Theory of Firms

Objectives to study The theory of firms

• We want to understand how the firms make economic
decisions.
• By economic decisions we mean how much to produce, how to
minimize costs, or maximize revenue or profit.
• Much of the Firm behavior depends on the market structure within
which the firm operates. Market Structure?
Goals of a firm
• Standard Economic Theory of the Firms assumes that firm behavior is guided by the firm’s goal to
maximize profit.
• Profit maximization involves determining the level of output that the firm should produce to make profit
as large as possible. Profit maximization/Wealth maximization objective becomes loss minimization
when firms incur losses. Or invest in the projects to generate maximum additional value for the
stakeholders.
• Usually, Investment is not a one-period activity. It spans across multiple periods. So as rational economic
decision makers, we should see the total profitability of the project.
• This process involves the concept of time-value of money.
• Time-value of money is the process of finding value of the project’s future cash flows in present value of
money.
Other Goals
• Revenue Maximization: the separation of firm management from firm ownership,
which increasingly dominates businesses organization, has meat that firm’s
objective have changed. Whereas profit maximization may be the dominant
motive of the traditional owner-managed firm, firms managers who are hired by
the owners to perform management task may be more interested in increasing
sales and maximizing revenue that arise from larger quantities sold.
• Satisficing: Henry Simon argued that the large modern firms cannot be views as a
single entity with single maximizing objective; instead, it is composed of many
separate units within the firm, each with its own objective which may overlap or
may conflict. This multiplicity of objectives does not allow the firms to pursue any
kind of maximizing behavior. Firms therefore try to establish processes through
which they can make compromises and reconcile to arrive at agreements, the
result of which is the pursuit of many objectives that are placed in hierarchy. This
behavior is termed as satisficing by Simon. In short, firms try to achieve
satisfactory rather than optimal or best results.
Time Value of Money
• We need to understand following 3 concepts
• Simple Interest
• Compound Interest
• Discounting
• Compounding
• Annuities
Basic Equation
• Simple Interest = Principal amount x Interest rate x number of periods
• Simple Interest = PV + PV i N = PV(1+iN)
• Compound Interest
• Future Value = Present Value + Interest
• FV =PV (1+i)n
• PV = FV/ (1+i)n
• Frequency of Compounding-> Always remember: Interest rates are
always stated on annual basis.
Example 1
• Suppose you are faced with a choice between two accounts, Account
A and Account B. Account A provides 5 % interest, compounded
annually and Account B provides 5.25% simple interest. Consider a
deposit of $10,000 today. Which account provides the highest balance
at the end of 4 years?
• Account A: $12,155.06
• Account B: 12,100
Example 2
• Suppose you invest $20,000 in an account that pays 12% interest,
compounded monthly. How much do you have in the account at the
end of 5 years?
• N= 5
• I = 12%/12 =1%
• FV =20,000 (1+0.01)60 =36,333.93
Example 3
• Suppose you want to have $20,000 saved by the end of five years. And
suppose you deposit funds today in account that pays 4%, compounded
annually. How much must you deposit today to meet your goals?
• PV =$16,438.54
• How much would you have to deposit today in an account that pays 4%
annual interest, compounded quarterly, if you wish to have a balance of
$100,000 at the end of 10 years?
• i= 4%/4 = 1%
• PV = $67,165.31
Valuing a series of cashflows
• Suppose you deposit $100 today, $200 one year from today, and
$300 two years from today, in an account that pays 4% interest,
compounded annually.
• 1. what is the balance in the account at the end of two years?
• 2. what is the balance in the account at the end of three years?
• 3. what is the present value of these deposits?
Answer
• 1. FV = $100(1+0.4)2 +$200(1.04) + $300 = $616.16
• 2. FV = $100(1+0.4)3 + $200(1.04)2 + $300(1.04) =$640.81
• 3. PV =$100 + $200/(10.4) + $300/(1.04)2 =$569.68
• Annuity is a series of even cashflows.
• PV =CF (1 – (1+i)n/i)
Example
• Consider a four-payment annuity in which the payment is $5,000 and
the interest rate is 5% compounded annually
• What is the present value of this annuity?
• What is the future value of this annuity?
• PV =$8,662.76 [ N=4, I% = 5, FV = 0, PMT= 5000, PV =?]
• FV = $10,936.54 [ N=4, I% =5, PV =0, PMT =5000, FV =?]
Investment Criteria
• NPV
• IRR
• Profitability Index
• Payback Period
NPV (Net Present Value)
Internal rate of return
Procedure to find IRR
• Low rate + (NPV at low rate/ NPV low +NPV high)*difference in rates
Value of the Firms
• Sum of present value of all expected future cash flows
• Opportunity cost: Firms perceived risk and cost of borrowing funds