Economics and Managerial Decision Making

Management is the discipline of organizing and allocating a firm’s scarce resources to achieve
its desired objectives.

Introduction

• Economics and Managerial Decision Making

• The Economics of a Business

• Review of Economic Terms

Economics is “the study of the behavior of human beings in producing, distributing and
consuming material goods and services in a world of scarce resources.” (McConnell, 1993)

Management is the discipline of organizing and allocating a firm’s scarce resources to achieve
its desired objectives.

Managerial economics is the use of economic analysis to make business decisions involving the
best use (allocation) of an organization’s scarce resources.

• Questions that managers must answer:

1. What are the economic conditions in a particular market?

• Market Structure?

• Supply and Demand Conditions?

• Technology?

• Government Regulations?

• International Dimensions?

• Future Conditions?

• Macroeconomic Factors?

2. Should our firm be in this business?

3. If so, what price and output levels achieve our goals?

4. How can we maintain a competitive advantage over our competitors?

• Cost-leader?

• Product Differentiation?
 • Market Niche?

• Outsourcing, alliances, mergers, acquisitions?

• International Dimensions?

5. What are the risks involved?

Risk is the chance or possibility that actual future outcomes will differ from those expected
today.

a. Types of risk

• Changes in demand and supply conditions

• Technological changes and the effect of competition

• Changes in interest rates and inflation rates

• Exchange rates for companies engaged in international trade

• Political risk for companies with foreign operations

The Economics of a Business

The economics of a business refers to the key factors that affect the ability of a firm to earn
an acceptable rate of return on its owners’ investment.

• The most important of these factors are:

a. competition

b. technology

c. customers

Four Stage Model of Change

Stage I

• “the good old days”

• high profit margins

• cost plus

Stage II

• cost management
 • cost cutting, downsizing, restructuring

Stage III

• limits to the growth in profits

• revenue management

• “top-line growth”

Stage IV

• revenue plus

Review of Economic Terms

Microeconomics is the study of individual consumers and producers in specific markets.

• supply and demand

• pricing of output

• production processes

• cost structure

• distribution

Macroeconomics is the study of the aggregate economy.

• national income analysis

• gross domestic product

• unemployment

• inflation

• fiscal policy

• monetary policy

Scarcity is the condition in which resources are not available to satisfy all the needs and wants
of a specified group of people.

Opportunity cost is the amount or subjective value that must be sacrificed in choosing one
activity over the next-best alternative.
 • Because of scarcity, an allocation decision must be made. The allocation decision of a
society is comprised of three separate choices:

• What and how many goods and services should be produced?

• How should these goods and services be produced?

• For whom should these goods and services be produced?

• For the firm, these allocation choices can be restated as follows:

• What : The product decision.

• How : The hiring, staffing, procurement, and capital budgeting decisions.

• For whom : The market segmentation decision.

Resources

• Factors of production or inputs

• Land, labor, capital, entrepreneurship

Entrepreneurship is the willingness to take certain risks in the pursuit of goals.

Management is the ability to organize and administer various tasks in pursuit of certain
objectives.
 CHAPTER 2: The Firm and Its Goals

• The Firm

• The Goal of the Firm

• Do Companies Maximize Profits?

• Maximizing the Wealth of Stockholders

• Economic Profits

The Firm

A firm is a collection of resources that is transformed into products demanded by consumers.

It is the aim of the firm to MAXIMIZE PROFIT.

• The firm deals with internal costs and transaction costs.

a. transactions costs
• contracting and enforcement costs
• uncertainty
• frequency of transaction
• Explicit contracts
• asset-specificity
• opportunistic behavior

When transaction costs are very high, a company may choose to provide the product or
the service itself. Thus, the firm incurs internal costs.

b. Internal Costs
• Hiring and staffing
• Monitoring costs- Those who work with a fixed salary may have less
incentive to work efficiently

How to decrease monitoring costs?

1. Use incentives to increase outputs of employees

2. Bonuses
3. Benefits
4. Peks
5. Stock options
The Goal of the Firm

Throughout the text we will assume that the goal of the firm is to maximize profits.

 profit-maximization hypothesis

What is profit?

 revenue minus cost

Other goals that the firm might pursue:

 Economic Objectives

• market share

• profit margin

• return on investment

• technological advancement

• customer satisfaction

• shareholder value

 Noneconomic Objectives

• workplace environment

• product quality

• service to community

Knowing the firm’s goals allows the manager to make effective decisions

How might different goals lead to different decisions by the firm?

Do Companies Maximize Profit?

Criticism: Companies do not maximize profits but instead their aim is to “satisfice.”

Two components to criticism:

• Position and power of stockholders

• Position and power of professional management

Position and power of stockholders

• Medium-sized or large corporations are owned by thousands of shareholders who

may own only minute interests in the firm, and, in addition, own interests in an
entire portfolio of firms.

• Shareholders are concerned with performance of entire portfolio and not

individual stocks.

• 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.

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 follow their own objectives rather than those of the stockholders.

• Concern over job security may lead them to be too conservative and
instead pursue a steady performance.

• Management compensation may be based on some measure other than

profits.

Counter-arguments which support the profit maximization hypothesis.

• 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.

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.

Future cash flows must be “discounted” to the present.

The discount rate is affected by risk.

Two major types of risk:

• Business Risk

• Financial Risk

Business risk involves variation in returns due to the ups and downs of the economy, the
industry, and the firm. All firms face business risk to varying degrees.

Financial Risk concerns the variation in returns that is induced by leverage.

Leverage is the proportion of a company financed by debt.The higher the leverage, the greater
the potential fluctuations in stockholder earnings. Financial risk is directly related to the degree
of leverage.

The present price of a firm’s stock should reflect the discounted value of the expected future cash
flows.

• If the firm is assumed to have an infinitely long life, the price of a share of stock which
earns a dividend D per year is determined by the equation

P = D/k

Stock Price = P100

D = P10/share

n=infinite

k = 8%

Stock Price = P85

D = P5/share

n = infinite

k = 8%
 • Given an infinitely lived firm whose dividends grow at a constant rate (g) each year, the
equation for the stock price becomes

P = D1/(k-g)

where D1 is the dividend to be paid during the coming year.

Stock price = P50

n = infinite

D = P4/share

k = 10%

g = 4%

D1 = d x (1+g)

Stock Price = P110

n = infinite

D = P11/share

k = 12%

g = 4%

Under this framework, maximizing the wealth of the shareholder means that a company
tries to manage its business in such a way that the dividends over time paid from its earnings and
the risk incurred to bring about the stream of dividends always create the highest price for the
company’s stock.

• The equation for a company’s stock price shows us how the price is affected by changes
in the parameters.

P = D1/(k-g)

• How is the stock price affected by:

• changes in the size of the dividend?

• changes in the growth of dividends?

• changes in the risk faced by the firm?

• The total value of the company’s common equity is determined by multiplying the firm’s
stock price by the number of shares outstanding.

• Another measure of the wealth of stockholders is called Market Value Added (MVA)®

• MVA represents the difference between the market value of the company and the capital
that the investors have paid into the company.

• MVA includes adjustments for accumulated R&D and goodwill.

• While the market value of the company will always be positive, MVA may be positive or
negative.

• If MVA is positive, the firm has added value. If it is negative, the firm has destroyed
value.

• Increasing MVA or increasing shareholder wealth is the primary goal of any business and
the reason for its existence.

• For example, if bondholders and shareholders have contributed P1,000,000 to form

Company X and during its existence since inception and it is currently listed on the stock
exchange with a stock market value of P2,000,000, it can be said that the MVA of the
company is P1,000,000.

• This measures the performance of management. It also reflects the general market.
Management has a part in it but not entirely.

• In a bull stock market, the amount contributed by management may even be negative, but
the overall market may be driving the MVA into positive territory.

• MVA is not a performance metric like EVA, but instead is a wealth metric, measuring the
level of value a company has accumulated over time.

• As a company performs well over time, it will retain earnings. This will improve the
book value of the company's shares, and investors will likely bid up the prices of those
shares in expectation of future earnings, causing the company's market value to rise.

• The difference between the company's market value and the capital contributed by
investors (its MVA) represents the excess price tag the market assigns to the company as
a result of its past operating successes.

• To get MVA

(Price per share x shares outstanding) =MV of equity

Less: (BV of equity)

 MVA

Test I. Compute for the PV of inflow and decide whether or not you will invest on the business.

D = 50 , k= 11%, stock price: 250

• MVA = MV of equity less BV

• MV = Market price of stock x shares outstanding

• BV = Book value x shares outstanding

Another measure of the wealth of stockholders is called Economic Value Added (EVA)®

• EVA is calculated as

• EVA=(Return on Total Capital – Cost of Capital)

•Total Capital

If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder
wealth is being destroyed.

A company's after-tax earnings less its opportunity cost. The economic value-added measure is a
metric of how well it has performed over a given period of time compared to how it could have
performed.

EVA = NOPAT – Cost of capital

NOPAT = EBIT x (1-tax %)

Cost of Capital = Total investment supplied on operation x After tax cost of capital

• Total Investment Supplied on Operation = Total Liabilities and Equity – Accounts

Payable and accruals

Assets = P 5,000,000

Current Liability = P 700,000

Non-current Liability= P1,300,000

Equity = 3,000,000

WACC = 15%
Income statement

Sales P 4,000,000

COS 2,000,000

G. Profit 2,000,000

S and Ad 1,000,000

EBIT 1,000,000

Interest ( 200,000)

EBT 800,000

Tax 40%

The company’s Gross Profit is P700, 000. The selling and admin expenses from 20% of the
Gross Profit, while interest is 10% of the non-current liability. Tax is 40%.

Before-tax cost of capital= 12.5%

Non-current liability = P500,000

Owner’s equity = P 1,700,000

Economic Profits

• Economic profits equal revenue minus economic cost.

• Economic costs and accounting costs differ.

• Accounting costs are based on historical costs.

• Economic costs are based on replacement costs and also include opportunity costs.

• Normal Profit is the amount of profit that is equal to the profit that could be earned in
the firm’s next best alternative activity.

• It is the minimum profit necessary to keep resources engaged in a particular activity.