More Value, Less Profit: Achieving the Value of an Internally Financed Firm

Problem definition: Profit maximization is the default criterion in operations management and normative economics of industrial organizations, but its pursuit achieves a firm's financial value only under stringent conditions. Otherwise: (A) Profit optimization is sub-optimal, (B) the appropriate operational criterion to maximize value can be determined clearly for a firm that is financed internally and (C) a by-product of (A) identifies the proper organizational structure to coordinate the management of cash and operations. Methodology/results: The results emerge from the analysis of a Markov decision process model of a firm that makes periodic decisions regarding operations and cash. The value of the firm, which is the maximal expected present value of the time stream of net payouts (cash dividends, stock dividends, and stock buybacks), is one end of an axis on which the other end is profit. (a) Simple formulas connect the two criteria on the axis. The value corresponds to a perturbed profit criterion in which revenue is deflated. (b) Thus, the use of a straightforward profit criterion compromises value. (c) The analysis depends on whether a bankruptcy risk is present or not and, if present, how it is modeled. The paper analyzes two cases: no risk of bankruptcy, and risk of bankruptcy under a simplified version of Chapter 11 of the U.S. Bankruptcy Code. (d) If there is no risk of bankruptcy, profit-optimal and value-optimal decision rules have the same qualitative features, and the management of cash should be subordinated to operations management. (e) These results are applied to models of inventory, a vertically integrated supply chain, a fishery and capacity management. Managerial implications: CFOs should mandate lower inventories than operations managers deem profit-optimal. CEOs should not subordinate operations management to cash management.