MANAGEMENT AND

CORPORATE ECONOMICS

balintbicskei@yahoo.com
szabo@gabor.hu

1
 Introduction
To meet the requirements
Midterms after our classes
Material: all slides, explanations on the web (M&BE)

The midterm has two parts

Basics part: 20 minutes
Comprehensive part: 20-25 minutes, essay

Taking the midterm is compulsory for everyone

Final grade: sum of the 4 midterms
In case someone misses or fails: it is possible to retake 2 of
the 4 midterms during the semester

3
 Introduction
The aim of the class
Management
Roles of the management
Functioning and attributes of different types of organizations
Organizational issues
Quality management, mgm. of production processes

The financial part

Corporate economics (business and public economics)
Corporate goals, background (e.g. corporate decision making)
Closer to the production and service providing processes
Notions that we use: revenue, costs, profit
Economics of a business activity
Investment and financing issues, dividends, taxation

4
 Introduction
Corporate (business) economics
Is it worth it to realize a project (investment part)?
Our final goal is to answer this question
Quite hard task
Estimate the cash flows (far from the accounting p.o.v.)
Taxation (corporate and personal)
Can we ignore this?
Approximately it takes 50 %, so wed better not
There are many types of taxes
Income taxes, VAT, local taxes, public charges, national insurance
contribution, personal taxes, etc
Financing issues, dividend policies
Without these, analyzing a project is pointless

5
 Introduction
Business economics
Quite young: appeared in the 60
Before that: macro finances (20-40)
Economics: 1776 (Adam Smith)
Why did this business part peel off?
There were companies with revenues, expenses and taxes
Why couldnt they do this in 1950? What was missing?
What the normal profit (%) is of a business activity
Profit: 10 % is this really good? More than 5 %.
What is the difference between treasury bonds (2-3 %) and
biotechnology shares (20-30 %)?
Producing laptops 10 % what is the risk of the investment?
Financing and dividend issues
This was solved in the 60 at least 10 Nobel prizes (!)

6
 Introduction
Corporate (business) economics
1. Elementary notions and economic background
Value, utility, swap, alternative cost, efficiency, etc.
Investors behavior
Comparative advantages and the market price
2. General aim of a firm
Shareholders value
Value maximizing, utility maximizing, profit maximizing
Principal-agent problem
Free cash flows
3. Basics of corporate analysis
Limited rationality
Estimation of cash flows
Dividends, dividend policies
Independency of cash flows

7
 Introduction
Corporate (business) economics
4. Cost of capital
Expected utility maximizing
Risk aversion
Efficient portfolios
Relevant risk
Capital market expected returns
Basic models: CAPM, WACC
5. Corporate analysis
Expected profit
NPV
IRR

8
 1.1. Economic background of
corporate economics
1.1.1. Value, utility
These notions are in the background of all economic
decisions.
What is richness?
We want to understand what motivates us.
Money, wealth, good life, happiness?
Is richness equal to the goods that someone possesses?
We cant state that!
An object on its own is without a value (mouse, laptop).
if it means something to someone in a certain
situation

10
 Only those things increase richness that are
considered useful (i.e. people connect value to
them).
This value significantly differs among
individuals. But rationally (money)
Lets take some extreme examples!
Acceleration
Silence, peace (+1 room, travelling)
Symmetry
Taste
Human performance
Ability to see far
What is the real value of Hubble telescope?
For the astronomers (Big Bang 13,7 Mrd years) for us?
1,5 Mrd USD with a wrong mirror (unclear pictures)
Correction: 1 Mrd USD

11
 Examples
How much is it worth for you
Bricks, cement, gravel, building siting,
Built in wardrobe,
Tap,
Ancient Greek book,
A box of fined uranium,
A panel for a computer tomograph,
A professional baseball glove (for Joe Dimaggio)
Cycling, bowling What is the difference?

We attach value to these things because we think

that there are people who consider these
important, useful.

12
 Conclusions
Things on their own are useless, i.e. they dont
have a value. Value occurs only if they mean
something for someone.

If something has a value it means that it is useful

for someone: it satisfies a sort of desire or need.

In case of inefficient allocation in the society or

economy
Things dont worth their possible maximum value
This motivates individuals to swap their possessed goods
among each other
Goods move until they reach their maximum value

13
 Value utility
They are almost the same notions
For one person, value useful and useful value
Utility
An economic term referring to the total satisfaction
received from consuming a good or service.
Bernoulli: A things ability to cause happiness to
someone
Bentham: An objects attribute, that makes it able
to cause advantage, satisfaction, good or happiness
for the consumer OR makes it able to prevent the
consumer from any damage, pain, bad or sadness
(painkillers)

14
 In an economic sense we connect utility to a
thing in case it is able to satisfy the need of a
member of the society, i.e. someone longs for
it, considers it valuable.
In a certain situation.

Conclusion: things have value if they are

(expectedly) useful for someone!

15
 1.1.2. Opportunities and choices
At the roots of the explanations of economic
actions lay the individual choices and behavior
There are decisions made cooperatively, but we trace
these back to individual behavior, individual
decisions
We suppose that only individuals have aims
(companies, countries dont)
When do we have to make a decision?
Different actions that have different outcomes
Two basic mechanism exist
Rational decision making
Decisions made in a way to meet society standards

17
 Rationality
The keystone of economics
It is still really hard to give a proper, widespread
definition for it (previous slides)
Difference between psychology and economics:
actions can be considered rational from the point of
view of the psychology that are far beyond the
confines of the economic definition for rational
behavior (afraid of darkness, kindness, sell cheap,
etc.)
Homo oeconomicus
Self interest is the only drive
Not influenced by social standards
Desires utility
Clever

18
 The situation is not that bad
altruist behavior
Altruist: to give up something good without any interest
Traffic, eating, charity
Is there pure altruist behavior?
Maybe behind the altruist behavior there is self interest

China: every citizen has to sacrifice himself for the

Chinese nation this is not working, there must be
selfish people as well!
Parents help their child / someone helps his parents
Help a sick person
Anonym contribution
Someone has to leak this information.

19
 Conclusion
We consider an action rational in case it
maximizes someones expected utility
Maximizing the happiness
Shopping in a shopping mall
Special combination of goods that causes the maximum utility,
the maximum value
More precisely: maximizing the expected utility

We assume a certain level of the altruist behavior

rational.

If we understand how people decide, we can

calculate with this in the future.

20
 Irrationality

We cant always be rational, the more you want

it
To forget, to behave spontaneously, to frighten
myself, etc.

To set our desires to our actions and not

conversely: not to do what we desire, but to desire
what we did we want to be happy so much!
Cognitive dissonance and posterior self persuasion (that
what we did is very good for us)
When I cant reach something
I explain myself that it is not that good

21
 Irrationality
Narrowing the possibilities
Debility of purpose
Drinking, eating, dentist, gym
Strategic actions
Action movies: excluding the possibility of the deactivation of a
bomb
Burn the boats (bridge) behind the army

22
 Desire-driven irrational thinking
To see information as we want to see them (capital market)
This is not on purpose, there is no control over it
Collecting information in a selective way until my choice is
verified
Last information, exclusive information from a friend

Sometimes the best solution is just not the rational

thinking
Incomparable possibilities
Choosing a university: usually no one has enough information to make
a rational decision, no one can try all of them before deciding
we decide upon the available set of information (friend, teacher, etc.)
this is like tossing a coin
Lets take an other example: a firms R&D decision
Estimate the possible (expected) revenues and expenses (already a bit
hazy because we dont have historical data)
Behavior of competitors, general market conditions
To summarize: we dont have sufficient information to make a
rational decision
Leadership abilities
23
 When the obscurity of choices and possible
outcomes makes it impossible to make a
rational decision, we have to find an other
solution
To search for contentment
Choose something quite good
Toss a coin
It is really rare, people usually dont like it
There is no explanation
Deny the obscurity
Sometimes it is irrational to insist on rationality
It is expensive to acquire additional information
It would be better to accept that the possible outcomes of different
actions can not be evaluated (Excel sheets)
Pascal: sometimes the most rational thing to do is to give up
rationality

24
 The rationality of collecting information
It is not enough to decide rationally upon the
acquired information
It is essential to be rational during the collection of
information

Of course, acquiring more information and

exhaustive consideration of the possible outcomes
can improve the success of our decision, but they
have disadvantages as well
Cost
Time
Fast decision versus slow decision
Investment projects, hospital

25
 Conclusion
There are two main parts of rational behavior
1. Rational desires
2. Rational decisions (collecting information and
deciding rationally)
Keystones in economics
We consider investors rational
We do not accept the altruistic behavior
We accept that
Efforts to be appreciated and
efforts to avoid contempt can be considered rational
This is essential
The roots of economics rational utility maximizing
Economics: explaining human actions, forecast

26
 1.1.3. Swap, alternative cost, efficiency
Formerly: trading was considered as the
unproductive sector
When (rational) people swap their goods, the values
of these goods differ
Win-win situation
Both parties offer something less valuable for
something more valuable
We can swap our ancient Greek book, the box of fined
uranium, the baseball glove for a house
Dormitory: room allocation. What happens?
Both parties enrich, the whole society gains wealth
Better allocation of goods enrichment (production)

28
 It is a fact that swaps do not create anything new,
they only reallocate things in the society in a more
valuable way (better allocation)
Inefficient allocation efficient allocation
But this happens in the industry or agriculture as
well (raw materials, human resources, etc.)
Reallocation in a more efficient way
Swaps and trading are production activities
They produce wealth, raise welfare,
contribute to the development of the economy
Things on their own are without a value (i.e. utility),
they have to be in the right hands
Trading activity is substantial for this
With or without a dealer (GDP, soldiers' uniforms)

29
 During swaps one sacrifices the value of the
things he gives up (book, uranium, glove, etc.)
Sacrifice that one makes cost
The cost is not connected to the things that one
gets, but to the things he gives up
Cost of sitting here (school fee), working, money
i.e.: costs are alternative costs because they are
connected to the alternative possibility that has
been given up
This is in strong connection with our utility or
value maximizing approach
The gained utility exceeds the lost utility
The lost utility is the alternative cost

30
 Efficiency: output / input ratio
It is not an objective notion (previous slides)
Both are quite indefinite
Is it efficient to travel by car, to go to the theatre, wear a suit, to
build a telescope
Depends on the person and the situation
Heating a house with gas or with wood or with solar
energy
Which one should be considered efficient?
It changes in time
Depends on how rare the gas or wood is
What kind of alternative utilization exists for them
Debates - Who has the right to decide?
Heating at home, debates with the neighbour
Subjective economics (Marx - value)
31
 1.1. Economic background
1.1.1. Value, utility
1.1.2. Possibilities and choices
1.1.3. Swap, alternative cost, efficiency
1.1.4. Comparative advantages and the price

33
 1.1.4. Comparative advantages and the price
Two wine growers a good and a bad (?)
Tokaj Villny
1000 1000

900 900

800 800

700 700

szamorodni
szamorodni

600 600

500 500

400 400

300 300

200 200

100 100

100 200 300 400 500 600 700 800 900 1000 100 200 300 400 500 600 700 800 900 1000

kkfrankos kkfrankos

34
 1000
tokaji
The szamorodni
villnyi
1000 is relatively
900

800
cheaper at the Tokaj producer,
900

800

he is more efficient in its growth:

szam orodni
szam orodni

700 700

600 600

500 he has comparative advantage in

500

400

300
producing szamorodni
400

300

200 Tokaj: for 1 l szamorodni

200

0,5 l kkfrankos
100 100

100 200 300 400 500 600 700 800 900 1000 Villny: kkfrankos
for 1 l szamorodni
100 200 300 400 500 600 700 800 900 1000

kkfrankos
villnyi 1,25 l kkfrankos
1000

900
Conversely: the Villny
800
producer is better in
szam orodni

700

600 kkfrankos, he has a

500

400
comparative advantage in this
300 Tokaj: for 1 l kkfrankos
200

100
2 l szamorodni
Villny: for 1 l kkfrankos 0,8 l
szamorodni
1000 100 200 300 400 500 600 700 800 900 1000
kkfrankos

35
 Suppose that they specialize in the wine in which they
have comparative advantage, and swap them!
Tokaj Villny
1000 1000

900 900

800 800

700 700

szamorodni
szamorodni

600 600

500 500

400 400

300 300

200 200

100 100

100 200 300 400 500 600 700 800 900 1000 100 200 300 400 500 600 700 800 900 1000

kkfrankos kkfrankos

It is a win-win situation!
36
 Suppose that the demand is 50-50 % of the two wines in both regions!
Specialization and swap is worth it even if it has costs (export-import
trading, spec.).

Tokaj Villny
1000 1000

900 900

800 800

700 700

szamorodni
szamorodni

600 600

500 500

400 400

300 300

200 200

100 100

100 200 300 400 500 600 700 800 900 1000 100 200 300 400 500 600 700 800 900 1000

kkfrankos kkfrankos

37
 Lets look at this from a different aspect!
What changes if the possibility of the production a third
type of wine arises and
the production of this wine is more advantageous than the
previous ones?
Simply our example wouldnt be correct
We are interested in the second best opportunity

There is no point in dealing with the szamorodni or

kkfrankos problem, in case there is something even
better
The sacrifice is always the second best
Economic decision making is always about choosing
between the 1st and the 2nd best possibility! (we dont deal
with the potato)

38
 Suppose that the price of the szamorodni is quite
high, and the best solution is that the two actors
produce only szamorodni
In this case there must be a third party, who is good at the
production of the other wine. It is impossible that
something is cheap while everyone produces it at higher
expenses, ie. alternative costs (sacrifices).

if there is such an actor, we could think that the one who

produced 600 liters of szamorodni would go bankrupt,
since he does this at higher costs
This is impossible!
The costs in Tokaj (loss-making): land, unskilled labor,
equipments, entrepreneur
One of the costs above is not defined correctly!
Most likely the entrepreneur deserves a lower profit for his activity
(he will be poor).

39
 The cost or price of the things (land, equipment, people)
tend to their best possible way of utilization!
If the best way of utilization of the land is to produce
wine there, then the lands value tend to the value that
people connect to wine
Goldmine?

Everyone is competitive in his best domain of utilization,

the worst that can happen is that this specific area is not
outstandingly valuable for anyone

The optimal solution for everyone is to use his property

and workforce according to their comparative
advantages
and swaps/changes afterwards

40
 This leads to specialization and swaps
There are less and less handyman
To build a house, heal our children
What will you be when you grow up?
Find your comparative advantage
And pray for this being valuable for someone

Peoples need for swaps (due to the

specialization) led to the appearance of an
ultimate means of exchange: the money
Money has an abstract utility
It not directly gives happiness, but creates the
possibility of acquiring happiness
The utility of money is equal to the utility of
goods that you can buy with it
41
 Limits of swaps
There are costs connected to the matching of the
actors of an exchange
Transport
Searching for the possibilities (who is the best?)
We call these transaction costs

Traders
Their comparative advantage is in finding both sides
of an exchange , to settle up a trade
They are essential for specialization
They produce the necessary information
(transportation, where to buy, etc.) for exchanges at
lower costs than others
42
 Traders compete with each other
and with everyone else
you just dont have the time to deal with this and
you are willing to pay for this service
(interior designer, hairdresser, etc.)

Traders are evil because they use the ignorance

of others (buy cheap, sell expensive)
Correct
Like everyone else (architects, doctors, car
mechanics)

43
 Costs: conclusion

Costs are not objective, they are not

connected to the acquired objects
They occur for someone in a certain situation
To acquire something, the one has to give up the
utility of something else alternative cost (lost
utility)

I.e. costs are connected to the (human)

evaluation of the alternative utilization
possibilities

44
 Costs are equal to the utility that has to be
given up, in a MARGINAL sense (MC)
The point: what else do I have to sacrifice?
Marginal alternative costs

Examples
Correction of the Hubble Telescope
Airplane development

It is really important that we do not care

about sunk costs!
Cost that occurred in the past
Decision has been made in the past
45
 There are alternative possibilities in the
production as well
The best technology does not exist
Building highways is New-Delhi

A job offer: we give up something for money

From a marginal point of view

46
 1.2. Shareholders value
maximizing
1.2.1. Profit
Maybe the profit is the most improperly used
notion in economics Frank Knight
Our income minus all the costs that occur
Two remarks
Wages, rents we do not consider these as a
profit
Usage of capital interest

48
 F
1 0 F
1.2.1.1. Interest, return
These are not profits either
In a years time

Now
0onr)eal(1r
nnofnlnat
r1rnomrieaall10(1nom1irreraelal)(1inflartiF
49
rinfla)ton
 1.2.1.2. Risk free interest
The interest rate of risk free borrowing
Compensation, remuneration for
Positive time preference
Technical, technological, economic development

T-bonds

50
 (r)F1)0E(F01)1
E
1.2.1.3. Risky return
Risky investments expected return
Compensation, remuneration for

Positive time preference

Risk aversion (return above the RF interest of course this is just an expected
premium)
Possibility of utility-loss

51
 (r)F1)0E(F01)1
E
Risk
Deviation from the expected value
Fluctuation/oscillation
Standard deviation
Normal distribution
The effect of many factors
Purely random
Expected value - distribution
Expected return

52
 Risk free loan Risky investment

E(F1)
F1

F0 F0

E(r) E(r)

E(r)
rf

53
 1.2.1.4 Expected and realized profit
Income minus our costs
Wages, rents, interest
Other apparent costs (vendors, taxes, etc.)
The rest (positive or negative) is for the owner of the company is this profit?

We can talk about profit if we subtract the costs of the owner (alternative costs)
Wages, interest of his capital, rents of his assets contributed to the company, etc.
And the rest that is the profit!
What is the cost of you giving me?

54
 Is it possible that in a competitive market
economy a firm can make profit (excess return)
without any special effort?
Of course not! The competitors will appear.

To make profit, some kind of special

knowledge is essential
Just like everywhere else
Arbitrage, innovation, copying others
Creativity, intuition, charisma, steadiness
Entrepreneurs have comparative advantages in
these. His profit is his remuneration for the
abilities above.
This knowledge can be bought or sold
55
 This knowledge manager
Taking risk
Profit
Expected
Realized
Expected realized
Knowledge fortune
The owner
takes the risk
gets the profit
demands the profit maximizing corporate
behavior (expected profit)
Primary goal of a firm

56
 1.2.2. Shareholders value
Company (products - services)
Public company
Shareholders corporate objectives
Shareholders objective
Utility maximizing
Value maximizing
Profit maximizing

57
 1.2.3. Principal / agent
Early capitalistic firms
Owner and the manager: the same person
Legally responsible for the companys actions with his whole
property
Mass production concentration of capital
To do something together
Problem of joint responsibility
Public companies
Limited liability
Clear proprietorship
Legal entity
Owners and managers are separated
Buying and selling became really easy (capital market)
Huge advantage in capital concentration

58
 Many owners one company
Management agents
Everybody cant participate

Principal (owner)-agent problem

Supervision costs
Specialists
BOD
auditors
There is a rational limit
Capital market information

59
 1.2.4. Free cash flows
Corporate analysis is expressly connected to the
aim of the shareholders
Stakeholders (other owners) are not important
The question is: what is the rest for the owners
After customer payments, wages, vendors, other
costs, taxation, lending operations
The rest Free Cash Flows (FCF)
this is still not the profit
Because there is the (alternative) cost of the capital
Simplify the problem of the contributed assets

61
 E(Fn)
E(F2)
E(F1) E(FN)
0

1 2 n N

F0

Free cash flows in a company

We still have to calculate with the cost of the capital
Cost of not doing something else with the money
Discounted cash flows what is the value of E(F1)?
62
1.3. Basics of corporate analysis I.

1.3.1. Limited rationality

We already know what perfect rationality is

Good or bad Which one is better?
A problem contains enormous amount of
built-in analysis
Limited rationality
Economies of scale this is rational!

63
 1.3.2. Estimating the cash flows -
compromises
Annual CF
Accounting, taxation
Annual rhythm
Specialists Department of Finance

64
 Specialists
r
Db

Kltsgek
Db

r Kltsgek
Dbr
Kltsgek

Dpt. of Finance
E(Fn)
E(F2)
E(F1) E(FN)
0
1 2 n N

F0

65
1.3.2.1 Separation of the expected cash
flows and the risk

E(F1)

66
 1.3.2.2. Real cash flows
Inflation?
We have to conciliate this with the cost of
capital
Cost of capital in real sense
Constant prices
Typical problems
Depreciation
Real and nominal sense

67
 1.3.2.3. Revenue and costs
Not posterior analysis, but future estimations!
Revenue and costs that occur due to our
decision
With or without it?
Inevitable revenues and costs irrelevant
Happened in the past
Has been decided in the past

These are sunk costs!

68
 Costs
Resources that we have to acquire
The market price
Resources that we already possess
Irreplaceable
Best alternative utilization
Selling it
Possible realized value in an other project
Replaceable
Maximum its market price
Minimum its selling price

Zero: if it cant be sold or used somewhere else!

69
C

FC

70
C

VC

Economies of scale

71
 FC + VC = Total Costs (TC)

Our fix costs are sunk costs these are

irrelevant!

72
 1.3.3. Indifference of dividends
Lets get back to FCFs! Are these equal to the
dividends (of course after taxation)?
To answer this, first we have to clarify the
notion of indifference of dividends
Wealth of the shareholders does not depend on the
rhythm of dividends
For this,
The perfect representation of the shareholders objectives,
Zero transaction costs,
Efficient capital markets,
Taxation system without distortions are needed

73
 1.3.4. Independency of cash flows
Indifference of dividends
Its consequences on our approach
The goal is not the maximization of the corporate value,
but the shareholders value
Its consequences on the analysis
Are free cash flows equal to the dividends (after taxation)?
Not necessarily, but regarding their value, they are!
If this holds, the most practical thing to do is to suppose
that these free cash flows are always paid immediately to
the shareholders as dividends
Usually this does not happen so, but from the point of view
of the shareholders this is indifferent
We suppose continuous cash inflow and outflow (CICO)!

74
 This has an outstanding importance in
corporate analysis
Cash flows of different projects are separated this
way
Separate CICO diagrams
A projects cash flow can be (and should be) treated
separately
This is the independency of cash flows!

Free cash flows dividends after taxation net

cash flows
We have to subtract the cost of the capital
The cost of the capital that he did not take
somewhere else (our alternative cost approach)

75
 1.4. The cost of the capital
Capital market market of capital
Capital for different durations, with different risk
swapping money (present money future money)
field of this swap
We will examine the investors
Preferences,
Risk perception,
Pricing of different investment possibilities
Our basic model: Capital Asset Pricing Model
(CAPM)
Most widespread financial model

76
 In a $risky
withsituation

EW
piwmax
1.4.1. Maximizing the expected utility
A: 10 000 $ with a probability of 60 % or 0$ with 40 %
How do people decice?
B: 6 000 a probability of 50 % or 4 000 $ with 50 %
We make decisions according to the value?
Is this pure mathematics?

77
 EUW
FipiU(Fw)max

Not the acquired amounts are important, but their consequences, their utility.
Thus people dont maximize the expected value, but the expected utility:

W* wealth at the start point, F cash flow causes W (change). With the approach
above, it is the same if we talk about the utility maximization of F cash flow, or W
wealth:

78
 1.4.2. Risk aversion
What is the basic difference between the
maximization of the expected value and the
maximization of the expected utility?
Value utility, utility value

Apparently the increase of the amount of

money is not proportional to the increase of its
utility
In such case it would be the same to talk about the
maximization of the expected value or the
maximization of the expected utility

79
1.4.2.1. Decreasing marginal utility of money
MU(W) U(W) More money
is better...
MU(F) U(F)

W, F
The increase of the utility of wealth is in inverse
proportion to the amount of goods already
possessed () This hypothesis seems to be valid
for many people (Bernoulli)

80
1.4.2.2. Expected utility standard deviation preference map

We still searching for the answer to the

question: how do people decide in a risky
situation?

We summarize everything in one model

Maximization of the expected utility
Decreasing marginal utility of money
Normal distribution

81
 (rB)
(rC)
E(U) (rD)

E(U*)

F AE(F B) E(F C) E(F D) F

Suppose that we can get FA, E(FB), E(FC) and E(FD)

for F0 investment. We arrive to returns

82
 E(r)
U5
E(r)
U4E(U*)

U3
E(rD)

U2
E(rC)

U1
E(rB)
rA

(rB) (rC) (rD) (r)

(r)

83