Home  BADM449    Handout #11 Joseph T. Mahoney

College of Business
Department of Business Administration
BADM449  Strategic Management/Business Policy

Basic Financial Model of the Firm
in Strategic Management

The basic model of the business enterprise stems from what economists designate as the theory of the firm. In its most stripped-down version, this theory assumes that the firm tries to maximize its profits. But this version is too stark, to be useful in many circumstances, particularly where a problem facing the firm has important dynamic elements and where risk is involved. A richer version of this theory assumes that the firm tries to maximize its wealth or value. At present, this version is also the dominant theory used in finance and strategic management (see e.g., Anju Seth's work on value creation in Strategic Management Journal, 1990).

To understand this theory, we must spell out what strategic management researchers mean by the value of the firm. Since a firm's value can be defined in a variety of ways (e.g., its book value or liquidating value, among others), it will prevent confusion if we provide a detailed definition at this point. Put briefly, a firm's value will be defined here as the present value of its expected cash flows. For present purposes, we can regard a firm's cash flow as being the same as its profit.

Present value of
expected future
= Profit1/(1+i) + Profit2/(1+i)2 + Profit3/(1+i)3 + Profitn/(1+i)n

where Profitt is the expected profit in year t, i is the interest rate, and t goes from 1 (next year) to n (last year in the planning horizon). Because profit equals total revenue (TR) minus total cost (TC), this equation can also be expressed as

Present value of
expected future

where TRt is the firm's total revenue in year t, and TCt is the total cost in year t.

A central idea in strategic management is that a firm's managers and workers can influence the firm's values due to their choices. Consider, for example, the Ford Motor Company. Its marketing managers and sales representatives work hard to increase its total revenues, while its production managers and manufacturing engineers strive to reduce its total costs. At the same time, its financial managers play a major role in obtaining capital, and hence influence the present value of expected future cash flows, while its research and development personnel invent new products and processes that both increase the firm's total revenues and reduce its total costs. All of these diverse groups affect Ford Motor's value, defined here as the present value of future profits.

While the firm attempts to maximize the present value of future cash flows, there are input, legal and other constraints on a firm's strategies. Thus, the relevant techniques used to analyze many of the firm's problems are constrained optimization techniques, such as linear programming.

Values of Total Revenues depend on:

(i) Demand and forecasting
(ii) Pricing
(iii) New product development

Values of Total Costs depend on:

(i) Production techniques
(ii) Cost functions
(iii) Process development

The value of i depends on:

(i) Riskiness of firm
(ii) Conditions in capital markets

What are profits?

The differences between the concepts used by the accountant and the strategic manager reflect the difference in their functions. The accountant is concerned with controlling the firm's day-to-day operations, detecting fraud or embezzlement, satisfying tax and other laws, and producing records for various interested groups. The strategic manager is concerned primarily with decision making (under the burdens of responsibility) and rational choice among prospective alternatives. While the figures published on profits almost always conform to the accountant's not to the strategic management concept, the strategic management concept is the more relevant one for many kinds of decisions. (And this, of course, is recognized by sophisticated accountants). The strategic management concept takes into account the "opportunity cost" or "alternative use value" of resources in the calculation of profit.

Thus, if the accounting profit of Project A is $60,000 but an alternative use of the resources would yield $64,000 then the "economic profit" is -$4,000. Project A should not stay in existence.

Sources for Generating Profits:

1) Innovations (e.g., Boeing, Intel)
2) Reward for risk bearing (e.g., Nucor)
3) Efficiency (low costs) (e.g., Wal-mart)
4) Monopoly power (product differentiation) (e.g., General Mills)