Objectives of the Firm Essay Example for Free

Objectives of the self-coloured EssayThe standard frugal assumption underlying the abbreviation of degradeds is earn maximization. Real world starchys, however, faculty not, and many beats do not, make decisions based on the remuneration-maximization objective, or at least unaccompanied on the simoleons-maximization objective. Other objectives include (1) gross revenue maximization, (2) hunting of individual(prenominal) welfare, and (3) pursuit of social welfare. Although hards are imitation to make decisions that increase profit in standard sparing analysis, real world firms a good deal charter other objectives on a day-to-day ground.Some firms set their sights on maximise gross revenue. For other firms the owners or employees are inclined to enhance personal living standards. And more than a few firms take go that encourage the general welfare of society. In some cases, these other objectives help a firm copy profit maximization. In other cases, they p revent a firm from maximizing profit. reach maximisation Profit maximization is the process of obtaining the highest possible train of profit through the intersection and sale of goods and services.This is the guiding teaching underlying the analysis of short-run production by a firm. In special, economic analysis is fancied that firms undertake coiffureions and make the decisions that increase profit. Profit is the difference between the total taxation a firm receives from selling output and the total cost of producing that output. Profit-maximization means that a firm seeks the production level that generates the sterling(prenominal) difference between total revenue and total cost. Consider how profit maximization strength take a shit for The goofy Willy Company.Suppose that The soft Willy Company generates $100,000 of profit by producing 100,000 Stuffed Amigos, the difference between $1,000,000 of revenue and $900,000 of cost. * If profit locomote from this $100,000 level when The Wacky Willy Company wins more (100,001) or less (99,999) Stuffed Amigos, then(prenominal) it is maximizing profit at 100,000. Alternatively, if profit can be increased by producing more or less, then The Wacky Willy Company is NOT maximizing profit at the current level of production. Suppose, for example, that producing 100,001 Stuffed Amigos adds an extra $11 to revenue entirely only $9 to cost.In this case, profit can be increased by $2, stretching $100,002, by producing one more Stuffed Amigo. As such 100,000 is NOT the profit maximizing level of production. * In contrast, suppose that producing 99,999 Stuffed Amigos slashs cost by $11 but only reduces revenue by only $9. In this case, profit can also be increased by $2, reaching $100,002, by producing one fewer Stuffed Amigo. As such 100,000 is NOT the profit maximizing level of production.Sales Maximization A reasonable, and often chased objective of firms is to maximise sales, that is, to sell as much o utput as possible. Clearly sales lead to revenue, meaning that maximizing sales is also bound to maximize revenue. But as the analysis of short-run production indicates, maximizing sales does NOT necessarily maximize profit. So why do firms do it? Are firms unreasonable? Are they ir sagacious? Do they NOT understand the basic economic principles of short-run production? For some firms, the answers to these questions could be yes.But for other firms, sales maximization is actually a reasonable, even better, alternative to profit maximization. Consider, the day-to-day production of Wacky Willy Stuffed Amigos. Suppose the President of The Wacky Willy Company, William J. Wackowski, issues a corporate directive to sell as many Stuffed Amigos as possible, to maximize sales. Is Willy Wackowski wacky? It might be that Mr. Wackowski has no knowledge of basic economic principles. Alternatively Wacky William might encounter more work sense than it appears.In particular, if the price received from selling Stuffed Amigos is greater than the cost of producing each one, and looks to remain that room regardless of the standard turnd, then a reasonable close is to maximize sales. If sales are greater, then so too is profit. Wacky Willy does NOT maximize profit under these circumstances. That is, it does not pay back the quantity that achieves the highest possible profit. However, with each Stuffed Amigo produced, profit increases. In fact, Wacky Willy might not KNOW the profit-maximizing production level.All it knows is that selling more Stuffed Amigos, increases profit. While sales maximization can serve as a means of pursing profit maximization, it can also prevent a firm from maximizing profit. The reason, of course, is that if sales last so large that the cost of production increases such that marginal cost exceeds marginal revenue, the maximizing sales does not maximize profit. Pursuit of Personal Welfare The slew who make decisions for a business are, in fact, p eople. They have likes and dislikes. They have personal goals and aspirations just like people who do not make decisions for firms.On occasion these people use the firm to pursue their own personal welfare. When they do, their actions could enhance the firms profit maximization or, in many cases, prevent profit maximization. How about a few examples? Once again, consider William J. Wackowski, the prexy of The Wacky Willy Company. Perhaps Willy enjoys the finer things in lifea large house, fancy cars, and expensive vacationswhich require a powerful income. As the primary stockholder of The Wacky Willy Company, when the business maximizes profit, then William J. Wackowski benefits with more income.In this case, the pursuit of personal welfare coincides with profit maximization. Alternatively, suppose that the Mr. Wackowski hates the color empurple. He simply refuse to produce ANY purple Stuffed Amigos. However, securities industry studies clearly indicate that buyers want purple S tuffed Amigos. Moreover, the purple fabric that would be used to produce purple Stuffed Amigos is significantly less expensive than other colors. Mr. Willy clearly is wacky in this case. His purple-phobia prevents profit maximization. William the Wackster might also decide to enhance his corporate lifestyle at the expense of corporate profit.He could, for example, fall out himself a bigger, more luxurious (but unneeded) office, a higher (but unneeded) salary, a beau monde jet (also unneeded), season tickets to dark Valley Primadonnas baseball team (clearly unneeded) and other (unneeded) amenities that are NOT needed to profitably produce Stuffed Amigos. These improve Williams personal welfare, but at the expense of corporate profit. Pursuit of Social Welfare The people who make decisions for firms also have social consciences. Part of their likes and dislikes might be related to the overall relegate of society.As such, they might use the firm to pursue social welfare, which coul d enhance or prevent the firms profit maximization. How might William J. Wackowskis pursuit of social welfare enhance or prevent profit maximization of The Wacky Willy Company? Suppose that William wants a cleaner environment. As such, he might implement more dear(p) environmentally friendly production techniques and materials. He does his part to clean the environment, but at the expense of company profit. Then again, Mr. Wackowski might feel that government environmental quality regulations restrict capital investment and economic growth.As such, William might have The Wacky Willy Company use part of its advertising budget to promote this view point. He might even use company revenue to set up the Wackowski prat for Policy Studies that is both a scientific think tank and a special interest lobbying memorial tablet with the goal of reducing environmental quality regulations. While the pursuit of social welfare is likely to reduce company profit, it could have the opposite effect as well. Such activities could give The Wacky Willy Company a likeable public cypher that motivates people to buy more Stuffed Amigos than they would otherwise.In fact, some firms use the pursuit of social welfare as one aspect of their overall advertising efforts. They enhance their public image at the same time they do something good for society. Natural Selection Whichever objective a firm pursues on a day-to-day basis, the notion of indispensable selection suggests that successful firms intentionally or circumstantially maximize profit. That is, the firms best suited to the economic environment, and thus generate the most profit, are the ones that tend to survive.The natural selection of business firms is an adaptation of the biological process of natural selection, in which biological entities best suited to the natural environment are the ones that survive. The concept of economic natural selection means that those firms that generate the greatest profit are the ones that avoid bankruptcy and survive to produce another day. While firms might pursue sales maximization, personal welfare, or social welfare, only those firms that also maximize profit remain in business. 2) The following is from chapter one in the text Financial Management and Policy, by James C.Van Horne, procure 1974 by Prentice-Hall. It is classic finance. THE OBJECTIVE OF THE FIRM In this course, we assume that the objective of the firm is to maximize its rate to its shareholders. Value is represented by the commercialize price of the companys common stock, which, in turn, is a reflection of the firms investment, financing, and dividend decisions. Profit Maximization vs. Wealth Maximization Frequently, maximization of profits is regarded as the proper objective of the firm, but it is not as inclusive a goal as that of maximizing shareholder wealthiness.For one thing, total profits are not as serious as gain per share. A firm could always raise total profits by issuing stock and employ the proceeds to invest in Treasury bills. Even maximization of earnings per share, however, is not a full appropriate objective, partly because it does not specify the timing or duration of expected returns. Is the investment brook that give produce $100,000 return 5 years from now more valuable than the get wind that will produce annual returns of $15,000 in each of the next 5 years?An answer to this question depends upon the time value of money to the firm and to investors at the margin. Few existing stockholders would think favorably of a project that promised its first return in 100 years. We must take into account the time pattern of returns in our analysis. Another shortcoming of the objective of maximizing earnings per share is that it does not consider the risk or uncertainty of the prospective earnings stream. Some investment projects are far more risky than others. As a result, the prospective stream of earnings per share would be more uncertain if these proje cts were undertaken.In addition, a company will be more or less risky depending upon the amount of debt in coincidence to equity in its capital structure. This risk is known as financial risk and it, too, contributes to the uncertainty of the prospective stream of earnings per share. Two companies whitethorn have the same expected future earnings per share, but if the earnings stream of one is subject to considerably more uncertainty than the earnings stream of the other, the market price per share of its stock may be less. For the reasons above, an objective of maximizing earnings per share may not be the same as maximizing market price per share.The market price of a firms stock represents the focal judgment of all market participants as to what the value is of the particular firm. It takes into account present and prospective future earnings per share, the timing, duration, and risk of these earnings, and any other factors that bear upon the market price of stock. The market pr ice serves as a performance index or report bill poster of the firms progress it indicates how well circumspection is doing in behalf of its stockholders. Management vs. Stockholders In certain situations the objectives of focus may differ from those of the firms stockholders.In a large corporation whose stock is widely held, stockholders exert rattling little control or influence over the operations of the company. When the control of a company is crystalize from its ownership, management may not always act in the best interests of the stockholders Agency Theory. Managers sometimes are give tongue to to be satisficers rather than maximizers they may be content to play it safe and seek an acceptable level of growth, being more concerned with perpetuating their own existence than with maximizing the value of the firm to its shareholders.The most important goal to a management teamof this sort may be its own survival. As a result, it may be unwilling to take reasonable risks for fear of making a mistake, thereby becoming apparent to the outside suppliers of capital. In turn, these suppliers may pose a threat to managements survival. It is true that in order to survive over the long run, management may have to behave in a manner that is reasonably consistent with maximizing shareholder wealth. Nevertheless, the goals of the two parties do not necessarily have to be the same. Maximization of shareholder wealth, then, is an appropriate guide for how a firm should act.When management does not act in a manner consistent with this objective, we must recognize this as a constraint and model the opportunity cost. This cost is measurable only if we determine what the outcome would have been had the firm attempted to maximize shareholder wealth. A Normative Goal Because the principal of maximization of shareholder wealth provides a rational guide for running a business and for the efficient tryst of resources in society, we use it as our anticipate objective in considering how financial decisions should be made.The purpose of capital markets is to efficiently allocate savings in an economy from ultimate savers to ultimate users of pecuniary resource who invest in real assets. If savings are to be channeled to the most promise investment opportunities, a rational economic criteria must exist that governs their flow. By and large, the allocation of savings in an economy occurs on the basis of expected return and risk. The market value of a firms stock embodies both of these factors. It therefore reflects the markets tradeoff between risk and return.If decisions are made in keeping with the likely effect upon the market value of its stock, a firm will attract capital only when its investment opportunities justify the use of that capital in the overall economy. Put another way, the equilibration process by which savings are allocated in an economy occurs on the basis of expected return and risk. Holding risk constant, those economic units (b usiness firms, households, financial institutions, or governments) willing to pay the highest pay are the ones entitled to the use of funds.If rationality prevails, the economic units bidding the highest yields will be the ones with the most promising investment opportunities. As a result, savings will tend to be allocated to the most efficient users. Maximization of shareholder wealth then embodies the risk-return tradeoff of the market and is the focal point by which funds should be allocated within and among business firms. Any other objective is likely to result in the suboptimal allocation of funds and therefore lead to less than optimal level of economic want satisfaction. This is not to say that management should ignore the question of social responsibility.As related to business firms, social responsibility concerns such things as protecting the consumer, paying fair wages to employees, maintaining fair hiring practices, supporting education, and becoming actively involved in environmental issues like clean air and water. Many people feel that a firm has no choice but to act in socially responsible ways they argue that shareholder wealth and, perhaps, the corporations vary existence depends upon its being socially responsible. However, the criteria for social responsibility are not clearly defined, making formulation of a consistent objective function difficult.Moreover, social responsibility creates certain problems for the firm. One is that it falls unevenly on different corporations. Another is that it sometimes conflicts with the objective of wealth maximization. Certain social actions, from a long-range point of view, unmistakably are in the best interests of stockholders, and there is little question that they should be undertaken. Other actions are less clear, and to engage in them may result in a line of profits and in shareholder wealth in the long run. From the standpoint of society, this decline may produce a conflict.What is gained in hav ing a socially desirable goal achieved may be offset in whole or part by an accompanying less efficient allocation of resources in society. The last mentioned will result in a less than optimal growth of the economy and a impose total level of economic want satisfaction. In an era of unfilled wants and scarcity, the allocation process is passing important. Many people feel that management should not be called upon to resolve the conflict posed above. Rather, society, with its openhanded general perspective, should make the decisions necessary in this area.Only society, acting through Congress and other typical governmental bodies, can judge the relative tradeoff between the achievement of a social goal and the sacrifice in the efficiency of apportioning resources that may accompany realization of the goal. With these decisions made, corporations can engage in wealth maximization and thereby efficiently allocate resources, subject, of course, to certain governmental constraints. Under such a system, corporations can be viewed as producing both private and social goods, and the maximization of shareholder wealth mud a viable corporate objective.