Opportunity Cost, Profits, and Value

1. Opportunity Cost, Profits, and Value Shyam Sunder, Yale University National University of Colombia, Bogota August 16, 2005

2. An Overview • Opportunity costs is the concept of cost necessary for economic decisions • Explore its nature and measurement for different kinds of resources • Economic profit, the appropriate criterion for choice, depends on opportunity cost, and different from various agents • Value is the capitalization of profit • Value of the organization can be viewed as the some of the value generated for all participating agents Value of the Firm

3. What Is Opportunity Cost? • Sometimes it is easier to understand a concept starting out what it is not • Usually we think of costs as out-of-pocket costs • $1 (cost of a cup of coffee) • $20,000 (cost of a car) • At the time we make the decision to buy the cup of coffee or the car, this out-of-pocket cost is also (usually) the opportunity cost • With the passage of time, the two tend to diverge from each other Value of the Firm

4. Opportunity Costs • How are opportunity costs different from out-of-pocket costs? • Opportunity cost of choosing a decision (e.g., choosing A over B) is the sacrifice we make by not choosing B • Costs that were never, and would never, be incurred • Subjective, hypothetical (what might have been), speculative and uncertain, must be estimated • Opportunity cost has no existence apart from a decision problem • It is associated with the “road not taken” • Why should such costs count in our decisions? • Let us see a simple example Value of the Firm

5. Example of Opportunity Cost • An old painting bought for $5 • You plan to give it to a friend • Just before you give it to your friend, you find out that it is a rare painting by an old master which costs $5,000 • What is the cost of giving the painting to your friend? Value of the Firm

6. More Examples • Cost of material with no other use • Cost of material with other uses • Cost of material not yet bought • Interest on inventory • Cost of labor • Cost of capacity • Cost of excess capacity Value of the Firm

7. Decision with Opportunity Cost • Example illustrates that we can use one of two methods • Calculate the net benefit of each available option and pick the better one • Calculate the net benefit of one option, after subtracting the net benefit of the other option as the opportunity cost • If we calculate correctly, the decision would be the same from both methods of making decisions Value of the Firm

8. Opportunity Cost Illustration Value of the Firm

9. Contrast with Sunk Costs • One person buys a ticket to see the Olympics final of soccer for 200 dollars • A second person gets the ticket for free from a friend who has an emergency • Severe weather is predicted for the day of the game • Which person is more likely to attend the game? Why? Value of the Firm

10. Measuring Opportunity Costs In single person contexts, • use subjective or objective probability to model and solve the decision problem In multiperson contexts, • Absence of objective measures of opportunity costs exacerbates agency costs In either case, reduction in subjectivity of opportunity cost estimates may help make better decisions Perhaps we can use public information to reduce subjectivity in measured opportunity costs Value of the Firm

11. How resources behave with time may have to do with the problems of estimating opportunity costs • Cash, being a timeless resource, offers no problems (or perhaps merely because it is defined as the numeraire) • Let us explore the time dimension of resources Value of the Firm

12. How Do Resources Behave Over Time? • In acquisition • In expiration of their benefits • In consumption of their benefits Value of the Firm

13. Resources Vary in Their Lumpiness or Granularity Along All Three Dimensions • Let us look at their • Acquisition granularity • Expiration granularity • Consumption granularity Value of the Firm

14. Acquisition Granularity Three crude classes: • Low (electrical power, contract labor) • Acquisition and utilization are proximate • Not inventoried, JIT • Medium (groceries) • Economic order quantity (EOQ) Model • High (car, house, machinery and plant) • One-off Value of the Firm

15. Determinants of Acquisition Granularity • Transaction costs • Storage costs • Technology of supply Value of the Firm

16. Expiration Granularity • Same as storability • Low (highway sign, receptionist) • Medium (bag of sugar, fruit, car) • High (gold bar) • Note: Distinguish expiration granularity or storability from the rate of expiration of benefits Value of the Firm

17. Consumption Granularity(Closely linked to expiration granularity) • Extent of owner's control over the rate of extraction of benefits • Low (street sign, gold ring) • Medium (car) • High (sugar, production gold) Value of the Firm

18. Cross Tabulation Value of the Firm

19. Decisions • Consider a decision • List options • List resource consequences of options • For each resource, consider • Acquisition Granularity • If low, OC = purchase price • If high, consider expiration granularity of each relevant attribute of the resource Value of the Firm

20. Decisions (Continued) • Expiration granularity • If low, it is a pure capacity resource; Use time as the cost driver, • If high, consider consumption granularity of each attribute of the Value of the Firm

21. Decisions (Continued) • Consumption granularity • List driver for each attribute i • For each attribute/driver i calculate cost/unit ci • If a product consumes ui units of attribute i, cost of the resource assigned to the product = maxi (ciui) Value of the Firm

22. Example: Rental Car • Cost (net of salvage value) = $24,000 • Attribute 1: Time (Capacity 600 days) • Attribute 2: Mileage (Capacity 60,000 m) • Time Rate: $24,000/600 = $40 per day • Mil. Rate: $24,000/60,000 = $0.40 per m. • Cost of rental = max ($40.Days, $0.40. miles) Value of the Firm

23. Profits • Economic profit of an agent from a decision is the revenue less the opportunity cost of the decision • The profit from participation in an organization can be defined not only for the shareholders but for every participating agent • We can determine who gets how much profit and what is the total profit generated by an organization for all participants combined Value of the Firm

24. Neoclassical Firm • Firm is the instrument of the owner- entrepreneur • Every other agent gets the opportunity cost of the resource he/she contributes (i.e. no goodies) • All these factor markets are assumed to be perfectly competitive • All the surplus goes to the owner-entrepreneur • Value of the firm is the discounted present value of cash flows to the owner • IRR = O.C. of capital => zero value Value of the Firm

25. Contract or Organization Theory If the total surplus is negative the firm is infeasible; redesign the contracts or shut down • If the total surplus is zero, there is a unique distribution in which everyone gets zero surplus • If the total surplus is positive, there are multiple feasible allocations. There is no basis for choosing one allocation over another. Therefore, the distribution of surplus among agents is undetermined Value of the Firm

26. Firm as a Set of Contracts Value of the Firm

27. A Brief Detour • Am I talking about “social accounting?” • Yes, there are some common elements • But it differs in perspective • Let us do a brief overview of social accounting Value of the Firm

28. Social Accounting • Also called socioeconomic accounting, social responsibility accounting and social audit • Measure and report efforts, achievements and impact of firms on “social” dimensions • E.g., energy conservation, minority hiring, environmental preservation, support of community organizations (see Appendix A) • Often descriptive, may include financial and non-financial data Value of the Firm

29. Typical Elements of Social Accounts • A. Community Involvement: General philanthropy, Public and private transportation, Health services, Housing, Aid in personal and business problems, Community planning and improvement, Volunteer activities, Specialized food programs, Education, • B.Human Resources: Employment practices, Training programs, Promotion policies, Employment continuity, Remuneration, Working conditions, Drugs and alcohol, Job enrichment, Communications, • C. Physical Resources and Environmental Contributions: Air, Water, Sound, Solid waste, Use of scarce resources, Aesthetics • D. Product or Service Contributions: Labeling, Warranty, Responsiveness to consumer complaints, Consumer education, Product quality, Product safety, Advertising, Constructive research Value of the Firm

30. Examples of Social Accounting • Tradecraft, http://www.globalnet.co.uk/~traidcraft/sa9495/index.html • British Telecom, http://www.groupbt.com/society/index.htm • General Motors, http://www.gm.com/company/gmability/environment/env_annual_report/index.html • Intel http://www.intel.com/intel/finance/social.htm • United Airlines http://www.ual.com/site/primary/0,10017,1359,00.html Value of the Firm

31. Social Accounting Perspective • “Social” is construed narrowly, leaves out production, sale and distribution of goods and services, taken for granted • Managers responsible for preparing the social accounts • Information inherently dispersed • Uses perspective of the firm, not the members of society • Fuzzy image Value of the Firm

32. Profit/Value of the Firm • Extensive income as the sum of: • To the shareholders • To customers • To Vendors • To employees • To creditors • To government • To community, etc. • Inducement from the firm – O.C. of contributions Value of the Firm

33. Profit/Value to Investors • Residual income and corresponding shareholder value created • Focus of current financial reports • Apply similar perspective to other participants in the firm Value of the Firm

34. Profit/Value to Customers • Customer’s “investment” in the form in the form of search, learning, negotiation, payments, settlement of disputes • Expected PV of benefits from goods received should exceed the PV of investments • Includes immediate transaction as well as the consequences of the transaction for resource flows associated with any future transactions (reduction in time, cost, search etc. for later transactions) • In a perfect product market, consumer’s surplus from the firm is zero (may be +ve from industry) Value of the Firm

35. Value to Government • Various levels of government provide mostly non-priced services plus some priced goods • Resources from taxation • Value of the firm to the government from providing priced services is the same as for vendors • Value of the firm to the government from providing non-priced services is taxes plus fees minus O.C. of resources spent on providing services • Major challenge to put this in practice Value of the Firm

36. Value of the Firm to Community • Local, national and global • Most exchanges in form of externalities • Value of the firm to the community is the sum of net externalities plus the net payments Value of the Firm

37. Measurement of Profit/Value • J.M. Clark (1936): Three fundamental challenges to determining the value of private enterprise • Imperfect and incomplete markets • Fundamental values not as exact as market values • Fundamental concepts should be independent of specific institutions of exchange (generality) Value of the Firm

38. Markets and Value of the Firm • In a perfect market Law of one price holds, everyone gets the same price • Value to the supplier of factor is zero • Existence of value =>market imperfection • Perfection can be the tendency of markets under certain conditions, not the goal of any agent • Agents seek and create imperfections (specialization, differentiation, monopolies) • Value creation as a treadmill, not ski lift • Market frictions/trans. Costs create room for value Value of the Firm

39. Externalities in Value of the Firm • Difficult problems of measurement because there is no help from markets • Most organizations produce and consume public goods • Extensive concept of income includes the value of these benefits consumed and bestowed on the community Value of the Firm

40. Difficulties of Measuring Externalities • Example: Vans to transport employees from train station • Cost of service to the firm, and benefits of lowered costs of parking, absenteeism, morale, etc. • Employee savings: cash, time, fatigue, etc. best estimated by employees • Benefits to fellow commuters, local government, citizens • Lump together as community, apply social cost-benefit analysis to determine income to community • Sensitive to identity of preparer • Valuation: social rate of discount lower than private Value of the Firm

41. Implications: Mergers and Acquisitions • Extensive debates surrounding the consequences of corporate mergers and acquisitions • Empirical studies: Target firm shareholders gain, • Acquiring firm shareholders’ wealth effect not clear • Occasional attention to bondholders, and tax consequences • Effects on labor, customers, vendors, community rarely examined • What kind of policy decisions possible on the basis of shareholder value alone? Value of the Firm

42. Justification for Shareholder Value Criterion • Assume neoclassical model of the firm (all surplus always goes to the owner, income/value to all other agents is zero both before and after the event): no need to look at the effects on any other class of agents • Capital markets are said to be efficient, at least more perfect than other factor markets • Contradiction between the two assumptions Value of the Firm

43. Who Gets the Goodies? • Agents who transact in relatively perfect markets should get prices close to O.C. • U.S. capital markets said to be more perfect than others • Suppliers of capital should be expected to get close to their O.C. • Surplus/value of the firm should accrue mostly to agents who transact through less perfect markets • Yet, we assume that the surplus goes to the shareholders Value of the Firm

44. Contract Renegotiation • Shareholders have the only open-ended contract in the firm • All other contracts are periodically renegotiated; these agents try to capture a share of the surplus whenever possible • Short term contract agents have an option value that shareholders lack • Shareholders (as a group) and unvested pensioners cannot quit when faced with having to absorb negative surplus • Many mergers and acquisitions are followed by contract renegotiations Value of the Firm

45. Need Analysis of Extensive Income and Values • For policy, need analysis of income/values to all agents, not just shareholders • Given their long term inflexible contract, imperfections in corporate governance, they may not be able to capture all, or even most, of the ex post benefits of value-enhancing mergers and acquisitions • Possible leakage to other agents through market imperfections, holes in corporate governance when value is enhanced • Shareholders left holding the bag on depletion • Would not know without analysis of extensive income/value of the firm Value of the Firm

46. Shareholder Value As Guide for Accounting Policy • Event, ERC, Value-Relevance, R2 studies cited as justifications for accounting policy • What is the theoretical justification for using shareholder value for this purpose (other than neoclassical perspective) • Law of the Instrument (Kaplan): Use whatever data is available, extensive income/value measures unavailable Value of the Firm

47. Concluding Remarks • Neoclassical perspective is not useful for analyzing many accounting issues • Income and value concepts driven by this perspective have their limitations, and contradictions • For important classes of accounting matters, we may need extensive concepts of income and value • Lessons from national income accounting Value of the Firm

48. Thank you • The presentation will be available for downloading from • www.som.yale.edu/faculty/sunder • Please send your comments to • Shyam.Sunder@yale.edu Value of the Firm