1. What Should the Firm Do? CHAPTER 11
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2. Stakeholders and Shareholders
Firm’s objectives
Maximize shareholder value
May ignore important social issues
Other objectives?
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3. Business Insight. Who Does the Company Exist for,
Business Insight Who Does the Company Exist for, the Shareholders or the Stakeholders?
Companies should maintain dividend payments to stockholders
Even if it means the company has to lay off workers
Japan, 3% of managers agree
Germany, 41% agree
France, 40% agree
U.S. and U.K., 89% of managers agree
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4. Business Insight. Who Does the Company Exist for,
Business Insight Who Does the Company Exist for, the Shareholders or the Stakeholders?
A company exists for all stakeholders
Japan, 97% agree
Germany, 83% agree
France, 78% agree
U.S., 76% agree
U.K., 71% agree
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5. Maximizing the Power of the Firm
Value maximization
Manager should make all decisions
To increase the long-run market value of the firm
Maximize the sum of the value of all financial claims on the firm
Adding value
Produce an output
That is valued by customers
At more than the value of the inputs
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6. Maximizing the Power of the Firm
Value maximization
Benefits society - voluntary transactions
Inputs
Owners of inputs value them less than or equal to the price at which the firm buys them
Opportunity cost to society of those inputs
Is no higher than the total cost to the firm
Goods and services produced by the firm
Their value is at least as great as the price the firm receives from their sale
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7. Stakeholder Theory Has to Be to Maximize Profit
A firm most benefits society
By focusing on maximizing shareholder value or profit
Counterintuitive
Firm has to maximize value to all stakeholders
Firm maximizing profit - will not care if it harms employees, consumers, communities, or the environment
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8. Stakeholder Theory CSR
Make firms responsible for the social costs and benefits of economic change
Encourage corporations to be more employee-sensitive
Reward: reduction of corporate taxes
Punishment: extra taxes
Problems: trade-off
Maximize current profits, market share, future growth in profits, employee health and safety, and benefits for the local community
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9. Stakeholder Theory Firm - must maximize the value it adds to resources
Maximizing: shareholder value, profit, value added
Objective of business: create value
Managers - respond to all stakeholders:
Spend an additional dollar of resources
To satisfy the desires of each constituency
As long as consumers value the result at more than a dollar
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10. An Illustration of Profit Maximization
Maximize profit: MR = MC
Marginal cost (MC)
Additional cost of producing one more unit of output
Value of resources needed to produce one more unit
Marginal revenue (MR)
Additional revenue obtained from selling one more unit of output
Value society places on one more unit
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11. An Illustration of Profit Maximization
If MR>MC
Producing and selling more will increase profit
If MR<MC
Producing and selling more will lower profit
Maximize profit
When the quantity offered for sale creates MR = MC
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12. Table 11.1 Profit Maximization
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13. An Illustration of Profit Maximization
Problems
MR and MC are typically not known
Managers do not even think of marginal costs and revenues
Accountants do not provide marginal cost information
Executives say they pay no attention to marginal cost or marginal revenue
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14. An Illustration of Profit Maximization
MR and MC
Come into play in the managers’ decisions
Spend an additional dollar on any activity as long as consumers value the result at more than a dollar
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15. Competition and Price Competition Search for profit
Drives out inefficiency
Ensures that resources are allocated to their highest valued uses
To make and sustain profit
Build a better product; continually improve it
Learning process
Come up with the next great thing, the next innovation or technological change
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16. Competition and Price Market power Monopoly – single supplier
Higher profits
Monopoly – single supplier
Rent seeking – government
Created and sustained by the government
Patents
Licenses
Cost conditions – natural monopoly
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17. Competition and Price Differentiation and Market power
Higher profits
Product differentiation
Create a special attribute
Brand name or reputation
Promotion, placement, and packaging
Guarantees and warranties
Reduce the consumers’ costs of gathering information
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18. Exit Negative economic profit Firm - inefficient decisions
Firm - fails to match the efficiencies of other firms
In short-run
Continue operating until it is able to liquidate
Temporarily close down
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19. Exit Monopolist - negative economic profit Fixed costs Variable costs
Government subsidy
Temporarily shut down
Go out of business entirely
Fixed costs
Costs that do not vary as output changes
Variable costs
Costs that vary as output varies
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20. Table 11.2 Temporary Closures
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21. Value over Time Maximize profit Allocate resources to an activity
Only if the value society places on the activity exceeds the costs
Continue to expand purchases of inputs and sell the resulting outputs
As long as an additional dollar of inputs generates sales of at least a dollar
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22. Value over Time Future value = $1 × (1 + r) Present value = $1/(1 + r)
Value one year from now
Of a dollar saved today
For use one year from now
where r is the interest rate
Present value = $1/(1 + r)
Value today
Of a dollar of resources
To be received one year from now
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23. Value over Time Firm Risk
Maximize the present value of its expected profits
Risk
Financial markets - buy and sell risk at a given price
Risk adjusted interest rate
To calculate the present value of risky claims
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24. The Abnormal Net Income Model
Normal profit
Zero economic profit
Revenue = total opportunity cost
Abnormal profit
Positive economic profit
Revenue > total opportunity cost
Positive economic profit above normal profit
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25. The Abnormal Net Income Model
The market value of a firm
Is its book value (the current stockholder’s equity)
Plus the present value of economic profits expected to be earned in the future
P0 = current book value + present value of expected economic profits
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26. The Abnormal Net Income Model
Expected economic profits
Next year’s expected accounting profit in excess of the cost of capital
Abnormal net income next year
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27. The Abnormal Net Income Model
The Value of a Firm
Amount that owners would pay to keep ownership
Amount that new owners would pay to acquire ownership
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28. The Abnormal Net Income Model
Value of a Publicly held firm
Its market capitalization
Value per share
Multiplied by the number of shares of stock that are outstanding
Value of a Privately held company
At minimum: its liquidation value
Value of a firm’s assets when they are dismantled and sold
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29. The Abnormal Net Income Model
Economic profit & stock price performance – relationship?
Yes - Abnormal Net Income model
No - stock prices
Stock prices gains in one given year
Above the market average
Or below the market average
Snapshot at that year’s profits
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30. The Abnormal Net Income Model
Economic profit over several years
Great picture of performance
Present value of all expected future economic profits
Whether a company creates or destroys wealth
“Maximizing shareholder value”
Focus on short-term profits even at the expense of long-run losses
Incorrect!
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31. The Abnormal Net Income Model
Short Termism
Focusing on short-term results at the expense of long-term results
Drive the shareholder value down, not up
Short-term stock performance would be low
Reflecting the long-term prospects of the firm
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32. The Abnormal Net Income Model
Shareholder value
Reflection of the current and expected future economic profits of a firm
Stock price reflects the expected economic profit stream
Maximizing shareholder value = maximizing economic profit
Focus on long-term performance
Attempt to maximize the difference between net earnings and the cost of capital
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33. The Abnormal Net Income Model
Stock price
Demand for and supply of shares of that stock
Valuation of the price of the stock – based on expectations of future firm performance
Demanders and suppliers
Different viewpoints about the movement of the stock price
Different objectives for owning stock
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34. The Abnormal Net Income Model
Changes in stock price
Revisions of expectations
Expectations of future net income rise
When expectations of future net income rise
Market value declines
When the cost of capital, r, rises
Stock price rises
When expectations are revised upward
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35. The Abnormal Net Income Model
Abnormal profits
How long can they be maintained?
Depends on how fast competitors come on line to drive economic profit to zero
Decay rate
Speed at which abnormal net income is driven to zero
Rate at which entrepreneurs are able to innovate or otherwise compete with the firm
Defined by the competitive conditions
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