Goal of the firm maximize shareholder wealth

PART1 INTRODUCTION

ECONOMIC ANALYSIS AND DECISIONS

1. Demand Analysis 2. Production and Cost Analysis 3. Product, Pricing, and Output

Decisions 4. Capital Expenditure Analysis

ECONOMIC, POLITICAL, AND SOCIAL ENVIRONMENT

1. Business Conditions (Trends, Cycles, and Seasonal Effects)

2. Factor Market Conditions (Capital, Labor, and Raw Materials)

3. Competitors’ Reactions and Tactical Response

4. Organizational Architecture and Regulatory Constraints

Cash Flows Risk

Firm Value (Shareholders’ Wealth)

1

1 CHAP T E R

Introduction and Goals of the Firm CHAPTER PREVIEW Managerial economics is the application of microeconomics to problems faced by decision makers in the private, public, and not-for-profit sectors. Managerial economics assists managers in efficiently allocating scarce resources, planning corporate strategy, and executing effective tactics. In this chapter, the responsibilities of management are explored. Economic profit is defined and the role of profits in allocating resources in a free enterprise system is examined. The primary goal of the firm, namely, shareholder wealth maximization, is developed along with a discussion of how managerial decisions influence shareholder wealth. The problems associated with the separation of ownership and control and principal-agent relationships in large corporations are explored.

MANAGERIAL CHALLENGE How to Achieve Sustainability: Southern Company1

In the second decade of the twenty-first century, com- panies all across the industrial landscape are seeking to achieve sustainability. Sustainability is a powerful meta- phor but an elusive goal. It means much more than aligning oneself with environmental sensitivity, though that commitment itself tests higher in opinion polling of the latent preferences of American and European custo- mers than any other response. Sustainability also im- plies renewability and longevity of business plans that are adaptable to changing circumstances without up- rooting the organizational strategy. But what exactly should management pursue as a set of objectives to achieve this goal?

Management response to pollution abatement illus- trates one type of sustainability challenge. At the insis- tence of the Prime Minister of Canada during the Reagan Administration, the U.S. Congress wrote a bi- partisan cap-and-trade bill to address smokestack emis- sions. Sulfur dioxide and nitrous oxide (SOX and NOX) emissions precipitate out as acid rain, mist, and ice, im-

posing damage downwind over hundreds of miles to painted and stone surfaces, trees, and asthmatics. The Clean Air Act (CAA) of 1990, amended in 1997 and 2003, granted tradable pollution allowance assets (TPAs) to known polluters. The CAA also authorized an auction market for these TPA assets. The EPA Web site (www.epa.gov) displays on a daily basis the equilibrium, market-clearing price (e.g., $250 per ton of soot) for the use of what had previously been an un- priced common property resource—namely, acid-free air and rainwater. Thereby, large point-source polluters like power plants and steel mills earned an actual cost per ton for the SOX and NOX–laden soot by-products of burning lots of high sulfur coal. These amounts were promptly placed in spreadsheets designed to find ways of minimizing operating costs.2 No less importantly, each polluter felt powerful incremental incentives to mitigate compliance cost by reducing pollution. And an entire industry devoted to developing pollution abatement technology sprang up.

Cont.

2

The TPAs granted were set at approximately 80 per- cent of the known pollution taking place at each plant in 1990. For example, Duke Power’s Belews Creek power plant in northwestern North Carolina, generating 82,076 tons of sulfur dioxide acidic soot annually from burning 400 train carloads of coal per day, was granted 62,930 tons of allowances (see Figure 1.1 displaying the 329 × 365 = 120,085 tons of nitrous oxide). Although this approach “grandfathered” a substantial amount of

pollution, the gradualism of the 1990 cap-and-trade bill was pivotally important to its widespread success. In- dustries like steel and electric power were given five years of transition to comply with the regulated emis- sions requirements, and then in 1997, the initial allow- ances were cut in half. Duke Power initially bought 19,146 allowances for Belews Creek at prices ranging from $131 to $480 per ton and then in 2003 built two 30-story smokestack scrubbers that reduced the NOX emissions by 75 percent.

Another major electric utility, Southern Company, analyzed three compliance choices on a least-cost cash flow basis: (1) buying allowances, (2) installing smoke- stack scrubbers, or (3) adopting fuel switching technol- ogy to burn higher-priced low-sulfur coal or even cleaner natural gas. In a widely studied case, the South- ern Company’s Bowen plant in North Georgia necessi- tated a $657 million scrubber that after depreciation and offsetting excess allowance revenue was found to cost $476 million. Alternatively, continuing to burn high- sulfur coal from the Appalachian Mountain region and buying the requisite allowances was projected to cost

FIGURE 1.1 Nitrous Oxide from Coal-Fired Power Plants (Daily Emissions in Tons, pre Clean Air Act)

Asheville CP&L

Cliffside Duke

Duke Allen

Marshall Duke

Riverbend Duke

Belews Creek Duke

Buck Duke44

39 5924

164

329 tons NOx

14

13 55

194

17

13

Cape Fear

CP&L

Weatherspoon CP&L

Sutton CP&L

Lee CP&L

Mayo CP&L

Roxboro CP&L

Dan River Duke

55

27

Source: NC Division of Air Quality.

MANAGERIAL CHALLENGE Continued ©

AP Im ag es /S te ph en

M or to n

Chapter 1: Introduction and Goals of the Firm 3

Cont.

WHAT IS MANAGERIAL ECONOMICS? Managerial economics extracts from microeconomic theory those concepts and tech- niques that enable managers to select strategic direction, to allocate efficiently the re- sources available to the organization, and to respond effectively to tactical issues. All such managerial decision making seeks to do the following:

1. identify the alternatives, 2. select the choice that accomplishes the objective(s) in the most efficient manner, 3. taking into account the constraints 4. and the likely actions and reactions of rival decision makers.

For example, consider the following stylized decision problem:

$266 million. And finally, switching to low-sulfur coal and adopting fuel switching technology was found to cost $176 million. All these analyses were performed on a present value basis with cost projections over 25 years.

Southern Company’s decision to switch to low-sulfur coal was hailed far and wide as environmentally sensi- tive. Today, such decisions are routinely described as a sustainability initiative. Many electric utilities support these sustainable outcomes of cap-and-trade policies and even seek 15 percent of their power from renewable energy (RE). In a Case Study at the end of the chapter, we analyze several wind power RE alternatives to burn- ing cheap high-sulfur large carbon footprint coal.

The choice of fuel-switching technology to abate smoke- stack emissions was a shareholder value-maximizing choice for Southern Company for two reasons. First, switching to low-sulfur coal minimized projected cash flow compliance costs but, in addition, the fuel-switching technology created a strategic flexibility (a “real option”) that created additional shareholder value for the Southern Company. In this chapter, we will see what maximizing capitalized value of equity (shareholder value) is and what it is not.

Discussion Questions

� What’s the basic externality problem with acid rain? What objectives should management serve in responding to the acid rain problem?

� How does the Clean Air Act’s cap-and-trade approach to air pollution affect the Southern Company’s analysis of the previously unpriced common property air and water resources damaged by smokestack emissions?

� How should management comply with the Clean Air Act, or should the Southern Com- pany just pay the EPA’s fines? Why? How would you decide?

� Which among Southern Company’s three alternatives for compliance offered the most strategic flexibility? Explain.

1Based on Frederick Harris, Alternative Energy Symposium, Wake Forest Schools of Business (September 2008); and “Acid Rain: The Southern Com- pany,” Harvard Business School Publishing, HBS: 9-792-060. 2EPA fines for noncompliance of $2,000 per ton have always far exceeded the auction market cost of allowances ($131–$473 in recent years).

Example Capacity Expansion at Honda, N.A., and Toyota Motors, N.A. Honda and Toyota are attempting to expand their already substantial assembly op- erations in North America. Both companies face increasing demand for their U.S.-manufactured vehicles, especially Toyota Camrys and Honda Accords. Camrys and Accords rate extremely highly in consumer reports of durability and reliability. The demand for used Accords is so strong that they depreciate only 45 percent in their first four years. Other competing vehicles may depreciate as much

(Continued)

MANAGERIAL CHALLENGE Continued

4 Part 1: Introduction

THE DECISION-MAKING MODEL The ability to make good decisions is the key to successful managerial performance. All decision making shares several common elements. First, the decision maker must establish the objectives. Next, the decision maker must identify the problem. For example, the CEO of electronics retailer Best Buy may note that the profit margin on sales has been decreas- ing. This could be caused by pricing errors, declining labor productivity, or the use of out- dated retailing concepts. Once the source or sources of the problem are identified, the manager can move to an examination of potential solutions. The choice between these al- ternatives depends on an analysis of the relative costs and benefits, as well as other organi- zational and societal constraints that may make one alternative preferable to another.

The final step in the decision-making process, after all alternatives have been evalu- ated, is to analyze the best available alternative under a variety of changes in the assump- tions before making a recommendation. This crucial final step is referred to as a sensitivity analysis. Knowing the limitations of the planned course of action as the deci- sion environment changes, the manager can then proceed to an implementation of the decision, monitoring carefully any unintended consequences or unanticipated changes in the market. This six-step decision-making process is illustrated in Figure 1.2.

The Responsibilities of Management In a free enterprise system, managers are responsible for a number of goals. Managers are responsible for proactively solving problems before they become crises and for selecting strat- egies to assure the more likely success of the current business model. Managers create organi- zational structure and culture based on the organization’s mission. Senior management especially is responsible for establishing a vision of new business directions and setting stretch goals to get there. In addition, managers monitor, motivate, and incentivize teamwork and coordinate the integration of marketing, operations, and finance functions. In pursuing all of these responsibilities, managers in a capitalist economy are ever conscious of their over- arching goal to maximize returns to the owners of the business—that is, economic profits.

as 65 percent in the same period. Toyota and Honda have identified two possible strategies (S1NEW and S2USED) to meet the growing demand for Camrys and Ac- cords. Strategy S1NEW involves an internal expansion of capacity at Toyota’s $700 million Princeton, Indiana, plant and Honda’s Marysville, Ohio, plant. Strategy S2USED involves the purchase and renovation of assembly plants now owned by General Motors. The new plants will likely receive substantial public subsidies through reduced property taxes. The older plants already possess an enormous infrastructure of local suppliers and regulatory relief.

The objective of Toyota’s managers is to maximize the value today (present value) of the expected future profit from the expansion. This problem can be sum- marized as follows:

Objective function: Maximize the present value (P.V.) of profit (S1NEW, S2USED)

Decision rule: Choose strategy S1NEW if P.V.(Profit S1NEW) > P.V.(Profit S2USED) Choose strategy S2USED if the reverse.

This simple illustration shows how resource-allocation decisions of managers attempt to maximize the value of their firms across forward-looking dynamic strat- egies for growth while respecting all ethical, legal, and regulatory constraints.

Chapter 1: Introduction and Goals of the Firm 5

Economic profit is the difference between total sales revenue (price times units sold) and total economic cost. The economic cost of any activity may be thought of as the highest valued alternative opportunity that is forgone. To attract labor, capital, intellectual property, land, and materiel, the firm must offer to pay a price that is suffi- cient to convince the owners of these resources to forego other alternative activities and commit their resources to this use. Thus, economic costs should always be thought of as opportunity costs—that is, the costs of attracting a resource such as investment capital from its next best alternative use.

THE ROLE OF PROFITS In a free enterprise system, economic profits play an important role in guiding the deci- sions made by the thousands of competing independent resource owners. The existence of profits determines the type and quantity of goods and services that are produced and sold, as well as the resulting derived demand for resources. Several theories of profit indicate how this works.

FIGURE 1.2 The Decision-Making Process

Analyze alternatives

and select the best

Implement and monitor the

decision

Consider societal

constraints

Consider organizational and input constraints

Establish objectives

Identify the problem

Examine possible alternative solutions

Perform a sensitivity analysis

economic profit The difference between total revenue and total economic cost. Economic cost includes a “normal” rate of return on the capital contributions of the firm’s partners.

6 Part 1: Introduction

Risk-Bearing Theory of Profit Economic profits arise in part to compensate the owners of the firm for the risk they assume when making their investments. Because a firm’s shareholders are not entitled to a fixed rate of return on their investment—that is, they are claimants to the firm’s residual cash flows after all other contractual payments have been made—they need to be compensated for this risk in the form of a higher rate of return.

The risk-bearing theory of profits is explained in the context of normal profits, where normal is defined in terms of the relative risk of alternative investments. Normal profits for a high-risk firm, such as Las Vegas hotels and casinos or a biotech pharmaceutical company or an oil field exploration well operator, should be higher than normal profits for firms of lesser risk, such as water utilities. For example, the industry average return on net worth for the hotel/gaming industry was 12.6 percent in 2005, compared with 9 percent for the water utility industry.

Temporary Disequilibrium Theory of Profit Although there exists a long-run equilibrium normal rate of profit (adjusted for risk) that all firms should tend to earn, at any point in time, firms might earn a rate of return above or below this long-run normal return level. This can occur because of temporary dislocations (shocks) in various sectors of the economy. Rates of return in the oil indus- try rose substantially when the price of crude oil doubled from $75 in mid-2007 to $146 in July 2008. However, those high returns declined sharply by late 2008, when oil market conditions led to excess supplies and the price of crude oil fell to $45.

Monopoly Theory of Profit In some industries, one firm is effectively able to dominate the market and persistently earn above-normal rates of return. This ability to dominate the market may arise from economies of scale (a situation in which one large firm, such as Boeing, can produce ad- ditional units of 747 aircraft at a lower cost than can smaller firms), control of essential natural resources (diamonds), control of critical patents (biotech pharmaceutical firms), or governmental restrictions that prohibit competition (cable franchise owners). The conditions under which a monopolist can earn above-normal profits are discussed in greater depth in Chapter 11.

Innovation Theory of Profit The innovation theory of profit suggests that above-normal profits are the reward for successful innovations. Firms that develop high-quality products (such as Porsche) or successfully identify unique market opportunities (such as Microsoft) are rewarded with the potential for above-normal profits. Indeed, the U.S. patent system is designed to en- sure that these above-normal return opportunities furnish strong incentives for contin- ued innovation.

Managerial Efficiency Theory of Profit Closely related to the innovation theory is the managerial efficiency theory of profit. Above-normal profits can arise because of the exceptional managerial skills of well- managed firms. No single theory of profit can explain the observed profit rates in each industry, nor are these theories necessarily mutually exclusive. Profit performance is in- variably the result of many factors, including differential risk, innovation, managerial skills, the existence of monopoly power, and chance occurrences.

Chapter 1: Introduction and Goals of the Firm 7

OBJECTIVE OF THE FIRM These theories of simple profit maximization as an objective of management are insight- ful, but they ignore the timing and risk of profit streams. Shareholder wealth maximiza- tion as an objective overcomes both these limitations.

The Shareholder Wealth-Maximization Model of the Firm To maximize the value of the firm, managers should maximize shareholder wealth. Shareholder wealth is measured by the market value of a firm’s common stock, which is equal to the present value of all expected future cash flows to equity owners dis- counted at the shareholders’ required rate of return plus a value for the firm’s embedded real options:

V0 · ðShares OutstandingÞ = π1ð1+keÞ1 +

π2

ð1+keÞ2 +

π3

ð1+keÞ3 + . . . +

π∞ ð1+keÞ∞

+ Real Option Value

V0 · ðShares OutstandingÞ = ∑ ∞

t=1

πt ð1+keÞt

+ Real Option Value [1.1]

where V0 is the current value of a share of stock (the stock price), πt represents the eco- nomic profits expected in each of the future periods (from period 1 to ∞), and ke equals the required rate of return.

A number of different factors (like interest rates and economy-wide business cycles) influence the firm’s stock price in ways that are beyond the manager’s control, but many factors (like innovation and cost control) are not. Real option value represents the cost savings or revenue expansions that arise from preserving flexibility in the business plans the managers adopt. For example, the Southern Company saved $90 million in comply- ing with the Clean Air Act by adopting fuel-switching technology that allowed burning of alternative high- and low-sulfur coals or fuel oil whenever the full cost of one input became cheaper than another.

Note that Equation 1.1 does take into account the timing of future profits. By discount- ing all future profits at the required rate of return, ke, Equation 1.1 shows that a dollar

Example Shareholder Wealth Maximization at Berkshire Hathaway Warren E. Buffett, chairman and CEO of Berkshire Hathaway, Inc., has described the long-term economic goal of Berkshire Hathaway as follows: “to maximize the average annual rate of gain in intrinsic business value on a per-share basis.”3 Berk- shire’s book value per share has increased from $19.46 in 1964, when Buffett ac- quired the firm, to $91,485 at the end of 2005, a compound annual rate of growth of 21.5 percent. The Standard and Poor’s 500 companies experienced 10.3 percent growth over this same time period.

Berkshire’s directors are all major stockholders. In addition, at least four of the di- rectors have over 50 percent of their family’s net worth invested in Berkshire. Man- agers and directors own over 47 percent of the firm’s stock. As a result, Buffet’s firm has always placed a high priority on the goal of maximizing shareholder wealth.

3Annual Report, Berkshire Hathaway, Inc. (2005).

shareholder wealth A measure of the value of a firm. Shareholder wealth is equal to the value of a firm’s common stock, which, in turn, is equal to the present value of all future cash returns expected to be generated by the firm for the benefit of its owners.

8 Part 1: Introduction

received in the future is worth less than a dollar received immediately. (The techniques of discounting to present value are explained in more detail in Chapter 2 and Appendix A at the end of the book.) Equation 1.1 also provides a way to evaluate different levels of risk since the higher the risk the higher the required rate of return ke used to discount the future cash flows, and the lower the present value. In short, shareholder value is deter- mined by the amount, timing, and risk of the firm’s expected future profits.

SEPARATION OF OWNERSHIP AND CONTROL: THE PRINCIPAL-AGENT PROBLEM Profit maximization and shareholder wealth maximization are very useful concepts when alternative choices can be easily identified and when the associated costs and revenues can be readily estimated. Examples include scheduling capacity for optimal production runs, determining an optimal inventory policy given sales patterns and available produc- tion facilities, introducing an established product in a new geographic market, and choosing whether to buy or lease a machine. In other cases, however, where the alterna- tives are harder to identify and the costs and benefits less clear, the goals of owners and managers are seldom aligned.

Example Resource-Allocation Decisions and Shareholder Wealth: Apple Computer4

In distributing its stylish iMac personal computers and high tech iPods, Apple has considered three distribution channels. On the one hand, copying Dell’s direct- to-the-consumer approach would entail buying components from Motorola, AMD, Intel, and so forth and then hiring third-party manufacturers to assemble what each customer ordered just-in-time to fulfill Internet or telephone sales. In- ventories and capital equipment costs would be very low indeed; almost all costs would be variable. Alternatively, Apple could enter into distribution agreements with an independent electronics retailer like Computer Tree. Finally, Apple could retail its own products in Apple Stores. This third approach entails enormous cap- ital investment and a higher proportion of fixed cost, especially if the retail chain sought high visibility locations and needed lots of space.

Recently Apple opened its 147th retail store on Fifth Avenue in New York City. The location left little doubt as to the allocation of company resources to this new distribution strategy. Apple occupies a sprawling subterranean space topped by a glass cube that Steve Jobs himself designed, across from Central Park, opposite the famed Plaza Hotel. Apple’s profits in this most heavily trafficked tourist and retail corridor will rely on several initiatives: (1) in-store theatres for workshop training on iMac programs to record music or edit home movies, (2) numerous technical experts available for troubleshooting with no waiting time, and (3) con- tinuing investment in one of the world’s most valuable brands. In 2005, Apple made $151 million in operating profits on $2.35 billion in sales at these Apple Stores, a 6.4 percent profit margin relative to approximately a 2 percent profit mar- gin company-wide.

4Based on Nick Wingfield, “How Apple’s Store Strategy Beat the Odds,” Wall Street Journal (May 17, 2006), p. B1.

Chapter 1: Introduction and Goals of the Firm 9

Divergent Objectives and Agency Conflict As sole proprietorships and closely held businesses grow into limited liability corpora- tions, the owners (the principals) frequently delegate decision-making authority to pro- fessional managers (the agents). Because the manager-agents usually have much less to lose than the owner-principals, the agents often seek acceptable levels (rather than a maximum) of profit and shareholder wealth while pursuing their own self-interests. This is known as a principal-agent problem or “agency conflict.”

For example, as oil prices subsided with the collapse of the OPEC cartel in the 1990s, Exxon’s managers diversified the company into product lines like computer software development—an area where Exxon had little or no expertise or competitive advantage. The managers were hoping that diversification would smooth out their executive bonuses tied to quarterly earnings, and it did. However, the decision to diversify ended up caus- ing an extended decline in the value of Exxon’s stock.

Pursuing their own self-interests can also lead managers to focus on their own long-term job security. In some instances this can motivate them to limit the amount of risk taken by the firm because an unfavorable outcome resulting from the risk could lead to their dismissal. Kodak is a good example. In the early 2000s, Kodak’s executives didn’t want to risk developing immature digital photography products. When the demand for digital camera products subsequently soared, Kodak was left with too few markets for its traditional film products. Like Exxon, its stock value plummeted.

Finally, the cash flow to owners erodes when the firm’s resources are diverted from their most productive uses to perks for managers. In 1988, RJR Nabisco was a firm that had become bloated with corporate retreats in Florida, an extensive fleet of corporate airplanes and hangars, and an executive fixation on an awful-tasting new product (the “smokeless” cigarette Premier). This left RJR Nabisco with substantially less value in the marketplace than would have been possible with better resource allocation decisions. Recognizing the value enhancement potential, Kohlberg Kravis Roberts & Co. (KKR) initiated a hostile takeover bid and acquired RJR Nabisco for $25 billion in early 1989. The purchase price offered to common stockholders by KKR was $109 per share, much better than the $50 to $55 pre-takeover price. The new owners moved quickly to sell many of RJR’s poorly performing assets, slash op- erating expenses, and cancel the Premier project. Although the deal was heavily lev- eraged with a large amount of debt borrowed at high interest rates, a much-improved cash flow allowed KKR to pay down the debt within seven years, substantially ahead of schedule.

To forge a closer alliance between the interests of shareholders and managers, some companies structure a larger proportion of the manager’s compensation in the form of performance-based payments. For example, in 2002, Walt Disney’s Michael Eisner re- ceived over $20.2 million in long-term compensation (in addition to his $750,000 salary) as a reward for increasing Walt Disney’s market value 10-fold from $2 billion to $23 billion during his first 10 years as CEO.5 Other firms like Hershey Foods, CSX, Union Carbide, and Xerox require senior managers and directors to own a substantial amount of company stock as a condition of employment. The idea behind this is to align the pocketbook interests of managers directly with those of stockholders. In sum, how moti- vated a manager will be to act in the interests of the firm’s stockholders depends on the structure of his or her compensation package, the threat of dismissal, and the threat of takeover by a new group of owners.

5J. Steiner, Business, Society, and Government (New York: McGraw-Hill, 2003), pp. 660–662.

10 Part 1: Introduction

Agency Problems Two common factors that give rise to all principal-agent problems are the inherent un- observability of managerial effort and the presence of random disturbances in team pro- duction. The job performance of piecework garment workers is easily monitored, but the work effort of salespeople and manufacturer’s trade representatives may not be observ- able at less-than-prohibitive cost. Directly observing managerial input is even more prob- lematic because managers contribute what one might call “creative ingenuity.” Creative ingenuity in anticipating problems before they arise is inherently unobservable. Owners know it when they see it, but often do not recognize when it is missing. As a result, in explaining fluctuations in company performance, the manager’s creative ingenuity is often inseparable from good and bad luck. Owners therefore find it difficult to know when to reward managers for upturns and when to blame them for poor performance.

To an attempt to mitigate these agency problems, firms incur several agency costs, which include the following:

1. Grants of restricted stock or deferred stock options to structure executive compensa- tion in such a way as to align the incentives for management with shareholder interests.

Separation of ownership (shareholders) and control (management) in large cor- porations permits managers to pursue goals, such as maximization of their own personal welfare, that are not always in the long-term interests of shareholders. As a result of pressure from large institutional shareholders, such as Fidelity Funds, from statutes such as Sarbanes-Oxley mandating stronger corporate governance, and from federal tax laws severely limiting the deductibility of executive pay, a growing num- ber of corporations are seeking to assure that a larger proportion of the manager’s pay occurs in the form of performance-based bonuses. They are doing so by (1) tying executive bonuses to the performance of comparably situated competitor companies, (2) by raising the performance hurdles that trigger executive bonuses, and (3) by eliminating severance packages that provide windfalls for executives whose poor per- formance leads to a takeover or their own dismissal.

In 2005, CEOs of the 350 largest U.S. corporations were paid $6 million in median total direct compensation. The 10 companies with the highest shareholder returns the previous five years paid $10.6 million in salary, bonus, and long-term

Example Agency Costs and Corporate Restructuring: O.M. Scott & Sons6

The existence of high agency costs sometimes prompts firms to financially restruc- ture themselves to achieve higher operating efficiencies. For example, the lawn pro- ducts firm O.M. Scott & Sons, previously a subsidiary of ITT, was purchased by the Scott managers in a highly leveraged buyout (LBO). Faced with heavy interest and principal payments from the debt-financed LBO transaction and having the poten- tial to profit directly from more efficient operation of the firm, the new owner- managers quickly put in place accounting controls and operating procedures designed to improve Scott’s performance. By monitoring inventory levels more closely and negotiating more aggressively with suppliers, the firm was able to reduce its average monthly working capital investment from an initial level of $75 million to $35 million. At the same time, incentive pay for the sales force caused revenue to increase from $160 million to a record $200 million.

6A more complete discussion of the Scott experience can be found in Brett Duval Fromson, “Life after Debt: How LBOs Do It,” Fortune (March 13, 1989), pp. 91–92.

agency costs Costs associated with resolving conflicts of interest among shareholders, managers, and lenders. Agency costs include the cost of monitoring and bonding performance, the cost of constructing contracts designed to minimize agency conflicts, and the loss in efficiency resulting from unresolved agent- principal conflicts.

Chapter 1: Introduction and Goals of the Firm 11

incentives. The 10 companies with the lowest shareholder returns paid $1.6 million. Figure 1.3 shows that across these 350 companies, CEO total compensation has mirrored corporate profitability, spiking when profits grow and collapsing when profits decline. In the global economic crisis of 2008–2009, CEO salaries declined in 63 percent of NYSE Euronext companies, and bonuses and raises were frozen, cut, or eliminated in 47 percent and 52 percent, respectively.7

Example Executive Performance Pay: General Electric8

As a representative example of a performance-based pay package, General Electric CEO Jeff Immelt had a 2006 salary of $3.2 million, a cash bonus of $5.9 million, and gains on long-term incentives that converted to stock options of $3.8 million. GE distributes stock options to 45,000 of its 300,000 employees, but decided that one-half of CEO Jeff Immelt’s 250,000 “performance share units” should only con- vert to stock options if GE cash flow grew at an average of 10 percent or more for five years, and the other one-half should convert only if GE shareholder return ex- ceeded the five-year cumulative total return on the S&P 500 index.

Basing these executive pay packages on demonstrated performance relative to in- dustry and sector benchmarks has become something of a cause célèbre in the United States. The reason is that by 2008 median CEO total compensation of $7.3 million had grown to 198 times the $37,000 salary of the average U.S. worker. In Europe, the comparable figure was $900,000, approximately 33 times the median worker sal- ary of $27,000.9 And similar multipliers to those in Europe apply in Asia. So, what U.S. CEOs get paid was the focus of much public policy discussion even before the pay scandals at AIG and Merrill Lynch/Bank of America in the fall of 2009.

8Based on http://people.forbes.com/rankings/jeffrey-r-immelt/36126 9Mercer Human Resources Consulting, “Executive Compensation” (2006).

FIGURE 1.3 CEO Pay Trends

+25%

+15%

+5%

–15%

–25%

0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2009

–5%

Corporate profits CEO compensation

2008

Source: Mercer Human Resource Consulting.

7“NYSE Euronext 2010 CEO Report,” NYSEMagazine.com (September 2009), p. 27.

12 Part 1: Introduction

2. Internal audits and accounting oversight boards to monitor management’s actions. In addition, many large creditors, especially banks, now monitor financial ratios and investment decisions of large debtor companies on a monthly or even biweekly basis. These initiatives strengthen the firm’s corporate governance.

3. Bonding expenditures and fraud liability insurance to protect the shareholders from managerial dishonesty.

4. Lost profits arising from complex internal approval processes designed to limit managerial discretion, but which prevent timely responses to opportunities.

IMPLICATIONS OF SHAREHOLDER WEALTH MAXIMIZATION Critics of those who want to align the interests of managers with equity owners often allege that maximizing shareholder wealth focuses on short-term payoffs—sometimes to the detriment of long-term profits. However, the evidence suggests just the opposite. Short-term cash flows reflect only a small fraction of the firm’s share price; the first 5 years of expected dividend payouts explain only 18 percent and the first 10 years only 35 percent of the share prices of NYSE stocks.11 The goal of shareholder wealth maximi- zation requires a long-term focus.

WHAT WENT RIGHT • WHAT WENT WRONG

Saturn Corporation10

When General Motors rolled out their “different kind of car company,” J.D. Powers rated product quality 8 per- cent ahead of Honda, and customers liked the no-haggle selling process. Saturn achieved the 200,000 unit sales en- joyed by the Honda Civic and the Toyota Corolla in two short years and caught the 285,000 volume of the Ford Escort in Saturn’s fourth year. Making interpersonal as- pects of customer service the number-one priority and possessing superior inventory and MIS systems, Saturn dealerships proved very profitable and quickly developed a reputation for some of the highest customer loyalty in the industry.

However, with pricing of the base Saturn model $1,200 below the $12,050 rival Japanese compact cars, the GM parent earned only a $400 gross profit margin per vehicle. In a typical year, this meant GM was recovering only about $100 million of its $3 billion capital investment, a paltry 3 percent return. Netting out GM’s 11 percent cost of capital, each Saturn was losing approximately $1,000. These figures compare to a $3,300 gross profit margin per vehicle in some of GM’s other divisions. Consequently, cash flow was not reinvested in the Saturn division, products were not updated, and the models stagnated. By 1997, sales

were slumping at −9 percent and in 1998 they fell an ad- ditional 20 percent. In 2009, GM announced it was perma- nently closing the Saturn division.

What problems appear responsible for Saturn’s mid-life crisis? GM failed to adopt a change-management view of what would be required to transfer the first-time Saturn owners to more profitable GM divisions. The corporate strategy was that price-conscious young Saturn buyers would eventually trade up to Buick and Oldsmobile. In- stead, middle-aged loyal Saturn owners sought to trade up within Saturn, and finding no sporty larger models available, they switched to larger Japanese imports like the Honda Accord and Toyota Camry. Saturn has now learned that companies whose products are exposed to competition from foreign producers must plan product in- troductions and marketing campaigns to account for this global competitive environment. Recent product introduc- tions have included a sport wagon, an efficient SUV, and a high-profile sports coupe.

10Based on M. Cohen, “Saturn’s Supply-Chain Innovation,” Sloan Manage- ment Review (Summer 2000), pp. 93–96; “Small Car Sales Are Back” and “Why Didn’t GM Do More for Saturn?” BusinessWeek, September 22, 1997, pp. 40–42, and March 16, 1998, p. 62.

11J.R. Woolridge, “Competitive Decline: Is a Myopic Stock Market to Blame?” Journal of Applied Corporate Finance (Spring 1988), pp. 26–36.

Chapter 1: Introduction and Goals of the Firm 13

Admittedly, value-maximizing managers must manage change—sometimes radical changes in competition (free-wheeling electric power), in technology (Internet signal compression), in revenue collection (music), and in regulation (cigarettes)—but they must do so with an eye to the long-run sustainable profitability of the business. In short, value-maximizing managers must anticipate change and make contingency plans.

Shareholder wealth maximization also reflects dynamic changes in the information available to the public about a company’s expected future cash flows and foreseeable risks. An accounting scandal at Krispy Kreme caused the stock price to plummet from $41 to $20 per share in one month. Stock price also reflects not only the firm’s preexist- ing positive net present value investments, but also the firm’s strategic investment oppor- tunities (the “embedded real options”) a management team develops. Amgen, a biotechnology company, had shareholder value of $42 million in 1983 despite no sales, no cash flow, no capital assets, no patents, and poorly protected trade secrets. By 1993, Amgen had sales of over $1.4 billion and cash flow of $408 million annually. Amgen had developed and exercised enormously valuable strategic opportunities.

WHAT WENT RIGHT • WHAT WENT WRONG

Eli Lilly Depressed by Loss of Prozac Patent12

Pharmaceutical giants like GlaxoSmithKline, Merck, Pfizer, and Eli Lilly expend an average of $802 million to develop a new drug. It takes 12.3 years to research and test for efficacy and side effects, conduct clinical trials, and then produce and market a new drug. Only 4 in 100 candidate molecules or screening compounds lead to investigational new drugs (INDs). Only 5 in 200 of these INDs display sufficient efficacy in animal testing to warrant human trials. Clinical failure occurs in 6 of 10 human trials, and only half of the FDA-proposed drugs are ultimately ap- proved. In sum, the joint probability of successful drug discovery and development is just 0.04 × 0.025 × 0.4 × 0.5 = 0.0002, two hundredths of 1 percent. Those few pat- ented drugs that do make it to the pharmacy shelves, espe- cially the blockbusters with several billion dollars in sales, must contribute enough operating profit to recover the cost of all these R & D failures.

In 2000, one of the key extension patents for Eli Lilly’s blockbuster drug for the treatment of depression, Prozac,

was overturned by a regulator and a U.S. federal judge. Within one month, Eli Lilly lost 70 percent of Prozac’s sales to the generic equivalents. Although this company has several other blockbusters, Eli Lilly’s share price plum- meted 32 percent. CEO Sidney Taurel said he had made a mistake in not rolling out Prozac’s successor replacement drug when the patent extension for Prozac was first chal- lenged. Taurel then moved quickly to establish a new man- agement concept throughout the company. Now, each new Eli Lilly drug is assigned a team of scientists, marketers, and regulatory experts who oversee the entire life cycle of the product from research inception to patent expiration. The key function of these cross-functionally integrated teams is contingency analysis and scenario planning to deal with the unexpected.

12C. Kennedy, F. Harris, and M. Lord, “Integrating Public Policy and Public Affairs into Pharmaceutical Marketing: Differential Pricing and the AIDS Pandemic,” Journal of Public Policy and Marketing (Fall 2004), pp. 1–23; and “Eli Lilly: Bloom and Blight,” The Economist (October 26, 2002), p. 60.

Example Amgen’s Potential Profitability Is Realized Amgen, Inc. uses state-of-the-art biotechnology to develop human pharmaceutical and diagnostic products. After a period of early losses during their start-up phase, profits increased steadily from $19 million in 1989 to $355 million in 1993 to $670 million in 1996. On the strength of royalty income from the sale of its Epogen prod- uct, a stimulator of red blood cell production, profits jumped to $900 million per year by 1999. In 2009, Amgen was valued at $60 billion with revenues and cash flows hav- ing continued to grow throughout the previous 10 years at 19 percent annually.

14 Part 1: Introduction

In general, only about 85 percent of shareholder value can be explained by even 30 years of cash flows.13 The remainder reflects the capitalized value of strategic flexibil- ity to expand some profitable lines of business, to abandon others, and to retain but de- lay investment in still others until more information becomes available. These additional sources of equity value are referred to as “embedded real options.”

We need to address why NPV and option value are additive concepts. NPV was in- vented to value bonds where all the cash flows are known and guaranteed by contract. As a result, the NPV analysis adjusts for timing and for risk but ignores the value of flexibility present in some capital budgeting projects but not others. These so-called em- bedded options present the opportunity but not the obligation to take actions to maxi- mize the upside or minimize the downside of a capital investment. For example, investing in a fuel-switching technology in power plants allows Southern Company to burn fuel oil when that input is cheap and burn natural gas when it is cheaper. Similarly, building two smaller assembly plants, one in Japan and another in the United States, al- lows Honda Camry production to be shifted as currency fluctuations cause costs to fall in one plant location relative to the other. In general, a company can create flexibility in their capital budgeting by: (1) facilitating follow-on projects through growth options, (2) exiting early without penalty through abandonment options, or (3) staging investment over a learning period until better information is available through deferral options. The scenario planning that comes from such financial thinking compares the value of expanding, leaving, or waiting to the opportunity loss from shrinking, staying, or imme- diate investment. Flexibility of this sort expands upon the NPV from discounted cash flow alone.

Value-maximizing behavior on the part of managers is also distinguishable from satisficing behavior. Satisficers strive to “hit their targets” (for example, on sales growth, return on investment, or safety rating targets). Not value maximizers. Rather than trying to meet a standard like 97 percent, 99 percent, or 99.9 percent error-free takeoffs and landings at O’Hare field in Chicago, or deliver a 9, 11, or 12.1 percent return on share- holders’ equity, the value-maximizing manager will commit himself or herself to contin- uous incremental improvements. Any time the marginal benefits of an action exceed its marginal costs, the value-maximizing manager will just do it.

Example Real Option Value Attributable to Fuel-Switching Technology at Southern Company Ninety-six percent of all companies employ NPV analysis.14 Eighty-five percent employ sensitivity analysis to better understand their capital investments. Only 66.8 percent of companies pursue the scenario planning and contingency analysis that underlies real option valuation. A tiny 11.4 percent of companies formally cal- culate the value of their embedded real options. That suggests an opportunity for recently trained managers to introduce these new techniques of capital budgeting to improve stockholder value. Southern Company found its embedded real option from fuel switching technology was worth more than $45 million.

14Based on P. Ryan and G. Ryan, “Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?” Journal of Business and Management (Fall 2002).

13Woolridge, op. cit.

Chapter 1: Introduction and Goals of the Firm 15

Caveats to Maximizing Shareholder Value Managers should concentrate on maximizing shareholder value alone only if three con- ditions are met. These conditions require: (1) complete markets, (2) no significant asym- metric information, and (3) known recontracting costs. We now discuss how a violation of any of these conditions necessitates a much larger view of management’s role in firm decision making.

Complete Markets To directly influence a company’s cash flows, forward or futures markets as well as spot markets must be available for the firm’s inputs, output, and by- products. For example, forward and futures markets for crude oil and coffee bean inputs allow Texaco and Starbuck’s Coffeehouses to plan their costs with more accurate cash flow projections. For a small 3 to 5 percent fee known in advance, value-maximizing managers can lock in their input expense and avoid unexpected cost increases. This com- pleteness of the markets allows a reduction in the cost-covering prices of gasoline and cappuccino.