Why Profit Maximisation is Not Enough - Net Present Value

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Much has been said, not least in the popular media and even in intelligent literate writing, that decries the goal of profit maximisation as the stated goal of industry. Just off the top of my head, I think of Michael Moore's Roger and Me, where he rails against the fact that profitable industries are still closing plants and moving manufacturing to countries other than the US in the 80s and 90s (a process that, as far as I'm aware is largely complete nowadays). But even more recently The Wire - or more specifically the introduction the the 5th season - talks about how with journalism and the funding of newsrooms, it wasn't that they weren't making profits, it's just that they weren't making enough profits.

I've come to realise this to be true: that profit maximisation indeed is not a sufficient means of defining what companies should strive for. But of course my objection has little to do with agreeing with the discourse I've cited, and more to do with explaining exactly why "profitable" companies still desire to make sometimes large and drastic changes.

Much of this has to do with my having been contacted by The Christman Group, an investment bank that has an internship opening that I'm hoping to fill. But the less said about that the better, I'm sure - I don't have unrealistic expectations. Suffice to say between recieving an e-mail that expressed interest in me and arranging a phone interview, I decided to do what any responsible job-seeker would - find out as much as possible about my potential employer. Aside from reading their President Richard Jackim's very accessible book "The $10 Trillion Opportunity," (I bought the e-book online) about their company's focus on Exit Planning for mostly privately held middle market companies, I was also looking at what seems to be the beginners bible of MBA finance, Brealey-Myers' Principles of Corporate Finance. 

Brealey-Myers makes an intriguing and really rather stunning assertion about the brief managers should recieve from shareholders - exactly that profit maximisation is not the most appropriate objective of professional managers. This is in part because profit maximisation as a principle is needlessly vague - it is not time specific, it does not say for what period profit is being maximised - whether this year, next year or 5 years hence, each perhaps at the expense of the other, or of other longer term periods of profit. It makes no sense to have one year have the largest profits imaginable at the expense of profits for the next ten years. Similarly owners do not want to sacrifice profits for the next ten years in the hope that at the end of that period there will be one year of huge profits.

The answer is Net Present Value. I find it a little difficult to explain in totality the concept of Net Present Value except mathematically, and I don't wish to go into too much detail - you can read the wikipedia article on it, and download a copy of Brealey-Meyers (isn't piracy grand?). But suffice it to say it is the beginners holy grail of corporate finance. The maximisation of Net Present Value argues that given the same level of risk, the return on investment of a given amount of capital must exceed what that same capital would earn through the capital markets (buying govenment securities or shares of similar risk as the investment), or else the investment cannot be justified since it does not create more value than the opportunity cost of capital.

I'll try and make that a little more concrete. When you have a given amount of money, and you don't do anything with it other than stuff it under your mattress, you are losing money. Not just because of inflation, that makes your money less valuable, but because you are not investing it in order to create more wealth. This investment is not "funny money" - on the contrary it is very real. Whenever you put money into capital markets, that is the money that business users borrow to fund their businesses - to make more and better widgets. It's the money that people borrow to buy a house or car. These are things those people couldn't otherwise do, and you are allowing them to get those things done, for which they are paying you back your investment plus interest. That return on investment is the base level at which someone who doesn't stuff their money under the mattress operates. If you have $100 and you do nothing with it, at the end of one year you have $100 (before inflation). If you put that $100 towards buying government securities that give a 7% return at the end of one year, at the end of one year, you have $107.

What maximising NPV argues is that if you are investing in something at the same level of risk as a govenment security, it needs to provide a return of more than 7% in order to be a rational decision. Otherwise you are not making as much money as you can given the level of risk. Put another way, you are taking on too much risk for too little reward - when the going rate of that risk is lower than that of your investment.

This brings me back to the beginning of this post, about why "profitable" companies may still move factories or streamline newsrooms. Because if you are only making the amount of profit equal or less than the amount of profit you could be making by investing in capital markets, you are not making a rational decision. For the level of risk of your endeavour, you need to be making more profit than you would otherwise be making, or you're putting in all that effort and still losing money compared to investing it.

Of course in the real world this becomes more and more complicated as more variables come in, but in general this is a useful guide in terms of how to make rational decisions regarding the allocation of capital. And the efficient allocation of capital is a good thing. Me saying why that is will have to wait for another post, but suffice to say anything less is just irrational.

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This page contains a single entry by subtitles published on August 18, 2008 11:51 PM.

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