Use of Managerial Economics in Finance

This article focuses on how financial professionals utilize managerial economics in making decisions to resolve business problems. Managerial economics highlights how financial professionals make decisions regarding resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. Profits and wealth maximization are key factors in managerial economics. Profits are very crucial to a firm's bottom line, and wealth maximization is a long term operational goal. Market structures take into consideration: The number of firms in an industry, the relative size of the firms (industry concentration), demand conditions, ease of entry and exit, and technological and cost conditions.

Keywords Accounting Profits; Capital Budgeting; Discounted Cash Flow Analysis; Economic Profits; Managerial Economics; Present Value Analysis; Pricing Analysis; Production Analysis; Profit Maximization; Risk analysis; Time Value of Money; Wealth Maximization

Finance > Use of Managerial Economics in Finance

Overview

Managerial economics highlights how financial professionals make decisions regarding resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. These professionals use a series of techniques in order to find the most efficient way to reach the best decisions for the firm. The major emphasis is to provide the analytical tools and managerial insights essential to the analyses and solutions of those problems that have significant economic consequences, both for the firm and for the world economy.

Managerial economics occurs when the fundamental principles of microeconomics is applied in the decision making process of business and managerial problems. It can be applied to problems in private, public and non-profit organizations. According to Skim and Siegel (1998), the basic steps in the decision making process are:

• Recognize and define the problem. Once a problem has been identified, an exact statement describing the problem should be prepared.
• Select a goal. Is it profit maximizing or cost minimizing?
• Identify any constraints. All possible constraints need to be identified.

• Identify alternatives or define decision variables a firm is trying to solve for.

• Select the alternative consistent with the firm's objectives or determine the optimal solution (i.e. profit-maximizing or cost-minimizing solution), p. 3. Managerial economics connects the practical and theoretical aspects of economics. Many economists will utilize a variety of techniques from other business fields such as finance and operations management. Most business decisions can be analyzed with the techniques used in managerial economics. However, it is most often used in:
• Risk Analysis Assorted uncertainty models, decision guidelines, and risk quantification methods help to interpret how much risk is involved in a given arrangement of decision.
• Production Analysis Microeconomics methods help to assess the effectiveness of production, the best factor distribution, the costs involved, the frugality of scale and the company’s estimated cost function.
• Pricing Analysis — Microeconomic methods facilitate the analysis of multiple pricing options that involve transfer costs, joint product costs, cost discrimination, cost elasticity approximations, and deciding upon the right pricing technique for the job.
• Capital Budgeting — Investment theory allows for the examination of a corporation's capital purchasing decision.

Managerial economics is "the systematic studies of how resources should be allocated in such a way to most efficiently achieve a managerial goal" (Shim & Siegel, 1998, p. 2).

Profits

Profits are very crucial to a firm's bottom line. When a firm is able to make a profit, there is an assumption that the company has done a good job of effectively and efficiently in controlling cost while producing a quality product or performing a quality service. However, there are different types of profits. Two types of profits are accounting profits and economic profits. Accounting profits are determined by the difference between the total revenue and the cost of producing products or services, and they appear on the firm's income statement. Economic profits are determined by the difference between total revenue and the total opportunity costs. The opportunity costs tend to be higher than accounting and bookkeeping costs.

Profits tend to vary across industries, and there are a number of theories that attempt to provide an explanation as to why this occurs. Five of the most discussed theories in this area are:

• Risk-Bearing Theory. When the owners of a company make investments into the firm, they take on a certain amount of risk. In order to compensate them for their investment, the company will need to have an above average return on economic profits. An example would be a firm that has investors such as venture capitalists or angel investors.
• Dynamic Equilibrium Theory. Every firm should strive to have a normal rate of profit. However, each firm has the opportunity to earn returns above or below the normal level at any time.
• Monopoly Theory. There are times when one firm may have the opportunity to dominate in its industry and earn above normal rates of return over a long period of time. These firms tend to dominate the market as a result of economies of scale, control of essential natural resources, control of crucial patents and/or government restrictions. An example would be utility companies.
• Innovation Theory. A firm may earn above normal profits as a reward for its successful innovations, such as patents. An example would be a pharmaceutical organization such as Astra Zeneca.
• Managerial Efficiency Theory. A firm may be able to earn above average profits based on its strong leadership team. This type of organization gains profits as a result of being effective and efficient. An example would be General Electric under Jack Welch's leadership.

Wealth Maximization

Wealth maximization is a long term operational goal. Shareholders have a residual claim on the firm's net cash flows after expected contractual claims have been paid. All other stakeholders (i.e. employers, customers) have contractual expected returns. There tends to be a preference for wealth maximization because it takes into consideration (Shim & Siegel, 1998):

• Wealth for the long term
• Risk or uncertainty
• The timing of returns
• The stockholders' return.

Criterion for this goal suggests that a firm should review and assess the expected profits and or cash flows as well as the risks that are associated with them. When conducting this evaluation, there are three points to keep in mind. First, economic profits are not equivalent to accounting profits. Second, accounting profits are not the same as cash flows. Lastly, financial analysis must focus on maximization of the present value of cash flows to the owners of the firm when attempting to maximize shareholder wealth.

When making decisions, the financial management team has to anticipate certain factors and realize that they may not have control over some of them. Factors outside of their control tend to be ones that are a part of the economic environment.

• Factors under administrative command
• Products and services made available
• Production technology
• Marketing and distribution
• Investment plans of action
• Employment policies and compensation
• Ownership form
• Capital structure
• Successful capital management tactics
• Dividend policies
• Alliances, mergers, spinoffs
• Factors not under management control
• Level of economic activity
• Tax rates and regulations
• Competition
• Laws and government regulations
• Unionization of employees
• International business conditions and currency exchange rates

In order for wealth maximization to be at the optimal level, certain conditions need to be in place. The process has a good chance to be successful when:

• Complete markets are secure. Liquid markets are needed for the firm's inputs, products and by-products.
• There is no asymmetric information. Buyers and sellers have the same information and no information is hidden from either group.
• All re-contracting costs are known. Managers know or expect the exact impending input costs as a portion of the current worth of anticipated cash flows.

When one reviews the wealth maximization model, there are some basic assumptions made about how the financial management team should respond. Some recommendations include:

• Develop a dynamic long term vision/outlook.
• Anticipate and manage change.
• Secure strategic investment opportunities.
• Maximize the present value of expected cash flows to owners.

In order to account for timing, future cash flows must be discounted by an interest rate that represents the cost of the funds being used to finance the project. Financial analysts have found the time value of money to be an important factor when making decisions on projects. Present value is the value today of future cash flows, and the computation of present values (discounting) is the opposite of determining the compounded future value. The discounted cash flow (DCF) analysis is a tool that tends to be used to account for the timing of cash inflows and outflows.

The purpose of using the DCF analysis is to get an estimate of how much money can be gained by investing in a specific project. An adjustment for the time value of money is also taken into consideration. DCF analysis uses the weighted average cost of capital to discount future free cash flow projections in order to get the present value. Once the present value has been determined, it is used by financial analysts to determine whether or not a project is a potential investment. Good prospects are those projects in which the DCF analysis is higher than the current cost of the project investment. Currently, there are four different DCF methods utilized. The type of method utilized is determined based on the financing schedule of the firm. The four methods fall into two categories — equity approach and entity approach. The "flows to equity approach" falls under the equity approach. There are three methods under the entity approach, they are: The adjusted present value approach, weighted average cost of capital approach and the total cash flow approach.

However, there are some pitfalls with using the DCF analysis. Harman (2007) pointed out three potential problems with DCF.

• Operating Cash Flow Projections “The first and most important factor in calculating the DCF value of a stock is estimating the series of operating cash flow projections. There are a number of problems with earnings and cash flow forecasting that can generate problems with DCF analysis. The most prevalent is that the uncertainty with cash flow projection increases for each year in the forecast, and DCF models often use five or even 10 years' worth of estimates” (Harman, 2007, “Problems with DCF”). Analysts might be able to estimate what the operating cash flow will be for that year and the impending year. But, the projecting earnings and cash flow becomes more compromised as time progresses. Cash flow projections for a certain year will also weigh heavily on the recorded results from past years. Small, incorrect estimations during the first few years of a model can dramatically increase any differences in cash flow projections that are made down the road.
• Capital Expenditure Projections “Free cash flow projection involves projecting capital expenditures for each model year. The degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary. In a down year, a firm may elect to reduce capital expenditure plans since they tend to be risky. While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation” (Harman, 2007, “Problems with DCF”).
• Discount Rate and Growth Rate “There are many ways to approach the discount rate in an equity DCF model. Analysts might use the Markowitzian R = Rf + ? (Rm - Rf) or the weighted average cost of capital of the firm as the discount rate in the DCF model. Both approaches are quite theoretical and may not work well in real world investing applications” (Harman, 2007, “Problems with DCF”). Other methods involve choosing to use an “arbitrary standard hurdle rate” to estimate and assess each equity investment. Such a technique lets each investment be analyzed alongside the others. It is often hard to choose a particular estimating technique for discount rates that is both accurate and concise.

Application

Market Structures

Market structures take into consideration:

• The number of firms in an industry
• The relative size of the firms (industry concentration)
• Demand conditions
• Ease of entry and exit
• Technological and cost conditions.

The preferred structure is dependent on the type of industry. Therefore, the financial management team of each firm determines which of the above-mentioned factors will be a part of the decision making process.

The level of competition tends to be dependent on whether there are many (or a few) firms in the industry and if the firm's products are similar or different. Given this information, four basic approaches to market structure and the types of competition have been established.

• Perfect(Pure) Competition (Many sellers of a standardized product)

Characteristics of perfect competition are:

• Large number of buyers and sellers
• Homogeneous product
• Complete knowledge
• Easy entry and exit from the market.

A firm using this approach tends to be small relative to the total market, and it will offer its product at the going market price. A firm in this format operates at an output level where price (or marginal revenue) is equal to the marginal cost and profit maximized. This format is more theoretical because there is no firm that operates at this level.

• Monopolistic Competition (Many sellers of a differentiated product)

Characteristics of monopolistic competition are: One firm, no close substitutes, no interdependence among firms, and substantial barriers to entry. In addition, there tends to be many buyers and sellers, there is product differentiation, easy entry and exit and independent decision making by individual firms. An example of a firm fitting this profile would be a small business selling differentiated, yet similar, products. These firms will utilize three basic strategies in order to obtain their principal goal of maximum profits: Price changes, variations in the products, and promotional activities.

• Oligopoly (Few sellers of either a standardized or a differentiated product)

Characteristics of an oligopoly are few firms, high degree of interdependence among firms; product may be homogenous or differentiated, and difficult entry and exit from market. The market fits this approach when there are a small number of firms supplying the dominant share of an industry's total output. Oligopolists are interdependent based on all levels of competition — price, output, promotional strategies, customer service policies, acquisitions and mergers, etc. Therefore, decision makers may have a hard time anticipating what rivals will do in reaction to their position, which makes the process complex. Two popular models are Cournot's duopoly model and kinked demand curve. An example would be the NCAA. This organization controls the revenues and costs of its member schools. It has the power to limit the number of games and times that a school can have its games televised. The NCAA retains control over costs through its restrictions on the compensation of student athletes.

• Monopoly (A single seller of a product for which there is no close substitute)

A monopoly occurs when one firm produces a highly differentiated product in a market with significant barriers to entry. It may be large or small, and it must be the only supplier. In addition, there are not any similar substitutes available. Since the monopoly is the only producer, it is known as the industry, while its demand curve is called the industry demand. An example would be an electric utility company in a specific geographic area.

What is the difference between the monopoly and pure approach? A profit-maximizing monopoly firm will produce less and charge a higher price than firms collectively in a purely competitive industry. However, both demand and cost may be different for a monopoly firm (i.e. a monopoly may be able to take advantage of economies of scale).

Viewpoint

Capital Budgeting

Many organizations charge the finance department with overseeing the financial stability of the firm. The chief financial officer (CFO) may lead a team of financial analysts to determine which projects deserve investment. "The economic theory of the firm suggests that to maximize its profit, a firm should operate at the point where the marginal cost of an additional unit of output just equals the marginal revenue derived from that output, and this may be equally applicable to the capital budgeting process" (Shim & Siegel, 1998, p. 279). Capital budgeting is an example of how a firm may conduct a cost-benefit analysis. There is a comparison between the cash inflows (benefits) and outflows (costs) in order to determine which is greater. Capital budgeting could be the result of purchasing assets that are new for the firm or getting rid of some of the current assets in order to be more efficient. The finance team will be charged with evaluating which projects would be good investments, which assets would add value to the current portfolio, and how much the firm is willing to invest into each asset.

In order to answer questions about potential assets, there are a set of components to be considered in the capital budgeting process. The four components are: Initial investment outlay, net cash benefits (or savings) from the operations, terminal cash flow, and net present value (NPV) technique. "Capital budgeting is a financial analysis tool that applies quantitative analysis to support strong management decisions" (Bearing Point, n.d.).

Capital budgeting seeks to provide a simple way for the finance department to see the "big picture" of the benefits, costs and risks for a corporation planning to make short term and/or long term investments. Unfortunately, many of the leading methods have experienced problems, especially when a firm is using a standardized template. Examples of potential problems include:

The benefits, costs, and risks associated with an investment tend to be different based on the type of industry (i.e. technological versus agricultural).

A corporation may highlight the end results of the return on investment model and the assumptions that support the results versus a balanced analysis of benefits, costs, and risks.

If a firm does not account for the above-mentioned scenarios, there is a possibility of the results being skewed, which would make the data unusable. This type of error could hinder a project from getting approved. Therefore, it is critical for financial analysts to have a more effective and efficient technique to use. Bearing Point (n.d.) identified several leading practices that organizations are using in order to avoid reporting faulty information. The theme in all of the techniques is that capital budgeting is not the only factor considered. Other quantifiable factors are utilized in order to see the big picture.

Consider the nature of the request — The type of benefit obtained by the investment will determine the nature of the request. Therefore, it may be beneficial to classify the benefit types into categories such as strategic, quantifiable and intangible.

All benefits are not created equal — Benefits should be classified correctly in order to properly analyze them. There are two types of benefits — hard and soft. Hard benefits affect the profit and loss statement directly, but soft benefits do not have the same affect.

Quantify risk — Make sure that the risks are properly evaluated. In most cases, risks are neglected. Also, it would be a good idea to build a risk factor into whatever model is utilized.

Be realistic about benefit periods. Make sure that the expectations are realistic. In the past, corporations have created unrealistic goals for the benefits period by anticipating benefits to come too early and reusing models that reflect the depreciation period for the capital asset.

Conclusion

Managerial economics highlights how financial professionals make decisions regarding resource allocation, strategic, and tactical issues that relate to all types of firms from an economic perspective. Managerial economics occurs when the fundamental principles of microeconomics are applied to the decision making process of business and managerial problems. It can apply to problems in private, public and non-profit organizations. Managerial economics connects the practical and theoretical aspects of economics. Many economists will utilize a variety of techniques from other business fields such as finance and operations management.

Profits are very crucial to a firm's bottom line. There are two types of profits — accounting profits and economic profits. Profits tend to vary across industries, and there are a number of theories that attempt to provide an explanation as to why this occurs.

Wealth maximization is a long term operational goal. There tends to be a preference for wealth maximization because it takes into consideration wealth for the long term, risk or uncertainty, the timing of returns, and the stockholders' return (Shim & Siegel, 1998). "The economic theory of the firm suggests that to maximize its profit, a firm should operate at the point where the marginal cost of an additional unit of output just equals the marginal revenue derived from that output, and this may be equally applicable to the capital budgeting process" (Shim & Siegel, 1998, p. 279). Capital budgeting is an example of how a firm may conduct a cost-benefit analysis.

Terms & Concepts

Accounting Profits: The difference between the total revenue and the cost of producing goods or services.

Capital Budgeting: The process of choosing certain long-term projects that are worthy of undertaking and investment. The potential projects are usually chosen based on their prospective discounted cash flows and the internal rates of return.

Discounted Cash Flow Analysis: A valuation method used to estimate the attractiveness of an investment opportunity.

Economic Profits: The difference between the total revenue and the total opportunity costs.

Managerial Economics: The branch of economics applied in managerial decision making.

Present Value Analysis: The evaluation of the current value of impending payments that are discounted at the rate R, which is known as the current bank balance that is paying interest at the rate R that is necessary in order to accurately imitate the future payment values.

Pricing Analysis: Microeconomic methods that are utilized in order to assess different pricing decisions.

Production Analysis: Microeconomic methods that help to assess production effectiveness, the best factor allocation, the costs, the benefits of scale, and the estimation of the company’s cost function.

Profit Maximization: A hypothesis that the goal of a firm is to maximize its profit.

Risk Analysis: Assessing the extent of risk of a decision based on different uncertainty models, decision rules, and methods of risk quantification.

Time Value of Money: The concept that money available now has higher value than it will at the same amount in the future based on its potential earning capability. Assuming that money is likely to earn interest, any amount of dollars is more heavily weighted the sooner it is received. This concept is also known as "present discounted value."

Wealth Maximization: In an efficient market, it is the maximization of the current share price.

Bibliography

Andreae, C.A. (1970). The study of finance as a management science. Management International Review (MIR), 10, 87-99. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=12253215&site=ehost-live

Bearing Point (n.d.). Improve your capital budget techniques. Retrieved July 9, 2007, from http://office.microsoft.com/en-us/help/HA011553851033.aspx

Harman, B. (2007, July 9). Top three DCF analysis pitfalls. Retrieved July 28, 2007, from http://www.investopedia.com/articles/07/DCF%5fpitfalls.asp.

McGuigan, J., Moyer, C., & Harris, F. (2007). Managerial economics: Applications, strategies, and tactics. Southwestern Publishing.

Mintz, O., & Currim, I.S. (2013). What drives managerial use of marketing and financial metrics and does metric use affect performance of marketing-mix activities?. Journal of Marketing, 77, 17-40. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85725800&site=ehost-live

Shim, J., & Siegel, J. (1998). Managerial economics. New York: Barron's Educational Series, Inc.

Suggested Reading

Block, W. (2001). Cyberslacking, business ethics and managerial economics. Journal of Business Ethics, Part 1, 33, 225-231. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5440168&site=ehost-live

Cafferata, R. (1997). Nonprofit organizations privatization and the mixed economy: A managerial economics perspective. Annals of Public & Cooperative Economics, 68, 665-689. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4491985&site=ehost-live

Guiffrida, A., & Nagi, R. (2006). Economics of managerial neglect in supply chain delivery performance. Engineering Economist, 51, 1-17. Retrieved July 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19906612&site=ehost-live