Chapter 2:

The Firm and Its Goals

The Firm and Its Goals

The Firm
Economic Goal of the Firm
Goals Other Than Profit
Do Companies Maximize Profits?
Maximizing the Wealth of
Stockholders
Economic Profits

Learning Objectives
Understand reasons for existence of firms
and meaning of transaction costs
Explain economic goals and optimal
decision making
Describe meaning of principal-agent
problem
Distinguish between profit maximization
and shareholder wealth maximization
Demonstrate 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.

The Firm
Transaction costs are incurred when
entering into a contract.
Types of transaction costs

Investigation
Negotiation
Enforcing contract and coordinating
transactions

Influences

Uncertainty
Frequency of recurrence
Asset specificity
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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 minimum
Outsourcing of
peripheral, noncore activities

Economic Goal of the Firm

Primary objective of the firm (to
economists) is to maximize profits.
Profit maximization hypothesis

Optimal decision is the one that

brings the firm closest to its goal.

Economic Goal of the Firm

Short-run vs. Long-run
Nothing to do directly with calendar time
Short-run: firm can vary amount of some
resources but not others
Long-run: firm can vary amount of all
resources
At times short-run profitability will be
sacrificed for long-run purposes

Goals Other Than Profit

Economic Goals
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
Quality products and services
Corporate citizenship, social
responsibility

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Do Companies Maximize
Profit?
Criticism: Companies do not
maximize profits but instead their
aim is to satisfice.
Satisfice is to achieve a set goal, even
though that goal may not require the
firm to do its best.
Two components to satisficing:
Position and power of stockholders
Position and power of professional

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Do Companies Maximize
Profit?
Position and power of stockholders
Medium-sized or large corporations are owned
by thousands of shareholders
Shareholders own only minute interests in the
firm and diversify holdings in many firms
Shareholders are concerned with performance
of entire portfolio and not individual stocks.
Not likely to take any action as long as they are
earning a satisfactory return on their
investment.
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Do Companies Maximize
Profit?
Position and power of professional management
High-level managers who are responsible for major
decision making may own very little of the
companys stock.
Managers tend to be more conservative because
jobs will likely be safe if performance is steady, not
spectacular.
Management incentives may be misaligned
E.g. incentive for revenue growth, not profits
Managers may be more interested in maximizing own
income and perks

Divergence of objectives is known as principalagent problem or agency problem

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Do Companies Maximize
Profit?
Arguments which support the profit
maximization hypothesis.
Large number of shares is owned by
institutions (mutual funds, banks, etc.) utilizing
analysts to judge the prospects of a company.
Stock prices are a reflection of a companys
profitability. If managers do not seek to
maximize profits, stock prices fall and firms are
subject to takeover bids and proxy fights.
The compensation of many executives is tied
to stock price.
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Wealth Maximization

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Maximizing the Wealth

of Stockholders
Views the firm from the perspective of a
stream of earnings over time, i.e., a cash
flow.
Must include the concept of the time
value of money.
Dollars earned in the future are worth less
than dollars earned today.
Future cash flows must be discounted to the
present.
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Maximizing the Wealth

of Stockholders
The discount rate 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 )

D3

Dn

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

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
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.

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Economic Profits
Economic profits and accounting
profits are typically different.
Economists are more concerned with
opportunity costs or alternative costs
Accounting treatments allowed by GAAP

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Economic Profits
Historical costs vs. replacement costs
Implicit costs and normal profits

Return required by scarce resources to remain

committed to a particular firm

Economic costs include historical and explicit

costs (accounting) as well as replacement
and implicit costs
Economic profits is total revenue minus all
economic costs
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Copyrights Keat and Young

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