Ch 02 the Firm and Its Goals - Revised

Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*OverviewThe firmEconomic goal of the firmGoals other than profitDo companies maximize profits?Maximizing the wealth of stockholdersEconomic profit


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Learning objectives

understand the rationale for existence of firms

explain economic goals and optimal decision making

describe the principal-agent problem


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Learning objectives

distinguish between profit maximization and shareholder wealth maximization

apply Market Value Added and Economic Value Added


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*The Firm

A firm is a collection of resources that are transformed into products demanded by consumers. The firm is the producing unit.

Profit is the difference between revenue received and costs incurred over a specific period of time.



Transaction costs are incurred when entering into a contract

types of transaction costsinvestigationnegotiationenforcing contractsThese costs are related to the Principal Agent transactions.



Transaction costs are incurred when entering into (or preparing to enter into) a contractThey are influenced by:Uncertainty of contract outcomesfrequency of recurrence of contractspecificity of some assets in an economic activity => opportunistic behavior.


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*The FirmLimits 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


Homework Questions What is meant by the concept of trade-off between transactions cost and operating cost? How can the outsourcing and the offshore sourcing be examples of minimizing the total transactions costs and operating costs? Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Economic goal of the firmProfit 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


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Economic goal of the firmShort-run versus Long-run

nothing to do directly with calendar timeshort-run: firm can vary amount of some resources but not otherslong-run: firm can vary amount of all resourcesat times short-run profitability will be sacrificed for long-run purposes


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Goals other than profitEconomic goalsmarket share, growth rateprofit marginreturn on investment, return on assetstechnological advancementcustomer satisfactionshareholder valuethis may assure the importance of profit maximization hypothesis.


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Goals other than profitNon-economic objectives

good work environment

quality products and services

corporate citizenship, social responsibility


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Do companies maximize profit?Criticism: companies do not maximize profits but instead merely aim to satisfice, which means to achieve a satisfactory goal, one that may not require the firm to do its best

two forces affect satisficing:position and power of stockholdersposition and power of management


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Do companies maximize profit?

Position and power of stockholders

larger firms are owned by thousands of shareholdersshareholders own only minute interests in the firm ... and hold diversified holdings in many other firms


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Do companies maximize profit?Position and power of stockholders

shareholders are concerned with performance of entire portfolio and not individual stocksless informed about the firm than management

stockholders not likely to take any action if earning a satisfactory return


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Do companies maximize profit?Position and power of management

high-level managers may own very little of the firms stockmanagers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Do companies maximize profit?Position and power of management

managers may be more interested in maximizing own income and perksmanagement incentives may be misaligned (e.g. revenue not profits)

divergence of objectives is known as principal-agent problem


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Do companies maximize profit?Counter-arguments which support the profit maximization hypothesis

large stockholdings held by institutions (mutual funds, banks, etc.) scrutiny by professional analystsstockmarket discipline if managers do not seek to maximize profits, firms face threat of takeoverincentive effect the compensation of many executives is tied to stock price


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Maximizing the wealth of stockholdersViews 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: meaning that a dollar earned in the future is worth less than a dollar earned today


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Maximizing the wealth of stockholdersFuture 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


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*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


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*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


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Maximizing the wealth of stockholdersThe present price of a firms 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


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Economic profitsEconomic profits and accounting profits are typically different

accountants measure explicit incurred costs.

accountants use historical cost of machines


Chapter TwoCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.*Economic profitsEconomists are concerned with explicit and implicit costs, called opportunity costs

Accordingly, economists use replacement cost of machines economic costs include historical and explicit (accounting) costs as well as replacement and implicit (economic) costs economic profit is total revenue minus all economic costs


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Ch 02 the Firm and Its Goals - Revised