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)