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

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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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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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 D2 D3 Dn
P (1 k ) (1 k ) 2 (1 k )3 (1 k ) n
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
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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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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