Ebook Managerial economics (12th edition): Part 1

(BQ) Part 1 book Managerial economics has contents: Introduction and goals of the firm, fundamental economic concepts, demand analysis, estimating demand, business and economic forecasting, managing in the global economy, production economics,...and other contents.

Managerial Economics

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s

Strategy, and Tactics, 12th Edition

James R McGuigan, R Charles Moyer,

Frederick H deB Harris

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To my familyJ.R.M.

To Sally, Laura, and CraigR.C.M

To my family, Roger Sherman, and Ken ElzingaF.H.B.H

1 Introduction and Goals of the Firm 2

5 Business and Economic Forecasting 137

6A Foreign Exchange Risk Management 227

PART III

7A Maximization of Production Output

7B Production Economics of Renewable and

PRICING AND OUTPUT DECISIONS:

10 Prices, Output, and Strategy: Pure and

11 Price and Output Determination:

12 Price and Output Determination:

A Consumer Choice UsingIndifference Curve Analysis

B International Parity Conditions

C Linear-Programming Applications

D Capacity Planning and Pricing Against aLow-Cost Competitor: A Case Study ofPiedmont Airlines and People Express

E Pricing of Joint Products and Transfer Pricing

F Decisions Under Risk and Uncertainty

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Managerial Challenge: How to Achieve

Sustainability: Southern Company 2

The Responsibilities of Management 5

Risk-Bearing Theory of Profit 7

Temporary Disequilibrium Theory of Profit 7

Managerial Efficiency Theory of Profit 7

The Shareholder Wealth-Maximization

Separation of Ownership and Control: The

What Went Right/What Went Wrong:

Eli Lilly Depressed by Loss of

Managerial Challenge: Why Charge

$25 per Bag on Airline Flights? 26

The Diamond-Water Paradox and the

Marginal Utility and Incremental Cost Simultaneously Determine Equilibrium

Individual and Market Demand Curves 31

Individual and Market Supply Curves 35 Equilibrium Market Price of Gasoline 36

Total, Marginal, and Average Relationships 41

Determining the Net Present Value of an

Sources of Positive Net Present Value

Meaning and Measurement of Risk 49

PART II

Managerial Challenge: Health Care

The Demand Schedule Defined 64

Constrained Utility Maximization and

What Went Right/What Went Wrong:

Interpreting the Price Elasticity:

The Relationship between the Price

The Importance of Elasticity-Revenue

Factors Affecting the Price Elasticity of

International Perspectives: Free Trade

and the Price Elasticity of Demand:

The Income Elasticity of Demand 83

Cross Price Elasticity Defined 87

Interpreting the Cross Price Elasticity 87

Antitrust and Cross Price Elasticities 87

An Empirical Illustration of Price, Income,

The Combined Effect of Demand

Managerial Challenge: Global Warming

and the Demand for Public

Estimating Demand Using Marketing

Market Experiments in Test Stores 99Statistical Estimation of the Demand

A Simple Linear Regression Model 101Assumptions Underlying the Simple Linear

Multiple Linear Regression Model 114

Estimating the Population Regression

Alternative Forecasting Techniques 141

Components of a Time Series 141

Some Elementary Time-Series Models 142

Leading, Lagging, and Coincident Indicators 154

Survey and Opinion-Polling Techniques 155

Forecasting Macroeconomic Activity 158

Stochastic Time-Series Analysis 163

Forecasting with Input-Output Tables 166

International Perspectives: Long-Term

Sales Forecasting by General Motors

Case Exercise: Lumber Price Forecast 173

Managerial Challenge: Financial

Crisis Crushes U.S Household

Consumption and Business

Investment: Will Exports to

What Went Right/What Went Wrong:

Export Market Pricing at Toyota 179

Import-Export Sales and Exchange

International Perspectives: Collapse of

Export and Domestic Sales at

Import/Export Flows and Transaction

The Equilibrium Price of the U.S Dollar 189 Speculative Demand, Government

Transfers, and Coordinated Intervention 189 Short-Term Exchange Rate Fluctuations 190Determinants of Long-Run Trends in

The Role of Real Growth Rates 191 The Role of Real Interest Rates 194 The Role of Expected Inflation 194

PPP Offers a Better Yardstick of

Relative Purchasing Power Parity 197

What Went Right/What Went Wrong:

GM, Toyota, and the Celica GT-S Coupe 199The Appropriate Use of PPP: An Overview 200 Big Mac Index of Purchasing Power Parity 201 Trade-Weighted Exchange Rate Index 201International Trade: A Managerial

PART III

Managerial Challenge: Green Power

Initiatives Examined: What Went

Wrong in California’s Deregulation

Production Functions with One Variable

Marginal and Average Product Functions 235

The Law of Diminishing Marginal Returns 236

What Went Right/What Went Wrong:

Factory Bottlenecks at a Boeing

Increasing Returns with Network Effects 237

Producing Information Services under

The Relationship between Total, Marginal,

Determining the Optimal Use of the

Production Functions with Multiple

The Marginal Rate of Technical Substitution 245

Determining the Optimal Combination

Production Processes and Process Rays 251

Measuring the Efficiency of a Production

Measuring Returns to Scale 254

Increasing and Decreasing Returns to Scale 255

The Cobb-Douglas Production Function 255

Empirical Studies of the Cobb-Douglas

Production Function in Manufacturing 256

A Cross-Sectional Analysis of U.S.

Manufacturing Industries 256

7A Maximization of Production Output

Average and Marginal Cost Functions 281

Optimal Capacity Utilization: Three

8A Long-Run Costs with a Cobb-Douglas

Issues in Cost Definition and Measurement 307 Controlling for Other Variables 307 Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part.

The Form of the Empirical Cost-Output

What Went Right/What Went Wrong:

Boeing: The Rising Marginal Cost of

Engineering Cost Techniques 314

Case Exercise: Charter Airline Operating

PART IV

PRICING AND OUTPUT DECISIONS:

10 Prices, Output, and Strategy: Pure and

Generic Types of Strategies 337

Product Differentiation Strategy 338

Information Technology Strategy 339

The Relevant Market Concept 341

Porter’s Five Forces Strategic Framework 342

The Power of Buyers and Suppliers 346 The Intensity of Rivalrous Tactics 347

A Continuum of Market Structures 352

Optimal Advertising Intensity 366 The Net Value of Advertising 367Competitive Markets under Asymmetric

Incomplete versus Asymmetric Information 368 Search Goods versus Experience Goods 368 Adverse Selection and the Notorious Firm 369 Insuring and Lending under Asymmetric Information: Another Lemons Market 371Solutions to the Adverse Selection

11 Price and Output Determination:

Sources of Market Power for a

Increasing Returns from Network Effects 384

What Went Right/What Went Wrong:

Price and Output Determination for a

The Optimal Markup, Contribution

Margin, and Contribution Margin

Components of the Gross Profit Margin 394

Monopolists and Capacity Investments 396

What Went Right/What Went Wrong:

The Public Service Company of New

The Economic Rationale for Regulation 400

Case Exercise: Differential Pricing of

Pharmaceuticals: The HIV/AIDS Crisis 406

12 Price and Output Determination:

Managerial Challenge: Are Nokia’s

Margins on Cell Phones Collapsing? 409

Oligopolistic Market Structures 411

Oligopoly in the United States: Relative

Interdependencies in Oligopolistic

Cartels and Other Forms of Collusion 417

Factors Affecting the Likelihood of

Cartel Profit Maximization and the

Allocation of Restricted Output 421

International Perspectives: The OPEC

Cartel Analysis: Algebraic Approach 426

Barometric Price Leadership 430 Dominant Firm Price Leadership 430

What Went Right/What Went Wrong:Good-Better-Best Product Strategy at

Oligopolistic Rivalry and Game Theory 445

A Conceptual Framework for Game Theory

Cooperative and Noncooperative Games 449

Dominant Strategy and Nash Equilibrium

Computer Tournaments: Tit for Tat 459

Industry Standards as Coordination Devices 463

A Sequential Coordination Game 465 Subgame Perfect Equilibrium in Sequential

Credible Commitments of Durable Goods

Post-Purchase Discounting Risk 477

Lease Prices Reflect Anticipated Risks 480

Case Exercise: International Perspectives:

13A Entry Deterrence and Accommodation

Excess Capacity as a Credible Threat 488

Pre-commitments Using Non-Redeployable

Tactical Insights about Slippery Slopes 495

14 Pricing Techniques and Analysis 499

Managerial Challenge: Pricing of Apple

Computers: Market Share versus

Multiple-Product Pricing Decision 506

Differential Pricing and the Price Elasticity

Differential Pricing in Target Market

Direct Segmentation with “Fences” 513

What Went Right/What Went Wrong:

Two-Part Pricing at Disney World 517

What Went Right/What Went Wrong:

Price-Sensitive Customers Redeem 517

Product Life Cycle Framework 523

Full-Cost Pricing versus Incremental

The Practice of Revenue Management,

Contracting, and Post-Contractual

The Efficiency of Alternative Hiring

of Scale and International Joint

Prospect Theory Motivates Full-Line

What Went Right/What Went Wrong:

Dell Replaces Vertical Integration with

The Dissolution of Assets in a Partnership 574

Case Exercise: Borders Books and

Amazon.com Decide to Do Business

Case Exercise: Designing a Managerial

Case Exercise: The Division of Investment

15A Auction Design and Information

First-Come, First-Served versus Last-Come,

Incentive-Compatible Revelation

International Perspectives: Joint Venture

in Memory Chips: IBM, Siemens,

International Perspectives: Whirlpool’s

Joint Venture in Appliances Improves

upon Maytag’s Outright Purchase of

Case Exercise: Spectrum Auction 608

Case Exercise: Debugging Computer

Managerial Challenge: Cap and Trade,

Deregulation, and the Coase Theorem 610

The Regulation of Market Structure and

The Federal Trade Commission Act

Mergers That Substantially Lessen

Constraints: An Economic Analysis 622

What Went Right/What Went Wrong:The Need for a Regulated Clearinghouse

to Control Counterparty Risk at AIG 625

The Optimal Deployment Decision:

What Went Right/What Went Wrong:

Pros and Cons of Patent Protection and Licensure of Trade Secrets 636What Went Right/What Went Wrong:Technology Licenses Cost Palm Its Lead

Summary 640

Case Exercise: Microsoft Tying

Case Exercise: Music Recording Industry

Managerial Challenge: Multigenerational

Effects of Ozone Depletion and

The Nature of Capital Expenditure

A Basic Framework for Capital Budgeting 647

Generating Capital Investment Projects 648

Evaluating and Choosing the Investment

Estimating the Firm’s Cost of Capital 653

Cost of Internal Equity Capital 655

Cost of External Equity Capital 656

Steps in Cost-Benefit Analysis 660

Objectives and Constraints in Cost-Benefit

Indirect Costs or Benefits and Intangibles 663

The Appropriate Rate of Discount 663

A Consumer Choice UsingIndifference Curve Analysis

B International Parity Conditions

C Linear-Programming Applications

D Capacity Planning and Pricing Against aLow-Cost Competitor: A Case Study ofPiedmont Airlines and People Express

E Pricing of Joint Products and Transfer Pricing

F Decisions Under Risk and Uncertainty

ORGANIZATION OF THE TEXT

The 12th edition has been thoroughly updated with more than 50 new applications.Although shortened to 672 pages, the book still covers all previous topics Responding

to user request, we have expanded the review of microeconomic fundamentals in ter 2, employing a wide-ranging discussion of the equilibrium price of crude oil and gas-oline A new Appendix 7B on the Production Economics of Renewable and ExhaustibleNatural Resources is complemented by a new feature on environmental effects and sus-tainability A compact fluorescent lightbulb symbol highlights these discussions spreadthroughout the text Another special feature is the extensive treatment in Chapter 6 ofmanaging global businesses, import-export trade, exchange rates, currency unions andfree trade areas, trade policy, and an extensive new section on China

Chap-There is more comprehensive material on applied game theory in Chapter 13, 13A,

15, 15A, and Web Appendix D than in any other managerial economics textbook, and

a unique treatment of yield (revenue) management appears in Chapter 14 on pricing.Part V includes the hot topics of corporate governance, information economics, auctiondesign, and the choice of organization form Chapter 16 on economic regulation includes

a broad discussion of cap and trade policy, pollution taxes, and the optimal abatement ofexternalities By far the most distinctive feature of the book, however, is its 300 boxedexamples, Managerial Challenges, What Went Right/What Went Wrong explorations ofcorporate practice, and mini-case examples on every other page demonstrating whateach analytical concept is used for in practice This list of concept applications ishighlighted on the inside front and back covers

STUDENT PREPARATION

The text is designed for use by upper-level undergraduates and first-year graduate dents in business schools, departments of economics, and professional schools of man-agement, public policy, and information science as well as in executive trainingprograms Students are presumed to have a background in the basic principles of micro-economics, although Chapter 2 offers an extensive review of those topics No prior work

stu-in statistics is assumed; development of all the quantitative concepts employed is contained The book makes occasional use of elementary concepts of differential calculus

self-In all cases where calculus is employed, at least one alternative approach, such as ical, algebraic, or tabular analysis, is also presented Spreadsheet applications have be-come so prominent in the practice of managerial economics that we now addressoptimization in that context

graph-PEDAGOGICAL FEATURES OF THE 12TH EDITION

The 12th edition of Managerial Economics makes extensive use of pedagogical aids toenhance individualized student learning The key features of the book are:

xv ii Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part.

1. Managerial Challenges Each chapter opens with a Managerial Challenge (MC)illuminating a real-life problem faced by managers that is closely related to thetopics covered in the chapter Instructors can use the new discussion questions fol-lowing each MC to “hook” student interest at the start of the class or in pre-classpreparation assignments.

2. What Went Right/What Went Wrong.This feature allows students to relate ness mistakes and triumphs to what they have just learned, and helps build thatelusive goal of managerial insight

busi-3. Extensive Use of Boxed Examples.More than 300 real-world applications and amples derived from actual corporate practice are highlighted throughout the text.These applications help the analytical tools and concepts to come alive and therebyenhance student learning They are listed on the inside front and back covers tohighlight the prominence of this feature of the book

ex-4. Environmental Effects Symbol A CFL bulb symbol highlights numerous passagesthroughout the book that address environmental effects and sustainability

5. Exercises.Each chapter contains a large problem analysis set Check answers to lected problems color-coded in blue type are provided in Appendix C at the end ofthe book Problems that can be solved using Excel are highlighted with an Excelicon The book’s Web site (www.cengage.com/economics/mcguigan) has answers

se-to all the other textbook problems

6. Case Exercises Most chapters include mini-cases that extend the concepts andtools developed into a deep fact situation context of a real-world company

7. Chapter Glossaries In the margins of the text, new terms are defined as they areintroduced The placement of the glossary terms next to the location where theterm is first used reinforces the importance of these new concepts and aids in laterstudying

8. International Perspectives Throughout the book, special International tives sections are provided that illustrate the application of managerial economicsconcepts to an increasingly global economy A globe symbol highlights thisinternationally-relevant material

Perspec-9. Point-by-Point Summaries Each chapter ends with a detailed, point-by-pointsummary of important concepts from the chapter

10. Diversity of Presentation Approaches.Important analytical concepts are presented

in several different ways, including tabular analysis, graphical analysis, and braic analysis to individualize the learning process

ExamViewSimplifying the preparation of quizzes and exams, this easy-to-use test creation softwareincludes all of the questions in the printed test bank and is compatible with MicrosoftWindows Instructors select questions by previewing them on the screen, choosingthem randomly, or picking them by number They can easily add or edit questions, in-structions, and answers Quizzes can also be created and administered online, whetherover the Internet, a local area network (LAN), or a wide area network (WAN).

Textbook Support Web SiteWhen you adopt Managerial Economics: Applications, Strategy, and Tactics, 12e, you andyour students will have access to a rich array of teaching and learning resources that youwon’t find anywhere else Located at www.cengage.com/economics/mcguigan, this out-standing site features additional Web Appendices including appendices on indifferencecurve analysis of consumer choice, international parity conditions, linear programmingapplications, a capacity planning entry deterrence case study, joint product pricing andtransfer prices, and decision making under uncertainty It also provides links to addi-tional instructor and student resources including a“Talk-to-the-Author” link

PowerPoint PresentationAvailable on the product companion Web site, this comprehensive package provides anexcellent lecture aid for instructors Prepared by Richard D Marcus at the University ofWisconsin–Milwaukee, these slides cover many of the most important topics from thetext, and they can be customized by instructors to meet specific course needs

CourseMateInterested in a simple way to complement your text and course content with study andpractice materials? Cengage Learning’s Economics CourseMate brings course concepts tolife with interactive learning, study, and exam preparation tools that support the printedtextbook Watch student comprehension soar as your class works with the printed text-book and the textbook-specific Web site Economics CourseMate goes beyond the book

to deliver what you need! You and your students will have access to ABC/BBC videos,Cengage’s EconApps (such as EconNews and EconDebate), unique study guide contentspecific to the text, and much more

ACKNOWLEDGMENTS

A number of reviewers, users, and colleagues have been particularly helpful in providing

us with many worthwhile comments and suggestions at various stages in the ment of this and earlier editions of the book Included among these individuals are:William Beranek, J Walter Elliott, William J Kretlow, William Gunther, J WilliamHanlon, Robert Knapp, Robert S Main, Edward Sussna, Bruce T Allen, Allen Moran,Edward Oppermann, Dwight Porter, Robert L Conn, Allen Parkman, Daniel Slate,Richard L Pfister, J P Magaddino, Richard A Stanford, Donald Bumpass, Barry P.Keating, John Wittman, Sisay Asefa, James R Ashley, David Bunting, Amy H Dalton,Richard D Evans, Gordon V Karels, Richard S Bower, Massoud M Saghafi, John C.Callahan, Frank Falero, Ramon Rabinovitch, D Steinnes, Jay Damon Hobson, CliffordFry, John Crockett, Marvin Frankel, James T Peach, Paul Kozlowski, Dennis Fixler,Steven Crane, Scott L Smith, Edward Miller, Fred Kolb, Bill Carson, Jack W Thornton,Changhee Chae, Robert B Dallin, Christopher J Zappe, Anthony V Popp, Phillip M.Sisneros, George Brower, Carlos Sevilla, Dean Baim, Charles Callahan, Phillip Robins,

develop-Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part.

Bruce Jaffee, Alwyn du Plessis, Darly Winn, Gary Shoesmith, Richard J Ward, William

H Hoyt, Irvin Grossack, William Simeone, Satyajit Ghosh, David Levy, Simon Hakim,Patricia Sanderson, David P Ely, Albert A O’Kunade, Doug Sharp, Arne Dag Sti,Walker Davidson, David Buschena, George M Radakovic, Harpal S Grewal, Stephen J.Silver, Michael J O’Hara, Luke M Froeb, Dean Waters, Jake Vogelsang, Lynda Y de laViña, Audie R Brewton, Paul M Hayashi, Lawrence B Pulley, Tim Mages, Robert Brooker,Carl Emomoto, Charles Leathers, Marshall Medoff, Gary Brester, Stephan Gohmann, L JoeMoffitt, Christopher Erickson, Antoine El Khoury, Steven Rock, Rajeev K Goel, Lee S.Redding, Paul J Hoyt, Bijan Vasigh, Cheryl A Casper, Semoon Chang, Kwang Soo Cheong,Barbara M Fischer, John A Karikari, Francis D Mummery, Lucjan T Orlowski, DennisProffitt, and Steven S Shwiff

People who were especially helpful in the preparation of the 12th edition includeRobert F Brooker, Kristen E Collett-Schmitt, Simon Medcalfe, Dr Paul Stock, ShahabDabirian, James Leady, Stephen Onyeiwu, and Karl W Einoff A special thanks to

B Ramy Elitzur of Tel Aviv University for suggesting the exercise on designing a gerial incentive contract

mana-We are also indebted to Richard D Marcus, Bob Hebert, Sarah E Harris, Wake ForestUniversity, and the University of Louisville for the support they provided and owe thanks

to our faculty colleagues for the encouragement and assistance provided on a continuingbasis during the preparation of the manuscript We wish to express our appreciation to themembers of the South-Western/Cengage Learning staff—particularly, Betty Jung, JanaLewis, Jennifer Thomas, Deepak Kumar, Steve Scoble, and Joe Sabatino—for their help inthe preparation and promotion of this book We are grateful to the Literary Executor ofthe late Sir Ronald A Fisher, F.R.S.; to Dr Frank Yates, F.R.S.; and to Longman Group,Ltd., London, for permission to reprint Table III from their book Statistical Tables for Bio-logical, Agricultural, and Medical Research (6th ed., 1974)

James R McGuigan

R Charles MoyerFrederick H deB Harris

About the Authors

James R McGuiganJames R McGuigan owns and operates his own numismatic investment firm Prior to thisbusiness, he was Associate Professor of Finance and Business Economics in the School ofBusiness Administration at Wayne State University He also taught at the University ofPittsburgh and Point Park College McGuigan received his undergraduate degree fromCarnegie Mellon University He earned an M.B.A at the Graduate School of Business atthe University of Chicago and his Ph.D from the University of Pittsburgh In addition tohis interests in economics, he has coauthored books on financial management His re-search articles on options have been published in the Journal of Financial and QuantitativeAnalysis

R Charles Moyer

R Charles Moyer earned his B.A in Economics from Howard University and his M.B.A.and Ph.D in Finance and Managerial Economics from the University of Pittsburgh Pro-fessor Moyer is Dean of the College of Business at the University of Louisville He is DeanEmeritus and former holder of the GMAC Insurance Chair in Finance at the BabcockGraduate School of Management, Wake Forest University Previously, he was Professor

of Finance and Chairman of the Department of Finance at Texas Tech University sor Moyer also has taught at the University of Houston, Lehigh University, and the Uni-versity of New Mexico, and spent a year at the Federal Reserve Bank of Cleveland.Professor Moyer has taught extensively abroad in Germany, France, and Russia In addi-tion to this text, Moyer has coauthored two other financial management texts He has beenpublished in many leading journals including Financial Management, Journal of Financialand Quantitative Analysis, Journal of Finance, Financial Review, Journal of Financial Re-search, International Journal of Forecasting, Strategic Management Journal and Journal ofEconomics and Business Professor Moyer is a member of the Board of Directors of KingPharmaceuticals, Inc., Capital South Partners, and the Kentucky Seed Capital Fund

Profes-Frederick H deB HarrisFrederick H deB Harris is the John B McKinnon Professor at the Schools of Business,Wake Forest University His specialties are pricing tactics and capacity planning ProfessorHarris has taught integrative managerial economics core courses and B.A., B.S., M.S.,M.B.A., and Ph.D electives in business schools and economics departments in the UnitedStates, Europe, and Australia He has won two school-wide Professor of the Year teachingawards and two Researcher of the Year awards Other recognitions include OutstandingFaculty by Inc magazine (1998), Most Popular Courses by Business Week Online 2000–

2001, and Outstanding Faculty by BusinessWeek’s Guide to the Best Business Schools, 5th to9th eds., 1997–2004

Professor Harris has published widely in economics, marketing, operations, and financejournals including the Review of Economics and Statistics, Journal of Financial and Quanti-tative Analysis, Journal of Operations Management, Journal of Industrial Economics, andJournal of Financial Markets From 1988–1993, Professor Harris served on the Board ofAssociate Editors of the Journal of Industrial Economics His current research focuses on

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the application of capacity-constrained pricing models to specialist and electronic tradingsystems for stocks His path-breaking work on price discovery has been frequently cited inleading academic journals, and several articles with practitioners have been published inthe Journal of Trading In addition, he often benchmarks the pricing, order processing,and capacity planning functions of large companies against state-of-the-art techniques inrevenue management and writes about his findings in journals like Marketing Managementand INFORMS’s Journal of Revenue and Pricing Management.

Managerial Economics

Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part.

PART 1 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

Introduction and Goals

of the Firm

microeconomics to problems faced by decision makers in the private, public, andnot-for-profit sectors Managerial economics assists managers in efficientlyallocating scarce resources, planning corporate strategy, and executing effectivetactics In this chapter, the responsibilities of management are explored.Economic profit is defined and the role of profits in allocating resources in a

shareholder wealth maximization, is developed along with a discussion of howmanagerial decisions influence shareholder wealth The problems associated withthe separation of ownership and control and principal-agent relationships in largecorporations 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 topainted and stone surfaces, trees, and asthmatics TheClean 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 EPAWeb site (www.epa.gov) displays on a daily basis theequilibrium, market-clearing price (e.g., $250 per ton

of soot) for the use of what had previously been an priced common property resource—namely, acid-freeair and rainwater Thereby, large point-source polluterslike power plants and steel mills earned an actual costper ton for the SOX and NOX–laden soot by-products

un-of burning lots un-of high sulfur coal These amounts werepromptly placed in spreadsheets designed to find ways

of minimizing operating costs.2

No less importantly,each polluter felt powerful incremental incentives tomitigate compliance cost by reducing pollution And

an entire industry devoted to developing pollutionabatement technology sprang up

Cont 2

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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 billwas pivotally important to its widespread success In-dustries like steel and electric power were given fiveyears 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 bought19,146 allowances for Belews Creek at prices rangingfrom $131 to $480 per ton and then in 2003 built two30-story smokestack scrubbers that reduced the NOXemissions by 75 percent

Another major electric utility, Southern Company,analyzed three compliance choices on a least-cost cashflow basis: (1) buying allowances, (2) installing smoke-stack scrubbers, or (3) adopting fuel switching technol-ogy to burn higher-priced low-sulfur coal or evencleaner 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 andoffsetting excess allowance revenue was found to cost

$476 million Alternatively, continuing to burn sulfur coal from the Appalachian Mountain region andbuying the requisite allowances was projected to cost

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

Asheville

CP&L

Cliffside Duke DukeAllen

Marshall Duke Riverbend Duke

Belews Creek Duke

Buck Duke 44

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

WHAT IS MANAGERIAL ECONOMICS?

Managerial economics extracts from microeconomic theory those concepts and 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 Allsuch managerial decision making seeks to do the following:

tech-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 Andfinally, 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

I What’s the basic externality problem with acidrain? What objectives should managementserve in responding to the acid rain problem?

approach to air pollution affect the SouthernCompany’s analysis of the previously unpricedcommon property air and water resourcesdamaged by smokestack emissions?

Clean Air Act, or should the Southern

would you decide?

alternatives for compliance offered the moststrategic flexibility? Explain

1

Based 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.

2 EPA fines for noncompliance of $2,000 per ton have always far exceeded the auction market cost of allowances ($131–$473 in recent years).

Toyota Motors, N.A.

Honda and Toyota are attempting to expand their already substantial assembly erations in North America Both companies face increasing demand for theirU.S.-manufactured vehicles, especially Toyota Camrys and Honda Accords.Camrys and Accords rate extremely highly in consumer reports of durability andreliability The demand for used Accords is so strong that they depreciate only

op-45 percent in their first four years Other competing vehicles may depreciate as much

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THE DECISION-MAKING MODELThe ability to make good decisions is the key to successful managerial performance Alldecision making shares several common elements First, the decision maker must establishthe 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 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, themanager 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 asensitivity 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 thedecision, monitoring carefully any unintended consequences or unanticipated changes

decreas-in the market This six-step decision-makdecreas-ing process is illustrated decreas-in Figure 1.2

The Responsibilities of Management

In a free enterprise system, managers are responsible for a number of goals Managers areresponsible 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 managementespecially is responsible for establishing a vision of new business directions and setting stretchgoals to get there In addition, managers monitor, motivate, and incentivize teamwork andcoordinate the integration of marketing, operations, andfinance functions In pursuing all

of these responsibilities, managers in a capitalist economy are ever conscious of their arching goal to maximize returns to the owners of the business—that is, economic profits

over-as 65 percent in the same period Toyota and Honda have identified two possiblestrategies (S1NEW and S2USED) to meet the growing demand for Camrys and Ac-cords Strategy S1NEW involves an internal expansion of capacity at Toyota’s $700million Princeton, Indiana, plant and Honda’s Marysville, Ohio, plant StrategyS2USED involves the purchase and renovation of assembly plants now owned byGeneral Motors The new plants will likely receive substantial public subsidiesthrough reduced property taxes The older plants already possess an enormousinfrastructure of local suppliers and regulatory relief

The objective of Toyota’s managers is to maximize the value today (presentvalue) 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 managersattempt to maximize the value of their firms across forward-looking dynamic strat-egies for growth while respecting all ethical, legal, and regulatory constraints

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 asthe 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 andcommit their resources to this use Thus, economic costs should always be thought of asopportunity costs—that is, the costs of attracting a resource such as investment capitalfrom its next best alternative use.

THE ROLE OF PROFITS

In a free enterprise system, economic profits play an important role in guiding the sions made by the thousands of competing independent resource owners The existence

deci-of profits determines the type and quantity of goods and services that are produced andsold, as well as the resulting derived demand for resources Several theories of profitindicate 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

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.

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Risk-Bearing Theory of ProfitEconomic profits arise in part to compensate the owners of the firm for the risk theyassume 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’sresidual 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, wherenormal is defined in terms of the relative risk of alternative investments Normal profitsfor a high-risk firm, such as Las Vegas hotels and casinos or a biotech pharmaceuticalcompany or an oilfield exploration well operator, should be higher than normal profitsfor 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 ProfitAlthough there exists a long-run equilibrium normal rate of profit (adjusted for risk) thatall firms should tend to earn, at any point in time, firms might earn a rate of returnabove or below this long-run normal return level This can occur because of temporarydislocations (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 marketconditions 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 persistentlyearn above-normal rates of return This ability to dominate the market may arise fromeconomies of scale (a situation in which one largefirm, such as Boeing, can produce ad-ditional units of 747 aircraft at a lower cost than can smallerfirms), control of essentialnatural resources (diamonds), control of critical patents (biotech pharmaceuticalfirms),

or governmental restrictions that prohibit competition (cable franchise owners) Theconditions under which a monopolist can earn above-normal profits are discussed ingreater depth in Chapter 11

Innovation Theory of ProfitThe innovation theory of profit suggests that above-normal profits are the reward forsuccessful innovations Firms that develop high-quality products (such as Porsche) orsuccessfully identify unique market opportunities (such as Microsoft) are rewarded withthe 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 ProfitClosely 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 eachindustry, nor are these theories necessarily mutually exclusive Profit performance is in-variably the result of many factors, including differential risk, innovation, managerialskills, the existence of monopoly power, and chance occurrences

OBJECTIVE OF THE FIRMThese 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 wealthis measured by the market value of afirm’s common stock, which

is equal to the present value of all expected future cash flows to equity owners counted at the shareholders’ required rate of return plus a value for the firm’s embeddedreal options:

V0 · ðShares OutstandingÞ = ∑∞

t=1

πtð1+keÞt + Real Option Value [1.1]where V0is the current value of a share of stock (the stock price),πtrepresents the eco-nomic profits expected in each of the future periods (from period 1 to ∞), and keequalsthe 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 manyfactors (like innovation and cost control) are not Real option value represents the costsavings or revenue expansions that arise from preservingflexibility in the business plansthe 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 inputbecame cheaper than another

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

HathawayWarren E Buffett, chairman and CEO of Berkshire Hathaway, Inc., has describedthe long-term economic goal of Berkshire Hathaway as follows: “to maximize theaverage annual rate of gain in intrinsic business value on a per-share basis.”3Berk-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 percentgrowth over this same time period

Berkshire’s directors are all major stockholders In addition, at least four of the 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 firmhas always placed a high priority on the goal of maximizing shareholder wealth

common stock, which,

in turn, is equal to the

present value of all

future cash returns

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

SEPARATION OF OWNERSHIP AND CONTROL: THE PRINCIPAL-AGENT PROBLEM

Profit maximization and shareholder wealth maximization are very useful concepts whenalternative choices can be easily identified and when the associated costs and revenuescan be readily estimated Examples include scheduling capacity for optimal productionruns, determining an optimal inventory policy given sales patterns and available produc-tion facilities, introducing an established product in a new geographic market, andchoosing 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 andmanagers are seldom aligned

Wealth: Apple Computer4

In distributing its stylish iMac personal computers and high tech iPods, Apple hasconsidered 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 assemblewhat 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 costswould be variable Alternatively, Apple could enter into distribution agreementswith an independent electronics retailer like Computer Tree Finally, Apple couldretail 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 chainsought 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 newdistribution strategy Apple occupies a sprawling subterranean space topped by aglass cube that Steve Jobs himself designed, across from Central Park, oppositethe famed Plaza Hotel Apple’s profits in this most heavily trafficked tourist andretail corridor will rely on several initiatives: (1) in-store theatres for workshoptraining on iMac programs to record music or edit home movies, (2) numeroustechnical experts available for troubleshooting with no waiting time, and (3) con-tinuing investment in one of the world’s most valuable brands In 2005, Applemade $151 million in operating profits on $2.35 billion in sales at these AppleStores, a 6.4 percent profit margin relative to approximately a 2 percent profit mar-gin company-wide

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

Divergent Objectives and Agency Conflict

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

corpora-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 softwaredevelopment—an area where Exxon had little or no expertise or competitive advantage.The managers were hoping that diversification would smooth out their executive bonusestied 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 ownlong-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 riskcould lead to their dismissal Kodak is a good example In the early 2000s, Kodak’sexecutives didn’t want to risk developing immature digital photography products.When the demand for digital camera products subsequently soared, Kodak was leftwith too few markets for its traditional film products Like Exxon, its stock valueplummeted

Finally, the cash flow to owners erodes when the firm’s resources are divertedfrom their most productive uses to perks for managers In 1988, RJR Nabisco was afirm that had become bloated with corporate retreats in Florida, an extensive fleet ofcorporate airplanes and hangars, and an executive fixation on an awful-tasting newproduct (the “smokeless” cigarette Premier) This left RJR Nabisco with substantiallyless value in the marketplace than would have been possible with better resourceallocation decisions Recognizing the value enhancement potential, Kohlberg KravisRoberts & Co (KKR) initiated a hostile takeover bid and acquired RJR Nabisco for

$25 billion in early 1989 The purchase price offered to common stockholders byKKR was $109 per share, much better than the $50 to $55 pre-takeover price Thenew 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-improvedcash 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, somecompanies structure a larger proportion of the manager’s compensation in the form ofperformance-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 $23billion during his first 10 years as CEO.5 Other firms like Hershey Foods, CSX, UnionCarbide, 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 thepocketbook interests of managers directly with those of stockholders In sum, how moti-vated a manager will be to act in the interests of thefirm’s stockholders depends on thestructure of his or her compensation package, the threat of dismissal, and the threat oftakeover by a new group of owners

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

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Agency ProblemsTwo 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 thework 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.” Creativeingenuity in anticipating problems before they arise is inherently unobservable Ownersknow it when they see it, but often do not recognize when it is missing As a result, inexplaining fluctuations in company performance, the manager’s creative ingenuity isoften inseparable from good and bad luck Owners therefore find it difficult to knowwhen 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 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 ownpersonal welfare, that are not always in the long-term interests of shareholders As aresult of pressure from large institutional shareholders, such as Fidelity Funds, fromstatutes such as Sarbanes-Oxley mandating stronger corporate governance, and fromfederal 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’spay occurs in the form of performance-based bonuses They are doing so by (1) tyingexecutive bonuses to the performance of comparably situated competitor companies,(2) by raising the performance hurdles that trigger executive bonuses, and (3) byeliminating severance packages that provide windfalls for executives whose poor per-formance leads to a takeover or their own dismissal

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

O.M Scott & Sons6The 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 theScott managers in a highly leveraged buyout (LBO) Faced with heavy interest andprincipal 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 proceduresdesigned to improve Scott’s performance By monitoring inventory levels moreclosely and negotiating more aggressively with suppliers, the firm was able toreduce 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 forcecaused revenue to increase from $160 million to a record $200 million

6 A 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.

associated with

resolving conflicts

of interest among

shareholders,

managers, and lenders.

Agency costs include

the cost of monitoring

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 hasmirrored corporate profitability, spiking when profits grow and collapsing whenprofits 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

As a representative example of a performance-based pay package, General ElectricCEO 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 thatone-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 forfive 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 dustry and sector benchmarks has become something of a cause célèbre in the UnitedStates The reason is that by 2008 median CEO total compensation of $7.3 millionhad 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, whatU.S CEOs get paid was the focus of much public policy discussion even before thepay scandals at AIG and Merrill Lynch/Bank of America in the fall of 2009

in-8 Based on http://people.forbes.com/rankings/jeffrey-r-immelt/36126

9 Mercer Human Resources Consulting, “Executive Compensation” (2006).

FIGURE 1.3 CEO Pay Trends

Corporate profits CEO compensation

2008

Source: Mercer Human Resource Consulting

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

Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part Copyright 2011 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part.

2. Internal audits and accounting oversight boards to monitor management’s actions.

In addition, many large creditors, especially banks, now monitor financial ratios andinvestment 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 frommanagerial dishonesty

4. Lost profits arising from complex internal approval processes designed to limitmanagerial 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 oftenallege that maximizing shareholder wealth focuses on short-term payoffs—sometimes tothe 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 5years of expected dividend payouts explain only 18 percent and the first 10 years only

35 percent of the share prices of NYSE stocks.11The goal of shareholder wealth zation requires a long-term focus

maximi-WHAT WENT RIGHT • maximi-WHAT WENT WRONG

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 ditional 20 percent In 2009, GM announced it was perma- nently closing the Saturn division.

ad-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.

10 Based on M Cohen, “Saturn’s Supply-Chain Innovation,” Sloan ment Review (Summer 2000), pp 93–96; “Small Car Sales Are Back” and

Manage-“Why Didn’t GM Do More for Saturn?” BusinessWeek, September 22,

1997, pp 40–42, and March 16, 1998, p 62.

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

Admittedly, value-maximizing managers must manage change—sometimes radicalchanges in competition (free-wheeling electric power), in technology (Internet signalcompression), in revenue collection (music), and in regulation (cigarettes)—but theymust 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 informationavailable to the public about a company’s expected future cash flows and foreseeablerisks 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 ing positive net present value investments, but also thefirm’s strategic investment oppor-tunities (the “embedded real options”) a management team develops Amgen, abiotechnology company, had shareholder value of $42 million in 1983 despite no sales,

preexist-no cash flow, no capital assets, no patents, and poorly protected trade secrets By 1993,Amgen had sales of over $1.4 billion and cashflow of $408 million annually Amgen haddeveloped and exercised enormously valuable strategic opportunities

WHAT WENT RIGHT • WHAT WENT WRONG

Eli Lilly Depressed by Loss of Prozac

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.

12 C 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.

Amgen, Inc uses state-of-the-art biotechnology to develop human pharmaceuticaland 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 $670million 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 ing continued to grow throughout the previous 10 years at 19 percent annually

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In general, only about 85 percent of shareholder value can be explained by even

30 years of cashflows.13The remainder reflects the capitalized value of strategic 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 additionalsources of equity value are referred to as“embedded real options.”

flexibil-We need to address why NPV and option value are additive concepts NPV was vented to value bonds where all the cash flows are known and guaranteed by contract

in-As a result, the NPV analysis adjusts for timing and for risk but ignores the value offlexibility 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 toburn 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 createflexibility intheir capital budgeting by: (1) facilitating follow-on projects through growth options, (2)exiting early without penalty through abandonment options, or (3) staging investmentover a learning period until better information is available through deferral options.The scenario planning that comes from such financial thinking compares the value ofexpanding, leaving, or waiting to the opportunity loss from shrinking, staying, or imme-diate investment Flexibility of this sort expands upon the NPV from discounted cashflow alone

Value-maximizing behavior on the part of managers is also distinguishable fromsatisficing 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 andlandings 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 itsmarginal costs, the value-maximizing manager will just do it

Technology at Southern CompanyNinety-six percent of all companies employ NPV analysis.14 Eighty-five percentemploy sensitivity analysis to better understand their capital investments Only66.8 percent of companies pursue the scenario planning and contingency analysisthat 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 forrecently trained managers to introduce these new techniques of capital budgeting

to improve stockholder value Southern Company found its embedded real optionfrom fuel switching technology was worth more than $45 million

14

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

13 Woolridge, op cit.

Caveats to Maximizing Shareholder ValueManagers 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 firmdecision making

Complete Markets To directly influence a company’s cash flows, forward or futuresmarkets as well as spot markets must be available for thefirm’s inputs, output, and by-products For example, forward and futures markets for crude oil and coffee bean inputsallow Texaco and Starbuck’s Coffeehouses to plan their costs with more accurate cashflow projections For a small 3 to 5 percent fee known in advance, value-maximizingmanagers 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 andcappuccino

By establishing a market system for tradable air pollution permits, the Clean AirAct set a price on the sulfur dioxide (SO2) by-product from burning high-sulfurcoal SO2 emissions from coal-fired power plants in the Midwest raised the acidity

of rain and mist in eastern forests from Maine to Georgia to levels almost 100times higher than the natural acidity of rainfall in the Grand Tetons in the farnorthwestern United States Dead trees, peeling paint, increased asthma, and stonedecomposition on buildings and monuments were the result

To elicit substantial pollution abatement at the least cost, the Clean Air Act of

1990 authorized the Environmental Protection Agency to issue tradable pollutionallowances (TPAs) to 467 known SO2polluters for approximately 70 percent of theprevious year’s emissions The utility companies doing the polluting then began totrade the allowances Companies that were able to abate their emissions at a lowcost (perhaps because they had smokestack scrubbing equipment) sold their allow-ances to plants that couldn’t abate their emissions as cost effectively In otherwords, the low-cost abaters were able to cut their emissions cheaply and then sellthe permits they didn’t need to high-cost abaters The result was that the nation’sair got 30 percent cleaner at the least possible cost

As a result of the growing completeness of this market, electric utilities likeDuke Power now know what expense line to incorporate in their cash flow projec-tions for the SO2by-products of operating with high-sulfur coal TPAs can sell formore than $100 per ton, and a single utility plant operation may require 15,000tons of permits or more The continuous tradeoff between installing 450-million-dollar pollution abatement equipment, utilizing higher-cost alternativefuels like low-sulfur coal and natural gas, or paying the current market price ofthese EPA-issued pollution permits can now be explicitly analyzed and the least-cost solutions found

15 Based on “Acid Rain: The Southern Company,” Harvard Business School Publishing, HBS: 9-792-060; “Cornering the Market,” Wall Street Journal (June 5, 1995), p B1; and Economic Report of the President, February 2000 (Washing- ton, DC: U.S.G.P.O., 2000), pp 240 –264.

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