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The Firm and Its Goals

Learning Objectives. Understand reasons for existence of firms and meaning of transaction costsExplain economic goals and optimal decision makingDescribe meaning of principal-agent" problemDistinguish between profit maximization" and shareholder wealth maximization"Demonstrate usefulness of M

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The Firm and Its Goals

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    2. 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

    3. 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

    4. 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.

    5. 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

    6. 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, non-core activities

    7. Economic Goal of the Firm Primary objective of the firm (to economists) is to maximize profits. Profit maximization hypothesis Other goals include market share, revenue growth, and shareholder value Optimal decision is the one that brings the firm closest to its goal.

    8. 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

    9. Goals Other Than Profit Economic Goals Market share, Growth rate Profit margin Return on investment, Return on assets Technological advancement Customer satisfaction Shareholder value

    10. Goals Other Than Profit Non-economic Objectives Good work environment Quality products and services Corporate citizenship, social responsibility

    11. 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 management

    12. 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 Shareholders diversify holdings in many firms Shareholders are concerned with performance of entire portfolio and not individual stocks.

    13. Do Companies Maximize Profit? Position and power of stockholders Most stockholders are not well informed on how well a corporation can do and thus are not capable of determining the effectiveness of management. Not likely to take any action as long as they are earning a “satisfactory” return on their investment.

    14. 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 company’s stock. Managers tend to be more conservative because jobs will likely be safe if performance is steady, not spectacular.

    15. Do Companies Maximize Profit? Position and power of professional management 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 “principal-agent” problem or “agency problem”

    16. Do Companies Maximize Profit? Counter-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 company’s 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.

    17. 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.

    18. Maximizing the Wealth of Stockholders Future cash flows must be discounted to the present. The discount rate is affected by risk. Two major types of risk:

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