2 - Goals of A Firm

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
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 Added®

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

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

The Firm
• Transaction costs are incurred when

entering into a contract
– Influences
• uncertainty
• frequency of recurrence
• asset specificity

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.)

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

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.

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.

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 firm’s goals.
Different goals can lead to very different managerial
decisions given the same, limited amount of resources.

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

Goals other than Profit
• Non-economic objectives
– Good work environment for employees
– Quality products and services for customers
– Good corporate citizenship and social

responsibility

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’.

– Two forces leading to satisficing

• position and power of stockholders
• position and power of management

• 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

• 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.

• Position and power of management
– high-level managers may own very little of the

firm’s stock
– managers tend to be more conservative—that is,
risk averse—than stockholders would be because
their jobs will most likely be safer if they turn in
a competent and steady, if unspectacular,
performance

• 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

• 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

• 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.

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.

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

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.

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

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 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

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

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’).

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.

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

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

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

Economic Profits
• Economic profits and accounting profits are

typically different
– accountants measure explicit incurred costs, as

allowed by GAAP
– accountants use historical cost

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.

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

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

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2 - Goals of A Firm

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Chapter 2

• The firm and resource allocation

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-2

• Understand the reasons for the existence of firms

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-3

• A firm is a collection of resources that is

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-4

• Why does a firm perform certain functions

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-5

• Transaction costs are incurred when

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-6

• Examples of transaction costs

– Offshoring to source consumer products

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-7

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-8

• Reshoring: Operations returning to the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-9

• Illustration: Coase and the Internet

– Ronald Coase wrote in 1937, pre-internet,

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-10

• Optimal decision is the one that brings the firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-11

– market share, growth rate

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-12

– Good work environment for employees

– Quality products and services for customers

– Good corporate citizenship and social

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-13

• Argument against companies not

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-14

– Two forces leading to satisficing

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-15

• Position and power of stockholders

Reasons for satisficing by companies

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-16

• Position and power of stockholders

– Stockholders are concerned with performance of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-17

• Position and power of management

– high-level managers may own very little of the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-18

• Position and power of management

– managers may be more interested in maximizing

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-19

• Arguments supporting the profit

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-20

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-21

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-22

• Future cash flows (Di) must be ‘discounted’

• The discount rate (k) is affected by risk

• Two major types of risk:

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-23

• Business risk involves variation in returns

All firms face business risk to varying degrees.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-24

• Financial risk concerns the variation in

– Leverage is the proportion of a company financed

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-25

• The present price of a firm’s stock should

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-26

• If the firm is assumed to have an infinitely

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2-27

• Given an infinitely lived firm whose dividends