Transcript Slide 1
WHY DO SOME FIRMS SUCCEED?
• Why do some firms succeed and others fail? Possible explanations
include• Luck. How does this help us understand decision-making?
• Quality. Are all improvements in quality good for business?
• First Mover. Are there advantages to going second?
• Size and Market Share. Market share and profits are positively
related, although the relationship is not perfect.
• Mergers and Acquisitions. 57% of merged firms lagged behind
their industries in terms of total returns to shareholders three years
after the merger. Over a twenty-five year period nearly half of all
acquisitions are subsequently divested.
• Globalization. Are world markets eventually going to converge?
• Leadership. Is success due to a charismatic personality or
visionary leader, or is it independent of the person in charge?
MANAGEMENT AND
ECONOMICS
•There is no formula that
guarantees success in
business!!!
•Why?
•What can we do? We can
teach how to make good
decisions.
WHY IS ECONOMICS NOT
EMPLOYED BY PEOPLE IN BUSINESS?
• The value of economics is not well understood,
because economics is not well understood.
• As a consequence, business often falls prey to
consultants and gurus. These people often
provide simple answers to complex problems
• Examples:
• Know your Customer: Should the customer always be
number 1?
• Total Quality Management: Should a firm always adopt
improvements in quality?
THE STUDY OF MANAGERIAL
ECONOMICS
• What is economic decision making?
• Cost-Benefit Analysis (CBA): Comparing the
costs and benefits of each decision.
• Managerial gurus often promise something
for nothing. Economics teaches that this is
not possible. To make good decisions one
must recognize both the costs and benefits of
each decision.
• This is an old saying… “TO EVERY PROBLEM THERE IS A SIMPLE
ANSWER THAT IS BOTH EASILY UNDERSTOOD AND COMPLETELY
WRONG!!!”
SUMMARIZING MANAGERIAL
ECONOMICS
• Managerial Economics is the study of business
decision making and strategy.
• The study of managerial economics helps
managers recognize how economic forces affect
organizations and describes the economic
consequences
• Management is about making choices.
• Choice is selecting one thing or one use of
resources over other things or other uses.
• There is no single formula for success. There is no
quick and easy solution to business problems.
OBJECTIVE OF THE FIRM
•Firms Seek to Maximize
Profits!
•But What about Ethics?
BASIC BUSINESS ETHICS
• Why are Ethics Important?
• Basic Ethics
• Keep your word
• Accept responsibility
• Work with people (not off of people)
• Decision-making requires that we make predictions.
Unethical behavior reduces are ability to forecast the
future.
MAXIMIZING PROFITS
Profit maximization: The problem with this objective is that it is
vague. A firm can maximize profit yet still not be adding
value.
Added Value – Excess of revenues over the cost of all
resources.
If a firm fails to add value it cannot exist in the long-run.
Economic Profit = Total Revenue – Explicit Cost – Implicit Cost
Accounting Profit = Total Revenue – Explicit Cost
ECONOMIC PROFIT
Positive Economic Profit = Total revenue exceeds the value of both implicit
and explicit costs.
a firm who is creating more value from its resources than those resource could
generate in an alternative employment.
Negative Economic Profit = Total revenue is less than the value of both
implicit and explicit costs.
a firm who is creating less value from its resources than those resource could
generate in an alternative employment.
Zero Economic Profit = Total revenue equals the value of implicit and
explicit costs.
Zero economic profit = Normal accounting profit
If a market is competitive we expect all firms to earn normal economic profits.
ECONOMIC VALUE ADDED
What if you don’t learn the lessons we teach in the course?
Stern Stewart and Company
Problem - Capital financed with equity is frequently regarded
as free. It may be free to the firm but it is not to the
shareholders.
Terms
NOPAT = Net Operating Profit After Tax
WACC = Weighted Average Cost of Capital
Economic Value Added = Economic Profit
EVA = NOPAT – WACC*Capital
EVA EXAMPLE
After-tax Profit = $8 million (ignoring the cost of debt or interest payments)
Capital = $100 million
50% is financed through equity - @ 15%
50% is financed through debt - @ 5%
15% return on equity is determined by stockholder (owner) expectation
which in turn is determined by the risk of the firm.
Weighted average cost of capital = .50*15 + .50*5 = 10%
Cost of capital = $100 million * 10% = $10 million
EVA = -$2 million
Debt is paid $2.5 million ($50 million * 5%)
Stockholders demand $7.5 million ($50 million * 15%) but only receive
$5.5 million.
EVA LESSONS
If EVA is negative, stockholders might sell the stock, hence driving
down its price. This will signal the firm that its performance is
below expectations. Furthermore, future stock issues may be
difficult, hindering firm growth.
Stockholder opportunity cost (the return they could receive for their
financial resources) is going to drive their response to the
companies performance.
If the company does not consider the opportunity cost of their
capital (the return the capital could generate in alternative uses)
they will not maximize the return the firm could be receiving.
STOCK PRICES AND EVA
What determines the value of a firm’s stock?
Current measures of EVA are only important if it tells
us about the future.
Stock Price = Present Value of Expected Future
Economic Profit
P = Σ[(Economic Profit)/(1+r)i]
P = stock price
r = cost of capital (WACC)
Why do stock prices rise and fall? Investors revise
expectations
Variability of Business Profits
• Profit margin = accounting net income divided by
sales or profit as a percentage of sales revenue
• Return on Stockholders’ Equity = accounting net
income divided by the book value of total assets
minus total liabilities
Why Profits Vary
• Frictional Profit Theory (focus on changing demand
and cost conditions)
• Monopoly Profit Theory
• Innovation Profit Theory
• Compensatory Profit Theory (focus on efficiency)