At its simplest level, a business enterprise represents a series of contractual relationships that specify the rights and responsibilities of various parties (see Figure 1.2). People directly involved include customers, stockholders, management, employees, and suppliers. Society is also involved because businesses use scarce resources, pay taxes, provide employment opportunities, and produce much of society’s material and services output. 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.
Expected Value Maximization
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. Today, the emphasis on profits has been broadened to encompass uncertainty and the time value of money. In this more complete model, the primary goal of the firm is long-term expected value maximization.
The value of the firm is the present value of the firm’s expected future net cash flows. If cash flows are equated to profits for simplicity, the value of the firm today, or its present value,
is the value of expected profits or cash flows, discounted back to the present at an appropriate
interest rate.2
This model can be expressed as follows:
Here, π1, π2, . . . πn represent expected profits in each year, t, and i is the appropriate interest, or discount, rate. The final form for Equation 1.1 is simply a shorthand expression in which sigma (Σ) stands for “sum up” or “add together.” The term
means, “Add together as t goes from 1 to n the values of the term on the right.” For Equation
1.1, the process is as follows: Let t = 1 and find the value of the term π1/(1 + i)1, the present value of year 1 profit; then let t = 2 and calculate π2/(1 + i)2, the present value of year 2 profit; continue until t = n, the last year included in the analysis; then add up these present-value equivalents of yearly profits to find the current or present value of the firm.
Because profits (π) are equal to total revenues (TR) minus total costs (TC), Equation 1.1 can be rewritten as
This expanded equation can be used to examine how the expected value maximization model relates to a firm’s various functional departments. The marketing department often has primary responsibility for product promotion and sales (TR); the production department has primary responsibility for product development costs (TC); and the finance department has primary responsibility for acquiring capital and, hence, for the discount factor (i) in the denominator. Important overlaps exist among these functional areas. The marketing department can help reduce costs associated with a given level of output by influencing customer order size and timing. The production department can stimulate sales by improving quality. Other departments, for example, accounting, human resources, transportation, and engineering, provide information and services vital to sales growth and cost control. The determination of TR and TC is a complex task that requires recognizing important interrelations among the various areas of firm activity. An important concept in managerial economics is that managerial decisions should be analyzed in terms of their effects on value, as expressed in Equations 1.1 and 1.2.