| In managerial economics, the primary objective of management is assumed to be maximization of the firm’s value. The value can be defined as the present value of the firm’s expected future cash flows. Cash flows may be for now, be equated to profits, therefore the value of the firm today, its present value, is the value of its expected future profits, discounted back to the present at an appropriate interest rate. |
The essence of the model with which are concerned expressed as follows:
Value of the firm = PV of expected future profits
PV is the abbreviation for the present value, and so forth represent the expected profits in each year ‘t’, ‘i’ is the appropriate interest rate.
Since profits are equal to total revenue (TR) minus total cost (TC), equation (i) may be written as
Maximizing equation (ii) involves the determinants of revenues, costs and the discount rates in each future year of some unspecified time. Revenues, costs and the discount rates are interrelated, complicating the problem even more.
A firm’s total revenues are directly determined by the quantity of its products sold and the process received, for managerial decision making, the important considerations relate to factors that affect prices and quantities, and to the interrelationships between them. These factors include the choice of products of the firm designs, manufactures and sells the advertising-strategies, it employs, the pricing it established, the general state of the economy it encounters and the nature of the competition it faces in the market place. In short, revenue relationship encompasses both demand and supply considerations.
The cost relationships involved in producing a firm’s products are similarly complex. Costs require examination of alternative production systems, technological options, input possibilities, and so on. The prices of the factors of production play an important role in cost determination, and thus factors supply considerations are important.
Finally, there is the relationship between the discount rate and the company’s production mix, physical assets and financial structure. These factors affect the cost of availability of financial resources for the firm and ultimately determine the discount rate used by investors to establish a value of the firm.
To determine the optional course of action requires that marketing, production and financial decisions as well as decisions related to personnel, product distribution and so on be combined into a single integrated system, one which shows how any action affects all parts of the firm. The economic model of the firm provides a basis for this integration and the principles of economic analysis enable to analyze the important interrelations.
Superiority of Maximization Theory
- Efficient allocation of resources: It provides guideline for making decision of firm and also promotes an efficient allocation of resources. Resources are generally allocated by taking into consideration the expected return and risk associated to course of action. The market value of stock itself reflects the risk return trade off associated to any investor in the capital market.
- Separation between ownership and management: The goal of shareholder wealth maximization is also justifiable from the view point of separation of ownership and management in a business firm. Stockholders provides funds to operate a business firm and they appoint a team of management to run the firm.
- Residual owners: Shareholders are the last to share in earnings and assists of the company. Therefore, shareholders wealth is maximized, and then all other with prior claim that shareholder could be satisfied.
- Emphasis on cash flow: Wealth maximization goal uses cash flows rather than accounting profit as the basic input for decision making. The use of cash flow is clearer because it uniformly means profit after tax plus non-cash outlays to all.
- Recognizes time value of money: It also recognizes the time value of money. All the cash flow generated over the life of the business firms are discounted back to present value using required rate of return and decision is based on the present value of future returns.
- Consideration risk: Wealth maximization objective also considers the risks associated to the streams of future cash flows. Depending on the degree of risk, a proper required rate of return is determined to discount back the future streams of cash flows. Greater the risk larger will be the required rate of return and vice-versa.
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