Capital Structure

What is “Capital Structure”?

Definition

The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Best, or optimal, capital structure, is where the value of the

firm is maximized.

Securities:

_ Bonds, bank loans

_ Ordinary shares (common stock), Preference shares (preferred stock)

_ Hybrids, eg. warrants, convertible bonds

Sources of capital

• Ordinary shares (common stock)

• Preference shares (preferred stock)

• Hybrid securities

- Warrants

- Convertible bonds

• Loan capital

- Bank loans

- Corporate bonds

Ordinary shares (common stock)

• Risk finance

• Dividends are only paid if profits are made

• A high rate of return is required

• Provide voting rights - the power to hire and fire directors

• No tax benefit, unlike borrowing

Preference shares (preferred stock)

• Lower risk than ordinary shares - and a lower dividend

• Fixed dividend - payment before ordinary shareholders and in a liquidation situation

• No voting rights - unless dividend payments are in arrears

• Cumulative - dividends rise in the event that the issuer does not make timely dividend payments

• Participating - an extra dividend is possible

• Redeemable - company may buy back at a fixed future date

Loan capital

Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed) Bank loans or corporate bonds Interest on debt is allowed against tax

Determination of capital structure

Capital structure—combination of various types of capital the firm uses to finance assets.

Capital structure is part of a company's package of financial policies, which include dividend policy and the type and amount of debt and equity claims issued. Assessment of the optimal capital structure has the following main elements:

• Financial flexibility assessment.

• Weighted average cost of capital.

• Optimal debt arrangements.

The theoretical notion of the optimal capital structure is the structure that maximizes the value of the firm, not the value of the equity.

Debt

Using more debt generally increases the risk associated with future earnings.

Debt has a fixed cost (interest), so more debt allows the firm to earn a higher expected rate of return.

Debt is less expensive than equity capital. Shareholders bear more risk of loss in the event of financial distress than do lenders and seek a higher return to compensate for that higher risk.

Equity

Less risky to financial operations than debt, because there is no contractual obligation to pay dividends. Higher cost, because stock is a riskier investment for investors. There is a risk/return tradeoff associated with increasing (decreasing) debt relative to equity.

The cost of equity

The most difficult question on the subject of cost of capital. The reason of this difficult question is that there is no way of directly observing the return that the firm's equity investors require on their investment. The cost of equity for a firm is the minimum rate of return necessary to attract investors to buy or hold a firm's common stock. If dividends per share are expected to grow at a constant growth rate indefinitely, we can measure the cost of equity Re by the following formula:

Re = D1/P + g

D1 is the expected dividends per share to be paid at the end of 1 year,

P is the current market price per share,

g is the annual dividend growth rate.

But this model has drawbacks when considering that some firms concentrate on growth and do not pay dividends at all, or only irregularly. Growth rates may also be hard to estimate. Also this model doesn't adjust for market risk. Therefore many financial managers prefer the security market line/capital asset pricing model (SML or CAPM) for estimating the cost of equity:

RE = Rf + βE x (RM - Rf)

or Return on Equity = Risk free rate + (risk factor x risk premium)

• Rf is the risk - free rate of interest

• ßi (the beta coefficient) is the sensitivity of the asset returns to market returns

• RM is the expected return of the market

Advantages of SML: Evaluates risk, applicable to firms that don't pay dividends

Disadvantages of SML: Need to estimate both Beta and risk premium (will usually base on past data, not future projections.)

The cost of debt

The explicit cost of debt for a firm may be defined as the discount rate that equates the net yield of the debt issue with the present value of interest and principal payments. If we want to express all cost-of-capital rates on an after-tax basis, we must adjust this explicit cost of debt for taxes, because interest charges are usually tax deductible. We denote the after-tax cost of debt by kt and determine it using the following equation:

kt = ki*(1-t)

ki is the before-tax cost of debt

t is the tax rate

Business risk and Financial risk

• Firms have business risk generated by what they do

• But firms adopt additional financial risk when they finance with debt

Business Risk

The basic risk inherent in the operations of a firm is called business risk. Business risk can be viewed as the variability of a firm's Earnings Before Interest and Taxes (EBIT).

Financial Risk

Debt causes financial risk because it imposes a fixed cost in the form of interest payments.

The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firm's return on equity or the variability of its earnings per share.

Financial Risk vs. Business Risk

There is a trade-off between financial risk and business risk. A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even.

A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).

Why should we care about capital structure?

By altering capital structure firms have the opportunity to change their cost of capital and - therefore - the market value of the firm, and the aim of management is to maximize the value of the firm.

What is an optimal capital structure?

An optimal capital structure is one that minimizes the firm's cost of capital and thus maximizes

firm value Cost of Capital:

- Each source of financing has a different cost

- The WACC is the “Weighted Average Cost of Capital”

- Capital structure affects the WACC

Capital Structure Theory

• Basic question

- Is it possible for firms to create value by altering their capital structure?

• Major theories

- Modigliani and Miller theory - „MM“

- Trade-off Theory

- Signaling Theory

Modigliani and Miller (MM)

• Basic theory: Modigliani and Miller (MM) in 1958

• Old - so why do we still study them?

- Before MM, no way to analyze debt financing

- First to study capital structure and WACC together

- Won the Nobel prize in 1990

Modigliani and Miller (MM)

The Modigliani / Miller proposition states that the market value of any firm is independent of its capital structure. Changes in capital structure do not affect the stockholders' welfare. Two companies that generate the same stream of operating income and differ only in capital structure will have the same valuation.

Modigliani and Miller (MM)

The Modigliani Miller proposition is based on the following assumptions (perfect capital markets):

• Every investor maximizes his financial utility

• Corporations and individuals can borrow at the same interest rate

• The borrowing interest rate equals the lending interest rate

• No transaction costs

• No bankruptcy costs

• Debt instruments can be divided at the discretion of market participants

• Taxation of all investment and debt instruments for all market participants is equal

Weighted Average Cost of Capital

An optimal capital structure is one that minimizes the firm's cost of capital, that means the WACC is minimal. The weighted average cost of capital (WACC) is defined as the average cost of equity and debt weighted in proportion to their contribution to the total capital of the company. To calculate the firm's overall cost of capital, we multiply the capital structure weights by the associated costs and add them up.

WACC  rd * (1  t ) *C/D re *E/C

• D - market value of Debt

• E - market value of Equity

• C = E + D - market value of firms´s capital

• rd - cost of debt

• t - tax rate

• re - cost of equity

Capital Structure - WACC

If the firm uses only equity to finance its assets (that is, zero debt is used) then WACC = rE

As the firm begins to use some debt for financing, WACC declines, primarily because the tax benefit offered by the debt more than offsets the increased cost of equity The point where WACC is the lowest is the optimal capital structure—this is the point where the value of the firm is maximized

Summary

• A firm's capital structure is the proportion of a firm's long-term funding provided by long-term debt and equity.

• Capital structure influences a firm's cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk.

• Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

INTRODUCTION TO BUSINESS ECONONOMICS

FIRMS / ENTERPRENEURSHIPS are major economic institutions in market economies. Economics is the study of allocation, of how societies solve their allocational problems, and how they might do better. That there is an allocation problem is due to the scarcity of resources that can serve alternatives, and the fact that wants are insatiable.

Business Economics solves these basic questions:

• What has economics got to do with business?

• What do students heading for a business career need to study economics?

The answer is that economics addresses many questions that help us to understand the environment in which all businesses operate.

Business leaders are continually asking themselves questions like “ Will the economy pick up next year? What will happen if a new producer enters my market? Will the Euro appreciate against the dollar? How will the introduction of a European single currency affect the economies of member countries, and of those who stay outside?

These are all questions that an understanding of economics helps to answer.

Economics is not only the subject that is needed in business. Many other subjects -such as accounting, statistics, law, psychology, computer science, management science are important.

However, economics has to be one of the core subjects relevant to business because economics studies key aspects of the behavior of business itself, as well as of the environment in which business operate.

Economics and the analysis of business issues

Definition: “Economics is a social science that tries to explain the behaviour of economy and builds theories of how the economy works and tests these theories against data”.

The models used in Business Economics are simplifications of the real world that are potentially useful in illustrating some key feature of how the world works. Theories are tested by their internal consistency, by their conformity with established principles.

Business study as a subject has the goal of identifying the knowledge that will help people to

make a success of a career in business, either by offering skills that business will value or by managing a business successfully.

KEY ISSUES FOR BUSINESS

Economics as a subject can be divided broadly into two general topic areas - microeconomics and

macroeconomics.

Microeconomics focuses on explaining the behaviour of individual firms, consumers, or product markets. It is concerned with looking at a small part of the economy.

Macroeconomics, in contrast, look at the output of the economy as a whole and is concerned with aggregate questions relating to inflation, unemployment, the balance of payment and business cycles.

MARKET AND PRICES

Products are bought and sold in markets. All markets have two sides to them. Suppliers start off with (or make) the product and offer it for sale in the market. Demanders want to acquire the product and potentially offer to buy it through the market. Hence, each market has a supply side and demand side. The market is simply the area over which suppliers and demanders interact in order to determine the

prices and quantities of the product exchanges that take place.

A MARKET

A market, then, would be described as the getting together of buyers and sellers to make

exchanges seen as beneficial. This is shown graphically as the supply and demand curves

“together” on the same graph. The instructor should note that

1. A market requires both buyers and sellers.

2. A unit of goods or services will be exchanged

if the exchange benefits both buyer and seller.

Equilibrium

Equilibrium is a status when is supply and demand saturated, suppliers and demanders are satisfied.

Equilibrium is a cross point of supply and demand curves.

Since this situation has both of the following characteristics:

1. once a market reaches this point, there is a tendency to stay at this point,

2. when a market is not at this point, the resulting surplus or shortage will move the price toward this point, it is an equilibrium point. For a futures contract such as those, the equilibrium can be

described as the amount where the bid price equals the ask price.

THE ECONOMICS OF THE FIRM

• One of the key decision-making units studied in economics is the firm.

• Firms are decision-making units that hire workers and use capital and row materials in order to make products for sale in the market.

• The firm is a business organization. There are several alternative legal and financial structures available to firms, but for now, the important point to notice about the firm is that we treat it as an entity in itself that is conceptually separate from the owners and workers.

• In economics, the elementary theory of the firm refers to a particular conceptual experiment in which we ask questions about a single-product firm.

• This product is generally assumed to be a manufactured product, but the principles involved can be applied to any firm.

• In order to manufacture its product a firm typically needs plant and equipment; it hires workers and buys components and raw materials. Plant and machinery (land, factory buildings, machines, tools and vehicles) is often referred to as capital or capital goods.

• In the theory of the firm it will generally be used to refer to physical capital, such as the plant and equipment just mentioned.

• However, it can also refer to financial capital, which is the financial resources behind the firm, part of which is invested by the firm`s owners.

• The term working capital, for example, is often used to refer to financial resources of a firm that are kept in liquid form, such as bank deposits, rather than being invested in physical capital.

CONCENTRATION AND MARKET POWER

The economic theory of the firm distinguishes three distinct market structures, each with different implications for the choices available to firms.

Perfect competition

Under perfect competition, each firm is assumed to produce an identical product to all other firms and to be sufficiently small that it cannot influence the market price. In such an environment the key question for each firm is simply how much to produce. Each firm can sell as much as it wants at the going market price without having any significant influence over that price.

In extreme contrast to perfect competition is monopoly. This is a situation where there is only one producer of a product, and, hence, the single producer faces no competition from other producers. A monopolist will have power to set not just output but also the price of the product.

Monopoly may be good for the firm involved, but it will generally be bad for consumers, because the monopolist will tend to charge high prices. This is why most countries have regulations to prohibit monopolies or regulatory agencies to stop the monopolist setting prices too high.

Imperfect competition is the range of different cases between two extremes of perfect

competition and monopoly. This is a commonest characterisation of real markets. Imperfect

competitive market often involve products that are similar but not identical and for which there

are a finite number of potential producers, each of which can influence the others by its own

behaviour. There are many sub-cases of imperfect competition. The most common such are oligopoly and monopolistic competition.

• Oligopoly arises where the market is dominated by a small group of competing firms. Here each

firm is greatly affected by what its close rivals do in terms of product prices and innovations.

• Monopolist competition is a term reserved for a market environment in which there are enough

potential suppliers that one firm does not have to worry about the reaction of any other single firm,

and yet the product of each firm is differentiated from all others in some way, so that each firm can influence its own price.

Conclusion:

Firms operate in many different market structures, but the most common structure is imperfect competition, in which there are a finite number of competing suppliers, each selling differentiated products. So most firms do make decisions about how much produce and what price to sell, and they have to worry to varying degrees about what the competition is doing.

RESOURCES AND SCARCITY

Kinds of resources

The resources of a society consist not only of the free gifts of nature, such as land, forests, and minerals, but also of human capacity, both mental and physical, and of all sort of man-made aids to further production, such as tools, machinery, computers, and buildings. It is sometimes useful to divide these resources into three main groups:

1. natural resources, known as land

2. all human resources, which economist call labour

3. capital - physical, not financial capital, that are used up in the process of making other goods and services and that, as we have already seen.

• Often a fourth resource is distinguished. This is entrepreneurship, meaning the one who undertakes tasks. Entrepreneurs take risks by introducing both new products and new ways of making old products. They organize the other inputs into production and direct them along new lines. Entrepreneurs often set up firms and become to managers of these firms.

• Collectively these resources are called factors of production, obviously as inputs

Kinds of production

The factors of production are used to make products that are divided into goods and services. Goods are tangible, such as cars or shoes, services are intangible, such as haircuts and education. They also use the terms products and commodities.

Anyone who makes goods or provides services is called a producer, and anyone who consumes them to satisfy his or her wants is called a consumer.

Scarcity

In most societies goods and services are not regarded as desirable in themselves; few people

are interested in piling them up endlessly in warehouses, never to be consumed. Usually the

purpose of producing goods and services is to satisfy the wants of the individuals who consume

them. Goods and services are thus regarded as means to an end, the satisfaction of wants.

CHOICE

Choices are necessary because resources are scarce. Because the country cannot produce everything its citizens would like to consume, there must exist some mechanism to decide what will be done and what left undone; what goods will be produced and what left unproduced; what quantity of each will be produced; and whose wants will be satisfied and whose left unsatisfied.

Scarcity of resources is not abstract problem, it is a problem for firms. Each of us has a limited

amount of time and effort available to devote to work, recreation, or sleep. So we have to make

choices about how to allocate that time between the various alternatives. Also we have to decide

what type of work we could do most productively.

SPECIALIZATION AND COMPARATIVE ADVANTAGE

The managers of a firm have a similar problem. They have to allocate the time of hired workers and equipment to the activity of producing the firm`s output as efficiently as possible. So decisions have to be made about how many employees should be hired and how they can best be used in order to make profit for the firm. Economists call this allocation of different jobs to different people specialization of labour. There are two fundamental reasons why specialization is extraordinarily efficient compared to an economy in which self-sufficiency, or doing a wide range of jobs for yourself, is the norm.

• First, individual abilities differ, and specialization allows each person to do what he or she can do relatively well, while leaving everything else to be done by other specialists. Even when people`s abilities are unaffected by the act of specialization, production is greater with specialization than with self-sufficiency.

• This, which is one of the most fundamental principles in economics is called the principle of comparative advantage.

THE PRINCIPLE OF COMPARATIVE ADVANTAGE

The principle can be generalized as follows:

-Absolute advantages are not necessary for there to be gains from specialization

-Gains from specialization occur whenever the are differences in the margin of advantage one producer enjoys another in various lines of production

-Total production can always be increased when each producer specializes in the production of the commodity in which he or she has a comparative advantage.

THE PRODUCTION-POSSIBILITY BOUNDARY/FRONTIER

• We illustrate the choice problem faced by the economy as a whole - macro view. There is a

maximum that can be produced with the resources available, and society has to decide what combination of different goods should be produced.

• We can show the choice problem in a two dimensional diagram to simplify the reality, where the negatively sloped boundary shows the combinations that are just attainable when all of the society`s recourses are efficiently employed.

Boundary for an Individual

• A production possibility boundary measures the maximum combination of outputs that can be

achieved from a given number of inputs.

• It slopes downward from left to right.

The production possibility curve demonstrates that:

- There is a limit to what you can achieve, given the existing institutions, resources, and technology.

- Every choice made has an opportunity cost— you can get more of something only by giving up something else.

Boundary

Comparative advantage explains why opportunity costs increase as the consumption of a good increases.

- Some resources are better suited for the production of some goods than to the production of other goods.

Efficiency

• In production, we'd like to have productive efficiency - achieving as much output as possible from a given amount of inputs or resources.

• Efficiency involves achieving a goal as cheaply as possible.

• Efficiency has meaning only in relation to a specified goal.

• Any point within the production possibility curve represents inefficiency.

• Inefficiency - getting less output from inputs which, if devoted to some other activity, would produce more output.

• Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Shifts in the Production

Possibility Curve

• Can we produce outside the production possibility curve?

- Can we have more?

• Society can produce more output if:

- Technology is improved.

- More resources are discovered.

- Economic institutions get better at fulfilling our wants.

SUMMARY

1. Economics is one of the subjects relevant to understanding the environment in which business operates. Economics is a social science.

2. Key topics that are of interest to both economists and students of business include the behaviour of firms, the operation of markets, the nature of competition, optimal organization of firms and the cause and control of business cycles.

3. Scarcity is a fundamental problem faced by all economies, because not enough resources -land, labour, capital and entrepreneurship - are available to produce all the goods and services that people

would like to consume. Scarcity makes it necessary to choose among alternative possibilities: what products will be produced and in what quantities?

4. The concept of opportunities cost emphasizes scarcity and choice by measuring the cost of obtaining an unit of one product in terms of the number of units of other products that could have been obtained instead.

5. The principle of comparative advantage states that individuals, firms, and economies should concentrate on doing what they are relatively good at and trade with others who are relatively good at different things.

6. A production-possibility boundary shows all of the combinations of goods that can be produced by an economy whose resources are fully employed. Movement from one point to another on the boundary shows a shift in the amounts of goods being produced, which requires a reallocation of resources.

7. Modern market economies have generated sustained growth, which, over long periods, has raised material living standards massively

8. Modern market economies are characterized by constant change in such things as the structure of jobs, the structure of production, the technologies in use, and the types of products produced.

Introduction to Business Economics

The Objective of Business Economics

The firm is simply the fundamental microeconomic unit in the theory of supply. Firms are a useful device for producing and distributing goods and services. They are economic entities and are best analyzed in the context of an economic model.

The model of business is called the theory of the firm. In its simplest version, the firm is thought to have profit maximization as its primary goal. The firm's owner-manager is assumed to be working to maximize the firm's short-run profits.

In a free market economy, the economic system produces and allocates goods and services according

to the forces of demand and supply. Firms must determine what products customers want, and then

offer products for sale. In this process, each firm actively competes for a share of the customer's dollar.

TABLE 1: Characteristics of business organizations TABLE 1: Characteristics of business organizations

Businesses can be set up as limited partnerships. In this case, partners are classified as general or limited. General partners manage the business and have unlimited personal liability for the business's debts. Limited partners, however, are liable only for the money they contribute to the business. They can lose everything they put in, but not more. Limited partners usually have a restricted role in management.

In many states a firm can also be set up as a limited liability partnership (LLP) or, equivalently, a limited liability company (LLC). These are partnerships in which all partners have limited liability.

Another variation on the theme is the professional corporation (PC), which is commonly used by

doctors, lawyers, and accountants. In this case, the business has limited liability, but the professionals

can still be sued personally for malpractice, even if the malpractice occurs in their role as employees of the corporation.

Financial statements are frequently a key source of information for financial decisions, so our goal is to briefly examine such statements and point out some of their more relevant features.

• Balance Sheet

• Income Statement

• Cash Flow Compare trends year to year helps in the decision making of investors and creditors

The balance sheet is a snapshot of the firm. It is a convenient means of organizing and summarizing what a firm owns (its assets), what a firm owes (its liabilities), and the difference between the two (the firm's equity) at a given point in time.

Balance Sheet: Financial statement showing a firm's accounting value on a particular date.

The basic equation of the balance sheet is:

Assets = Liabilities

Assets = Liabilities + Shareholder's

Equity

Owner Equity = Assets -Liabilities

Assets: Everything owned that has value including claims

against others

Liabilities: Any obligation owed to others at the given moment in time - A claim by others against the assets

Assets: The Left-Hand Side

Assets are classified as either current or fixed.

1. Current Assets

• Current assets mean that the assets will not stay in the business for long.

• Examples: materials, money in the bank, …

2. Fixed Assets

• These are assets that the business owns.

• They will keep these assets for several years so they are fixed.

• Examples: Buildings , Machinery, Vehicles, …

Current assets or gross working capital comprise assets that are relatively liquid, or expected to be converted into cash within 12 months.

Current assets typically include:

• Cash = Marketable Securities = short term investments

• Accounts Receivable

-payments due from customers who buy on credit or you sent a bill and haven't been paid yet

• Inventory

-raw materials, work in process, and finished goods held for eventual sale

• Other expenses

-Prepaid expenses are those items paid for in advance

-Deposits

Fixed Assets

A long-term tangible piece of property that a firm owns and uses in the production of its income

• property, plant and equipment (PP&E)

• long-term assets that are used for more than one year or business cycle

• the cost of these assets is distributed over their useful life through depreciation

Intangible assets - immaterial assets that result from a merger or an acquisition (M&A), e.g. trademarks, patents, franchises, legal rights, goodwill, know-how etc.

Depreciation

In simple words we can say that depreciation is the reduction in the value of an asset due to usage, passage of time, wear and tear, technological outdating or obsolescence, depletion or other such factors.

The use of depreciation affects the financial statements and in some countries the taxes of companies and individuals.

Depreciation and its related concept, amortization (generally, the depreciation of intangible assets), are noncash expenses.

Salvage value/residual value is the estimated value of an asset at the end of its useful life. In accounting, the salvage value of an asset is its remaining value after depreciation.

Methods of depreciation

There are several methods for calculating depreciation, generally based on either the passage of time or the level of activity (or use) of the asset.

1. Straight-line depreciation

Straight-line depreciation is the simplest and most often used technique, in which the company estimates the salvage value of the asset at the end of the period during which it will be used to generate revenues (useful life).

The salvage value is an estimate of the value of the asset at the time it will be sold or disposed of. Salvage value is scrap value, by another name.

Book Value = Original Cost -Accumulated Depreciation

Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals residual value.

2. Accelerated depreciation

Depreciation methods that provide for a higher depreciation charge in the first year of an asset's life and gradually decreasing charges in subsequent years.

Book value at the end of year becomes book value at the beginning of next year. The asset is depreciated until the book value equals residual value.

Acquisition Value - Accelerated Depreciation = Residual Value

Liabilities: The Right -Hand Side

Liabilities are classified as either Current or Long Term.

1. Current Liabilities

• The amount of money that a business owes other people and other businesses (creditors).

• Liabilities are “current” because the amount owed can vary from one day to the next.

• They must be paid back within a year.

2. Long Term Liabilities

• These are debts need paying back in the future (one year +)

• Examples: Loans, mortgages,…

Liabilities: The Right -Hand Side

Shareholder's Equity = Total Assets -Total Liabilities

• Preferred Stock

- Hybrid, valued at the original issue price + cumulated unpaid dividends

• Common Stock at Par

• Capital Surplus: results from earnings on buying and selling stocks

- Treasury Stock: repurchased shares, reduce Book Value of equity

• Retained Earnings

The Income Statement - called the profit and loss account deals with the operating activities of a company and is intended to provide a report on its performance during the year.

Income Statement: gives details of a company`s income and expenditures for the year.

When sales revenue is greater than costs a profit is produced, where the reverse occurs a loss results.

A typical Income Statement format is as follows:

Turnover

minus Cost of sales

Gross profit

minus Other operating expenses

Operating profit

plus Other income

Profit on ordinary activities before interest

minus Interest

Profit on ordinary activities before tax

minus Tax

Profit on ordinary activities after tax

minus Minority interest

Profit attributable to shareholders

minus Dividends

Retained Profit

The Cash Flow Statement - The money coming into the business is called cash inflow, and money going out from the business is called cash outflow. The statement shows how changes in balance sheet and income accounts affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills.

BUSINESS OBJECTIVES AND THEORIES OF THE FIRM

INTRODUCTION

Firms are major economic institutions in market economies. Economics is the study of allocation, of how societies solve their allocational problems, and how they might do better. That there is an allocation problem is due to the scarcity of resources that can serve alternative ends, and the fact that wants are insatiable.

BUSINESS OBJECTIVES

To discuss the alternative objectives of the firm by using models of the firm developed by economists:

• Understand the assumptions of the profit-maximizing model of the firm and explain the implications for price and output.

• Explain the sales revenue maximization model of the firm and analyse the implications for price and output.

• Outline the managerial utility model of the firm and explain the implications for resource allocation.

• Outline the main criticisms of neoclassical and managerial models.

• Explain the behavioural model of the firm and its advantages and disadvantages for economic analysis of the firm.

• Discuss the arguments for firms adopting wider social obligations

• The objective is to explore how economists have developed models of the firm based on control by

owners and managers. Traditionally, it has been assumed that owners set the goal of profit maximization and that managers make decisions in pursuit of that goal. However, the divorce between ownership and control has led to the development of theories that emphasize the maximization of managerial objectives.

• The objective is also explores the notion that firms pursue multiple objectives and aim to satisfy rather than maximize an individual objective. The notion of incorporating wider social goals into the objectives of the firm is also examined

THEORIES OF THE FIRM

• Profit maximization

• Sales revenue maximization

• Williamson's managerial utility model

• Behavioural models

• Comparison of behavioural and traditional theories

• Corporate social responsibility

• Owners, managers and performance

PROFIT MAXIMIZATION

Alfred Marshall (1842-1924) was a representative of a neoclassical theory of profit maximization.

The traditional objective of the owner-managed firm is assumed to be short-run profit maximization. This presumption of profit maximization is the building block of neoclassical economics, not only for the theory of the firm but also for the theories of price and competitive markets. For firms where there is a divorce between ownership and control the assumption is that managers still maximize profits on behalf of the owners. Thus, the firm's owners and managers have a single objective.

• TR1, TR2 = total revenue at prices P1, P2, P3

• TC = total costs

• VC = variable costs

• IP = inflex point

• ZV = start of production = P1 = AVC resp.

TR1 = VC

• ZZ = start of profit = P2 = AVC resp. V2= TC

• PO = firm optimum = profit maximum = P3 =

MC

• Profit maximum = MR - MC = 0

The rules of profit maximization

Where profit maximization is the goal of the firm, economists have developed a set of rules to

guide decision makers to achieve it. Assuming the firm produces and sells a single product, then, given the associated revenue and cost functions, profit (.) is the difference between total revenue (TR) and total cost (TC). These three functions are shown in Figure 2.

The profit function shows a range of outputs at which the firm makes positive or super-normal profits. The profit-maximizing output is Q

The slopes of the total revenue and cost curves are equal at points A and B, which means that the addition to total cost or marginal cost is equal to the addition to total revenue or marginal

revenue at output Q. The decision maker must, if he wishes to maximize profits, have information

about the firm's revenue and cost functions and, more particularly, its marginal revenue and marginal cost curves.

Similar information is presented in Figure 3, but using marginal revenue and cost curves.

The firm maximizes profit where marginal revenue (MR) is equal to marginal cost (MC) at output Q. The price the firm charges is P and total profit is given by the area PCMN, which is equal to total profit (AB) in Figure 2.

The rules of profit maximization in perfect competition-short run view

• The short - term equilibrium of the firm in perfect competition could be graphically

represented by average and marginal costs functions

• By the price P firm will produce quantity of production when the MC= MR and firm will gain an economical profit, which is represented by the area “MNPC”

The rules of profit maximization in perfect competition-long run view

• In the long - run will be the equillibrium reached also at the point, where MC = MR, however in the long -run will be the economic profit equal to zero.

Criticisms of profit maximization

Criticisms of profit maximization as capturing the essence of a firm's objectives have come from empirical and theoretical perspectives. The main criticisms of the assumption of profit maximization from empirical studies are:

• Profit maximization is a poor description of what many firms actually try to achieve.

• Other objectives may be more important, such as increasing sales in the short run.

• No single objective may be maximized.

• Marginalism is a poor description of the processes used by businesses to decide output and price.

• Profit is a residual and its outcome is uncertain.

Theoretical criticisms

• The world is characterized by imperfect and uncertain information; this makes the calculation of marginal revenue and marginal cost quite dificult, even for a rational individual.

• Profit as a concept is related to time. Economists usually make a distinction between maximizing short-run and long-run profits. In practice, a firm may trade off lower profits in the short run for greater long-run profits, which is in the long-term interests of the firm.

• The theory of profit maximization does not recognize the complexity of the modern organization. Although the presumption is made that owners or chief executives control their firms, in practice they are run by committees -and committees tend to make compromises so that the firm may adopt a mixture of goals and not necessarily maximize any single goal.

Defence of profit maximization

Machlup (1967) has argued that profit maximization is not a hypothesis that can be tested, but a paradigm that is not itself testable; yet, the paradigm allows a set of possible hypotheses to be defined for subsequent validation. He argues that firms do not need accurate knowledge to maximize profits. Marginal revenue and marginal cost are subjective concepts, and their use by managers is not deliberate but done in an automatic way.

• An individual firm is also constrained in its choice of objectives by the actions of its rivals. If there is a significant degree of competition, then profit maximization may be the only goal the firm can adopt for it to survive and maintain its presence in the market. Likewise, pressure from shareholders will force the management of a firm to match the performance of their competitors if they are not to sell their shares.

• Further, unless the firm is earning a minimum acceptable level of profit it may find raising further capital difficult.

SALES REVENUE MAXIMIZATION

An alternative model recognizing the importance of profit, but assuming that managers set the goals of the firm, is that of sales maximization. This model was developed by Baumol (1959) who argued

that managers have discretion in setting goals and that sales revenue maximization was a more likely short-run objective than profit maximization in firms operating in oligopolistic markets.

The reasons are as follows:

• Sales revenue is a more useful short-term goal for the firm than profit. Sales are measurable and can

be used as a specific target to motivate staff, where as profits, which are a residual, are not so easily used in this way. Specific sales targets are thought to be clearly understood by all within the firm.

• Rewards for senior managers are often tied to sales revenue rather than profit, as they are for lower levels of staff.

The other reasons

• It is assumed that an increase in revenue will more than off set any associated increases in costs, so that additional sales will increase profit; therefore, increasing the size of the firm as measured by sales revenue or turnover is seen by shareholders as a good proxy for short-run profit increases.

• Increasing sales and, hence, the size of the firm makes it easier to manage, because it creates an environment in which everyone believes the firm is successful. A firm facing falling sales will be seen as failing and lead to calls for managers to reappraise their policies.

The static single-period sales maximization model

The static model assumes that:

• The firm produces a single product and has nonlinear total cost and revenue functions.

• The firm makes its price/output decision without taking account of the actions of other firms.

• The firm's objective is to choose a level of sales or output that maximizes sales revenue (TR)

subject to a minimum profit constraint set by shareholders (C).

The impact of the model can be observed in Figure 2.

The total revenue curve (TR), the total cost curve (TC) and the profit function are shown. Sales revenue is maximized at output level OQS at the highest point of the TR curve where marginal revenue is zero and becomes negative for any further increases in sales. For output (Figure 3) QS marginal cost is positive and marginal revenue zero. In fact, all units sold between Q and QS are sold at a loss because marginal cost exceeds marginal revenue. This efect can be seen in the fall in the profit curve after sales level OQ.

The profit constraint that reflects the preferences of shareholders (C) is shown as the absolute amount of profit that the firm has to earn on a given amount of capital employed (i.e., to give a

guaranteed rate of return on capital). This profit constraint is set at a level below that of maximum profits.

The profit constraint for each firm is

determined after taking into consideration:

• The normal profit levels/rate of returns in the sector taking into account cyclical/long-term trends.

• The level of return that will satisfy shareholders with the firm's performance, so that they continue to hold or buy shares rather than sell.

• If profits fall below expected levels, then the share price will fall and encourage further sales of shares and encourage takeover bids.

• A level of profits that will discourage hostile takeover bids would also satisfy the management's desire to retain control of the firm.

In Figure 3 the information in Figure 2 is presented in terms of average and marginal revenue and cost. The firm would maximize profits at output level OQ and maximize sales revenue at OSS. The constrained sales revenue maximization output level will be at OQC, which is somewhere between the profit and sales-maximizing outputs. Equally, the price set by the constrained sales revenue maximizer OPC will be lower than that set by the profit maximizer OP, because the model assumes a downward-sloping demand curve. Therefore, where the constrained sales revenue-maximizing output is greater

than the profit-maximizing output, the firm will always charge a lower price (i.e., OPC will be less than OP).

In the short run, if the firm assumes it faces linear total cost and total revenue curves, then

sales revenue maximization implies selling all the output the firm can produce.

In Figure 6 the firm will break even, where total cost TC is equal to total revenue TR at point E

selling output OQ1. The firm will meet its profit constraint (OC) selling output OQC, but will

maximize sales revenue and profits at output OQK, the capacity output of the firm. Thus, in this case sales revenue and profit maximization lead to the same outcome.

The Baumol sales revenue-maximizing model

The sales revenue-maximizing firm is in a stronger position than the profit maximizer

to increase market share, which business strategists see as an important objective.

Figure 7 and 7a shows differences between profits and sales revenue maximizing.

The Baumol sales revenue maximizing model

• The firm maximizing profit is reaching higher profit than is the minimal requested profit (difference TR and TC is higher than .0), (Figure 7). The optimal output and also the price are not modified.

• Figure 7b: firm is at the point of maximum sales gaining lower profit, than is required. In this situation firm has to increase profit. It could be reached by increasing price and decreasing output and also by decreasing of total incomes (we are moving in the elastic part of the supply curve).

• Is apparent that firm will decrease output until reach minimal required profit. Than the output is higher than minimal required profit.

• At the Figure 7b is the point E point of the equillibrium of firm maximizing profit. The point F is the point of equillibrium for the firm maximizing sales. The point G is the optimal point of firm maximizing sales by the limited condition of minimal requested profit (difference TR and TC is equal to .0).

Advertising and the static model

Baumol envisages enterprises moving to new and higher total revenue curves by advertising.

Advertising is used to give information to consumers and to persuade them to buy the product. Baumol assumes that the marginal revenue of advertising is always positive and that the market price of the goods remains unchanged. Thus, additional advertising will always increase sales but do so with decreasing effectiveness.

In Figure 8, advertising replaces quantity on the horizontal axis with revenue measured on the vertical axis. Advertising is shown as a cost per unit, with total expenditure increasing linearly. Production costs are assumed to be independent of advertising expenditure, but are added to advertising costs, to give a linear total cost curve (TC). The total revenue curve (TR) is drawn showing revenue always increasing as advertising increases. There is no maximum point to the total revenue compared with the curve in Figure 2.

The level of advertising expenditure that maximizes profit is OA. while the level of advertising that maximizes sales revenue subject to a profit constraint is OAC. The sales maximizer will therefore spend more on advertising than a profit maximizer.

The price charged by a sales-maximizing firm is again lower than that charged by a profit maximizing

enterprise.

The relationships as postulated by Baumol between sales revenue and advertising, on the one hand, and advertising and production costs, on the other, have been criticized.

The assumption that all costs other than advertising are fixed and do not vary with

output has also been criticized. This simplifying assumption can be changed and traditional cost curves incorporated into the analysis, as was done by Sandmeyer (1964).

Sandmeyer (1964).The impact of both price and advertising on sales revenue can be explained with the aid of Figure 9; this is done by:

• Treating the minimum profit constraint as a fixed cost that must be earned by the firm.

• Assuming advertising expenditure is increased in discrete steps.

• Assuming each level of advertising generates a unique sales revenue curve (and demand curve) that recognizes that revenue eventually decreases as prices fall.

The minimum profit constraint and advertising expenditure are measured on the vertical axis and output or sales on the horizontal axis. The lines AC1+ . represent the combined levels of the minimum profit constraint and advertising expenditure associated with total revenue curve R1A1. Thus, as expenditure on advertising increases from AC1+.C to BC2+. X to DC3+.C, the sales revenue curve moves from R1A1 to R2A2 to R3A3. The firm will continue expanding output from Q1 to Q2 to Q3 and total revenue from Q1T1 to Q2T2 to Q3T3, since advertising consistently increases sales.

Analysis of cost changes

The static model also enables predictions to be made about the impact of changes in costs, taxes and demand on price and output combinations. An increase in fixed costs will lead to a reduction in output. This contrasts with a profit maximizer which would keep output unchanged. In Figure 10(a) the impact of an increase in fixed costs is to move the profit function uniformly downward from .2 to .1.

The profit-maximizing output remains unchanged at Q1, while the profit constraint of the sales maximizer C.c induces a reduction in output from Q2 to Q3 and an increase in price.

An increase in variable costs (or a sales tax), which shifts the profit curve to the left

as well as downward (from 1 to 2), leads both the profit maximizer and the sales maximizer to reduce their output. This can be observed in Figure 10(b) where the profit maximizer reduces output from Q2 to Q1 and the sales maximizer from Q4 to Q3.

WILLIAMSON'S MANAGERIAL UTILITY MODEL

Williamson (1963) sought to explain firm behaviour by assuming senior management seeks to maximize its own utility function rather than that of the owners. Managers find satisfaction in receiving a salary, knowing they hold a secure job, that they are important, have power to make decisions and receive professional and public recognition. Of these, only salary is directly measurable in monetary terms, but the other non-pecuniary benefits are related to expenditures on:

• Staff (S), the more staff employed the more important the manager.

• Managerial emoluments or fringe benefits (M) are rewards over and above those necessary to secure the managers services and are received in the form of free cars, expense accounts, luxurious offices, etc. and are paid for by the firm.

• Discretionary investments (ID), which allow managers to pursue their own favoured projects.

Together these three elements comprise discretionary expenditure or managerial slack.

Expenditure on these three elements increases costs and reduces the firm's profits.

Thus, these expenditures can only be pursued providing actual profits (.1) are greater than the minimum profit that is necessary to keep shareholders happy and willing to hold their stock.

“D” is than discretionary profit that managers are able to utilize to increase their benefits. Managers maximize utility at point “E”.

The manager's preferences are shown by a set of indifference curves, each one showing the levels of

staff expenditure and discretionary profit, which give the same level of satisfaction or utility. It is also assumed that a manager will prefer to be on higher indifference curves.

The relationship between discretionary expenditure and discretionary profit is shown by a profit curve. Initially, discretionary profit and staff expenditure have a positive relationship, but after point “D” further discretionary expenditure reduces discretionary profits and, eventually, they fall to zero.

The manager will maximize utility at point “E” Managers, therefore, do not maximize utility where discretionary profits are maximized but at lower levels of discretionary profit and higher levels of discretionary expenditure.

A profit-maximizing firm has no managerial slack since costs are minimized and profits maximized.

A managerial utility-maximizing firm will respond to changes by increasing or decreasing discretionary expenditure. Williamson (1964) found that firms were able to make cost reductions in times of declining profit opportunities without hindering the operations of the firm.

BEHAVIOURAL MODELS

Behavioural theories of the firm, while based on the divorce between ownership and control, also

postulate that the internal structures of a firm and how various groups interact could influence a firm's objectives.

Behavioural theories set out to analyse the process by which firms decide on their objectives, which are assumed to be multiple rather than singular in nature.

Consequently, the firm tends to have a multiplicity of objectives rather than a single one and to have a

hierarchy of goals, so that some are achieved sooner than others.

The complexity of large modern enterprises means that the firm is made up of a number of separate groups, each responsible for a particular aspect of the firm's activities and each with its own objectives: for example, the marketing director and the finance director may have different priorities in terms of using the firm's resources. The overall strategy of the firm is based on the conflicting objectives of these groups and the processes used to achieve an agreed position. To achieve this, conflicts have to be resolved and compromises have to be made.

Simon (1959), a Nobel Prize winner for economics, argued that:

• The firm is not a well-defined ``individual entity'' with its own set of goals.

• Decisions are arrived at through interaction between the various interest groups or managerial departments of the firm.

• Studying these interactions in terms of agreement/conflicts will indicate whether the firm will have any clearly articulated long-run objective.

Simon also argued that a firm's goal is unlikely to be profit-maximizing and more likely to be about achieving a satisfactory rate of profit.

Simon termed such behaviour as satisfying, implying that the firm aims at outcomes that are satisfactory or acceptable, rather than optimal. He also articulated a process by which the firm arrives at a set of objectives through an iterative process of learning, as a result of either achieving or failing to achieve its set targets

In the long run this may lead to a performance that is close to the profit-maximizing position, but this is only achieved through revision of achieved targets rather than as the prime objective of the firm. In Figure 11 the process by which limited initial goals may lead to higher levels of achievement is illustrated as a decision making process .

Decision-making process

• Initially, managers set an objective and, then, the firm or part of the firm tries to achieve it (box 1).

• The next stage is an evaluation of performance against the goals (box 2).

• If the objective has not been achieved and the managers accept that it was set at too high a level, then they might lower their expectations or aspirations and set a revised lower objective in the next period (box 6).

• If the objective has been achieved, then the managerial team will raise their expectations or aspirations and, as a consequence, raise the objective set in the next period (box 7).

BEHAVIOURAL MODELS

Matthews (1981) argued that the ``the mainspring of the system appears to be a standard of

behaviour, which, in a non-economic context would be regarded as deplorable.'' Self-interest in both business and social contexts is not always in the interest of the wider community. He argues that the overriding objective of the firm is survival rather than the maximization of profit or sales. Survival is achieved if the performance of the firm is satisfactory and satisfies the various interest groups in the firm, including the owners.

Galbraith (1974) argued that ``for any organisation, as for any organism, the goal or objective that has a natural assumption of pre-eminence is the organisation's own survival.''

The notion of corporate social responsibility can be defined as the extent to which individual firms serve social needs other than those of the owners and managers, even if this conflicts with the maximization of profits (Moir 2001). This means that the firm might:

• Internalize social goals.

• Represent concerns of groups other than owners and managers.

• Undertake voluntary action beyond that required by law.

• Recognize the social consequences of economic activity.

Examples of expenditures on social responsibility might include:

• Charitable giving.

• Seconding staff to help with the management of community projects.

• Sponsorship of arts and sports, though at some point such expenditure might be regarded as advertising.

• And behaving in an environmentally responsible way by not polluting rivers, etc.

Cyert and March model

Cyert and March (1963) developed a behavioural model. They identify the various groups or coalitions which exist within the firm, defining a coalition as any group that shares a consensus on the goals to be pursued. The firm is seen as a collection of interest groups or stakeholders, each of which may be able to influence the set of objectives eventually agreed.

The agreed goals for the firm are the outcome of bargaining and, to some degree, satisfy everyone.

Cyert and March (1963) identify areas of activity within the firm where objectives have to be set. These might include specific goals to cover production, stocks, sales and market share. These specific objectives then guide decision making in the individual sections of the firm as follows: Production goal, Stock goal, Sales goal,

Market share goal and Profit goal.

• Production goal: the production division is largely concerned with decisions about output and employment. They want the latest equipment, to be able to utilize it fully and to have long production runs. If sales fall, the production division would tend to favour an increase in stocks rather than a reduction in output.

• Stock goal: the warehouse division holds stocks of raw materials and finished products. Sufficient stocks are held to keep both production and sales divisions happy, but too many stocks cost money and will therefore be regarded by the finance department as unprofitable.

• Sales goal: the marketing division will be interested in increasing sales that could be set in terms of revenue or in terms of output. Clearly, if sales were pushed too far this might lead to conflict with the finance department seeking to maximize profits.

• Market share goal: the marketing division might prefer to see their goal set in terms of a market share goal rather than just a sales objective. Raising market share might be seen to raise managerial utility because the firm becomes more important. However, such a goal might conflict with the concerns of the finance department.

• Profit goal: the objective is a satisfactory profit that enables the firm to keep its shareholders happy and to satisfy the needs of divisions for further funds. The goal is not set as a profit maximization goal because managers are always willing to trade of profits to fulfil other goals.

Comparison of traditional theory with behaviourism

Profit maximizing theory Behavioural theory

• Firm is synonymous with entrepreneur. Firm is made up of a coalition of groups

• No conflict between members. Conflict between members settled by discussion/debate

• Single goal to maximize profit Multiple goals to achieve a satisfactory outcome

• Entrepreneur has perfect information Managers have imperfect information

• Global rationality

• Marginalism

• Factors paid in line with marginal product

• No conflict

• Predictions of price/output made Bounded rationality Rules of thumb, search, learning Factors paid in excess of marginal product Conflict resolved by side-payments No predictions -every case unique

Profits and social responsibility

The potential relationship between expenditure on social responsibility and profit can be viewed in two ways. First, profits and social expenditure can be regarded as substitutes or, second, as complements.

The first relationship is illustrated in Figure 12(a), where on the vertical axis we have profits paid to shareholders and on the horizontal axis resources allocated to social concerns. The frontier assumes decreasing returns to social spending. Where the firm chooses to be on the curve will be a function of the preferences of management and are summed into a set of indifference curves. The firm chooses to be at point E where the two functions are tangential. The firm could have chosen a different point including point A where no social spending takes place or point B where all discretionary profits are spent on social concerns.

Complementary relationship

The second relationship is illustrated in Figure 12(b), where profits and social expenditures are both complements and substitutes. The line AB represents profits that would be earned if the firm did not engage in social expenditure. Initially profit is reduced below AB when the firm starts social expenditures, but after point E social expenditure raises profitability to higher levels.

OWNERS, MANAGERS AND PERFORMANCE

Some studies have attempted to measure the performance of firms depending on whether owners or managers were able to set the objectives of the firm. Short (1994) surveying studies finds that the majority give some support to the proposition that owner-controlled firms earn higher profits than managerially controlled firms. The results, however, are not always statistically significant.

Holl (1975) found no significant difference between owner-controlled and managerially controlled firms when the industries in which they operated were taken into account. Steer and Cable (1978) found owner-controlled firms outperformed managerially controlled firms, as did Leach and Leahy (1991). These results do not necessarily imply owner-controlled firms maximize profits but merely that owner controlled firms achieve higher profits, confirming the comparative static outcomes of

profit and sales revenue-maximizing models.

SUMMARY

In this chapter we explored the theoretically possible objectives pursued by the firm. To do this we analysed:

How the chosen objective influences the decision-making process of the firm.

How, despite a single objective leading to clarity of analysis, in practice firms are likely to pursue a multiplicity of objectives.

The main models: which were profit-maximizing reflecting the preferences of managers, on the one hand, and sales and utility maximization reflecting the preferences of managers and behavioural theory, on the other. In practice, an individual firm may well have multiple objectives and satisfice rather than maximize.

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