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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 firms 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

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