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Chapter 1

An Overview of Financial Management

LEARNING OBJECTIVES

After reading this chapter, students should be

able to:

• Explain the career opportunities available

within the three interrelated areas of

finance.

• Identify some of the forces that will affect

financial management in the new millennium.

Learning Objectives: 1 - 1
• Describe the advantages and disadvantages of

alternative forms of business organization.

• Briefly explain the responsibilities of the

financial staff within an organization.

• State the primary goal in a publicly traded

firm, and explain how social responsibility

and business ethics fit in with that goal.

• Define an agency relationship, give some

examples of potential agency problems, and

identify possible solutions.

• Identify major factors that determine the

price of a company’s stock, including those

that managers have control over and those

Learning Objectives: 1 - 2
that they do not.

• Discuss whether financial managers should

concentrate strictly on cash flow and ignore

the impact of their decisions on EPS.

Learning Objectives: 1 - 3
LECTURE SUGGESTIONS

Chapter 1 covers some important concepts, and

discussing them in class can be interesting.

However, students can read the chapter on their

own, so it can be assigned but not covered in

class.

We generally spend much of the first day

going over the syllabus and discussing grading

and other mechanics relating to the course. To

the extent that time permits, we talk about the

topics that will be covered in the course and the

structure of the book. We also discuss briefly

the fact that it is assumed that managers try to

maximize stock prices, but that they may have

Lecture Suggestions: 1 - 4
other goals, hence that it is useful to tie

executive compensation to stockholder-oriented

performance measures. If time permits, we think

it’s worthwhile to spend at least a full day on

the chapter. If not, we ask students to read it

on their own, and to keep them honest, we ask one

or two questions about the material on the first

mid-term exam.

One point we emphasize in the first class is

that students should get a copy of Blueprints and

a financial calculator immediately, and bring

both to class regularly. We also put copies of

the various versions of our “Brief Calculator

Manual,” which in about 12 pages explains how to

use the most popular calculators, in the copy

center. We want students to start learning to

use their calculators early, because in the past


we have found that many students wait to learn to

use their calculators at the same time they are

trying to understand time value of money

concepts. If students learn how to use the

calculator early, they are less likely to get

confused by time value concepts.

We are often asked what calculator students

should buy. If they already have a financial

calculator that can find IRRs, we tell them that

it will do, but if they do not have one, we

recommend either the HP-10B or 17B. Please see

the “Lecture Suggestions” for Chapter 7 for more

on calculators.

DAYS ON CHAPTER: 1 OF 58 DAYS (50-minute

periods)

Lecture Suggestions: 1 - 6
ANSWERS TO END-OF-CHAPTER QUESTIONS

1-1 The three principal forms of business

organization are sole proprietorship,

partnership, and corporation. The advantages

of the first two include the ease and low

cost of formation. The advantages of the

corporation include limited liability,

indefinite life, ease of ownership transfer,

and access to capital markets.

The disadvantages of a sole proprietorship

are (1) difficulty in obtaining large sums of

capital; (2) unlimited personal liability for

business debts; and (3) limited life. The

disadvantages of a partnership are (1)

Answers and Solutions: 1 - 8


unlimited liability, (2) limited life, (3)

difficulty of transferring ownership, and (4)

difficulty of raising large amounts of

capital. The disadvantages of a corporation

are (1) double taxation of earnings and (2)

setting up a corporation and filing required

state and federal reports, which are complex

and time-consuming.

1-2 No. The normal rate of return on investment

would vary among industries, principally due

to varying risk. The normal rate of return

would be expected to change over time due to

(1) underlying changes in the industry and

(2) business cycles.

Answers and Solutions: 1 - 9


1-3 An increase in the inflation rate would most

likely increase the relative importance of

the financial manager. Virtually all of the

manager’s functions, from obtaining funds for

the firm to internal cost accounting, become

more demanding in periods of high inflation.

Usually, uncertainty is also increased by

inflation, and hence, the effects of a poor

decision are magnified.

1-4 Stockholder wealth maximization is a long-run

goal. Companies, and consequently the

stockholders, prosper by management making

decisions that will produce long-term

earnings increases. Actions that are

continually shortsighted often “catch up”

with a firm and, as a result, it may find

Answers and Solutions: 1 - 10


itself unable to compete effectively against

its competitors. There has been much

criticism in recent years that U.S. firms are

too short-run profit-oriented. A prime

example is the U.S. auto industry, which has

been accused of continuing to build large

“gas guzzler” automobiles because they had

higher profit margins rather than retooling

for smaller, more fuel-efficient models.

1-5 Even though firms follow generally accepted

accounting principles (GAAP), there is still

sufficient margin for firms to use different

procedures. Leasing and inventory accounting

(LIFO versus FIFO) are two of the many areas

where procedural differences could complicate

relative performance measures.

Answers and Solutions: 1 - 11


1-6 The management of an oligopolistic firm would

be more likely to engage voluntarily in

“socially conscious” practices. Competitive

firms would be less able to engage in such

practices unless they were cost-justified,

because they would have to raise prices to

cover the added costs--quickly finding

themselves uncompetitive.

1-7 Profit maximization abstracts from (1) the

timing of profits and (2) the riskiness of

different operating plans. However, both of

these factors are reflected in stock price

maximization. Thus, profit maximization

would not necessarily lead to stock price

maximization.

Answers and Solutions: 1 - 12


1-8 The president of a large, publicly owned

corporation should maximize shareholders’

wealth or he risks losing his job. Many have

argued that when only a small percentage of

the stock is owned by management shareholder

wealth maximization can take a back seat to

any number of conflicting managerial goals.

Such factors as a compensation system based

on management performance (bonuses tied to

profits, stock option plans) as well as the

possibility of being removed from office

(voted out of office, an unfriendly tender

offer by another firm) serve to keep

management’s focus on stockholders’

interests.

Answers and Solutions: 1 - 13


1-9 a. Corporate philanthropy is always a sticky

issue, but it can be justified in terms of

helping to create a more attractive

community that will make it easier to hire

a productive work force. This corporate

Anegatively, especially those stockholders

not living in its headquarters city.

Stockholders are interested in actions that

maximize share price, and if competing

firms are not making similar contributions,

the “cost” of this philanthropy has to be

borne by someone--the stockholders. Thus,

stock price could decrease.

b. Companies must make investments in the

current period in order to generate future

cash flows. Stockholders should be aware

Answers and Solutions: 1 - 14


of this, and assuming a correct analysis

has been performed, they should react

positively to the decision. The Mexican

plant is in this category. Capital

budgeting is covered in depth in Part 4 of

the text. Assuming that the correct

capital budgeting analysis has been made,

the stock price should increase in the

future.

c. Provided that the rate of return on

assets exceeds the interest rate on debt,

greater use of debt will raise the expected

rate of return on stockholders’ equity.

Also, the interest on debt is tax

deductible and this provides a further

advantage. However, (1) greater use of

Answers and Solutions: 1 - 15


debt will have a negative impact on the

stockholders if the company’s return on

assets falls below the cost of debt, and

(2) increased use of debt increases the

chances of going bankrupt. The effects of

debt usage, called “financial leverage,”

are spelled out in detail in the chapter

titled, “Capital Structure and Leverage.”

d. Today (2003), nuclear generation of

electricity is regarded as being quite

risky. If the company has a heavy

investment in nuclear generators, its risk

will be high, and its stock price will be

adversely affected unless its costs are

much lower, hence its profits are much

higher.

Answers and Solutions: 1 - 16


Answers and Solutions: 1 - 17
e. The company will be retaining more

earnings, so its growth rate should rise,

which should increase its stock price. The

decline in dividends, however, will pull

the stock price down. It is unclear whether

the net effect on its stock will be an

increase or a decrease in its price, but

the change will depend on whether

stockholders prefer dividends or increased

growth. This topic will be discussed in

greater detail in the chapter titled,

“Distributions to Shareholders: Dividends

and Share Repurchases.”

1-10 The executive wants to demonstrate strong

performance in a short period of time, which

can be demonstrated either through improved


earnings and/or a higher stock price. The

current board of directors is well served if

the manager works to increase the stock

price; however, the board is not well served

if the manager takes short-run actions that

bump up short-run earnings at the expense of

long-run profitability and the company’s

stock price. Consequently, the board may

want to rely more on stock options and less

on performance shares that are tied to

accounting performance.

1-11 As the stock market becomes more volatile,

the link between the stock price and the

management ability of senior executives is

weakened. Therefore, in this environment

companies may choose to de-emphasize the


awarding of stock and stock options and rely

more on bonuses and performance shares that

are tied to other performance measures

besides the company’s stock price. Moreover,

in this environment it may be harder to

attract or retain top talent if the

compensation is tied too much to the

company’s stock price.

1-12 a. No, TIAA-CREF is not an ordinary

shareholder. Because it is one of the

largest institutional shareholders in the

United States and it controls nearly $280

billion in pension funds, its voice carries

a lot of weight. This “shareholder” in

effect consists of many individual


shareholders whose pensions are invested

with this group.

b. The owners of TIAA-CREF are the

individual teachers whose pensions are

invested with this group.

c. For TIAA-CREF to be effective in wielding

its weight, it must act as a coordinated

unit. In order to do this, the fund’s

managers should solicit from the individual

shareholders their “votes” on the fund’s

practices, and from those “votes” act on

the majority’s wishes. In so doing, the

individual teachers whose pensions are

invested in the fund have in effect

determined the fund’s voting practices.


1-13 a. If the capital markets perceive the

project as risky and therefore increasing

the firm’s risk, the value of the firm’s

outstanding bonds will decline--hurting the

firm’s existing bondholders. Subsequently,

if management’s analysis of the project

proves to be correct, the value of the

firm’s bonds should increase.

b. Dividends are paid from earnings

after bondholders and the government have

been paid. A dividend increase decreases

the firm’s addition to retained earnings

and subsequently lowers its growth rate;

however, shareholders receive more

dividends so the net effect on stock


price is indeterminate. If the firm’s

stock price increases as current

management believes it will, this may

cause some bondholders to sell their

bonds and buy the firm’s stock to earn a

higher return. So, the proposed dividend

increase may cause a decline in the value

of the firm’s existing bonds.

c. Yes, assuming that management has

performed the correct analysis it should

undertake projects/actions that will

increase the firm’s stock price.

Stockholder wealth maximization is the goal

of management.
d. Bondholders can take the following

actions to protect themselves against

managerial decisions that reduce bond

values:

1. Place restrictive covenants in debt

agreements.

2. Charge a higher-than-normal interest

rate to compensate for the risk of

possible exploitation.

3. Refuse to deal with management

entirely.

Firms that deal unfairly with creditors

either lose access to the debt markets or

are saddled with high interest rates and


restrictive covenants, all of which are

detrimental to shareholders.

1-14 a. Increasing corporate tax rates and

reducing individual tax rates will cause

the firm to remain as an unincorporated

partnership. In addition to higher

corporate tax rates, corporations are

exposed to double taxation.

b. By increasing environmental and labor

regulations to include firms with 50+

employees, this firm will choose to remain

an unincorporated partnership due to the

additional costs it would have to bear if

it operated as a corporation.
CINTEGRATED CASE

1-15 Earnings per share in the current year will

decline due to the cost of the investment

made in the current year and no significant

performance impact in the short run.

However, the company’s stock price should

increase due to the significant cost savings

expected in the future.

Take a Dive

Financial Management Overview


1-1 KATO SUMMERS OPENED TAKE A DIVE 17 YEARS

AGO; THE STORE IS LOCATED IN MALIBU,

CALIFORNIA, AND SELLS SURFING-RELATED

EQUIPMENT. TODAY, TAKE A DIVE HAS 50

EMPLOYEES INCLUDING KATO AND HIS DAUGHTER

AMBER, WHO WORKS PART TIME IN THE STORE TO

HELP PAY FOR HER COLLEGE EDUCATION.

KATO’S BUSINESS HAS BOOMED IN RECENT

YEARS, AND HE IS LOOKING FOR NEW WAYS TO

TAKE ADVANTAGE OF HIS INCREASING BUSINESS

OPPORTUNITIES. ALTHOUGH KATO’S FORMAL

BUSINESS TRAINING IS LIMITED, AMBER WILL

SOON GRADUATE WITH A DEGREE IN FINANCE.

KATO HAS OFFERED HER THE OPPORTUNITY TO

JOIN THE BUSINESS AS A FULL-FLEDGED

PARTNER. AMBER IS INTERESTED, BUT SHE IS


ALSO CONSIDERING OTHER CAREER OPPORTUNITIES

IN FINANCE.

RIGHT NOW, AMBER IS LEANING TOWARD

STAYING WITH THE FAMILY BUSINESS, PARTLY

BECAUSE SHE THINKS IT FACES A NUMBER OF

INTERESTING CHALLENGES AND OPPORTUNITIES.

AMBER IS PARTICULARLY INTERESTED IN FURTHER

EXPANDING THE BUSINESS AND THEN

INCORPORATING IT. KATO IS INTRIGUED BY HER

IDEAS, BUT HE IS ALSO CONCERNED THAT HER

PLANS MIGHT CHANGE THE WAY IN WHICH HE DOES

BUSINESS. IN PARTICULAR, KATO HAS A STRONG

COMMITMENT TO SOCIAL ACTIVISM, AND HE HAS

ALWAYS TRIED TO STRIKE A BALANCE BETWEEN

WORK AND PLEASURE. HE IS WORRIED THAT

THESE GOALS WILL BE COMPROMISED IF THE


COMPANY INCORPORATES AND BRINGS IN OUTSIDE

SHAREHOLDERS.

AMBER AND KATO PLAN TO TAKE A LONG

WEEKEND OFF TO SIT DOWN AND THINK ABOUT ALL

OF THESE ISSUES. AMBER, WHO IS HIGHLY

ORGANIZED, HAS OUTLINED A SERIES OF

QUESTIONS FOR THEM TO ADDRESS:

A. WHAT KINDS OF CAREER OPPORTUNITIES ARE OPEN

TO FINANCE MAJORS?

ANSWER: [SHOW S1-1 AND S1-2 HERE.] CAREER

OPPORTUNITIES FOR FINANCE MAJORS EXIST IN

THREE INTERRELATED AREAS: (1) MONEY AND

CAPITAL MARKETS,

WHICH DEALS WITH SECURITIES MARKETS AND

FINANCIAL INSTITUTIONS;
(2) INVESTMENTS, WHICH FOCUSES ON THE

DECISIONS OF BOTH INDIVIDUAL AND

INSTITUTIONAL INVESTORS AS THEY CHOOSE

SECURITIES FOR THEIR INVESTMENT PORTFOLIOS;

AND (3) FINANCIAL MANAGEMENT, OR “BUSINESS

FINANCE,” WHICH INVOLVES THE ACTUAL

MANAGEMENT OF FIRMS.

IN THE MONEY AND CAPITAL MARKETS AREA,

MANY FINANCE MAJORS GO TO WORK FOR

FINANCIAL INSTITUTIONS, INCLUDING BANKS,

INSURANCE COMPANIES, MUTUAL FUNDS, AND

INVESTMENT BANKING FIRMS. FINANCE

GRADUATES WHO GO INTO INVESTMENTS OFTEN

WORK FOR A BROKERAGE HOUSE EITHER IN SALES

OR AS A SECURITY ANALYST. OTHERS WORK FOR

BANKS, MUTUAL FUNDS, OR INSURANCE COMPANIES

IN THE MANAGEMENT OF THEIR INVESTMENT


PORTFOLIOS; FOR FINANCIAL CONSULTING FIRMS

THAT ADVISE INDIVIDUAL INVESTORS OR PENSION

FUNDS ON HOW TO INVEST THEIR FUNDS; FOR AN

INVESTMENT BANK WHOSE PRIMARY FUNCTION IS

TO HELP BUSINESSES RAISE NEW CAPITAL; OR AS

A FINANCIAL PLANNER WHOSE JOB IS TO HELP

INDIVIDUALS DEVELOP LONG-TERM FINANCIAL

GOALS AND PORTFOLIOS. THE JOB OPPORTUNITIES

IN FINANCIAL MANAGEMENT RANGE FROM MAKING

DECISIONS REGARDING PLANT EXPANSIONS TO

CHOOSING WHAT TYPES OF SECURITIES TO ISSUE

TO FINANCE EXPANSION. FINANCIAL MANAGERS

ALSO HAVE THE RESPONSIBILITY FOR DECIDING

THE CREDIT TERMS UNDER WHICH CUSTOMERS MAY

BUY, HOW MUCH INVENTORY THE FIRM SHOULD

CARRY, HOW MUCH CASH TO KEEP ON HAND,

WHETHER TO ACQUIRE OTHER FIRMS, AND HOW


MUCH OF THE FIRM’S EARNINGS TO PLOW BACK

INTO THE BUSINESS VERSUS TO PAY OUT AS

DIVIDENDS.

B. WHAT ARE THE PRIMARY RESPONSIBILITIES OF A

CORPORATE FINANCIAL STAFF?

ANSWER: [SHOW S1-3 AND S1-4 HERE.] THE FINANCIAL

MANAGER’S TASK IS TO ACQUIRE AND USE FUNDS

SO AS TO MAXIMIZE THE FIRM’S VALUE.

SPECIFIC ACTIVITIES INCLUDE: (1)

FORECASTING AND PLANNING, (2) MAKING MAJOR

INVESTMENT AND FINANCING DECISIONS, (3)

COORDINATING AND CONTROLLING, (4) DEALING

WITH THE FINANCIAL MARKETS, AND (5)

MANAGING RISK.
C. WHAT ARE THE MOST IMPORTANT FINANCIAL

MANAGEMENT ISSUES TODAY?

ANSWER: [SHOW S1-5 AND S1-6 HERE.] THE FOCUS ON

VALUE MAXIMIZATION CONTINUES AS WE BEGIN

THE 21st CENTURY. HOWEVER, TWO OTHER

TRENDS HAVE BECOME INCREASINGLY IMPORTANT

IN RECENT YEARS: THE GLOBALIZATION OF

BUSINESS AND THE INCREASED USE OF

INFORMATION TECHNOLOGY. THESE TRENDS WILL

UNDOUBTEDLY CONTINUE IN THE YEARS AHEAD.

D. 1. WHAT ARE THE ALTERNATIVE FORMS OF

BUSINESS ORGANIZATION?
ANSWER: [SHOW S1-7 HERE.] THE THREE MAIN FORMS

OF BUSINESS ORGANIZATION ARE

(1) SOLE PROPRIETORSHIPS, (2) PARTNERSHIPS,

AND (3) CORPORATIONS.

D. 2. WHAT ARE THEIR ADVANTAGES AND

DISADVANTAGES?

ANSWER: [SHOW S1-8 AND S1-9 HERE.] THE

PROPRIETORSHIP HAS THREE IMPORTANT

ADVANTAGES: (1) IT IS EASILY AND

INEXPENSIVELY FORMED, (2) IT IS SUBJECT TO

FEW GOVERNMENT REGULATIONS, AND (3) THE

BUSINESS PAYS NO CORPORATE INCOME TAXES.

THE PROPRIETORSHIP ALSO HAS THREE IMPORTANT


LIMITATIONS: (1) IT IS DIFFICULT FOR A

PROPRIETORSHIP TO OBTAIN LARGE SUMS OF

CAPITAL; (2) THE PROPRIETOR HAS UNLIMITED

PERSONAL LIABILITY FOR THE BUSINESS’S DEBTS,

AND (3) THE LIFE OF A BUSINESS ORGANIZED AS

A PROPRIETORSHIP IS LIMITED TO THE LIFE OF

THE INDIVIDUAL WHO CREATED IT.

THE MAJOR ADVANTAGE OF A PARTNERSHIP IS

ITS LOW COST AND EASE OF FORMATION. THE

DISADVANTAGES ARE SIMILAR TO THOSE

ASSOCIATED WITH PROPRIETORSHIPS: (1)

UNLIMITED LIABILITY, (2) LIMITED LIFE OF THE

ORGANIZATION, (3) DIFFICULTY OF TRANSFERRING

OWNERSHIP, AND (4) DIFFICULTY OF RAISING

LARGE AMOUNTS OF CAPITAL. THE TAX TREATMENT

OF A PARTNERSHIP IS SIMILAR TO THAT FOR


PROPRIETORSHIPS, WHICH IS OFTEN AN

ADVANTAGE.

THE CORPORATE FORM OF BUSINESS HAS THREE

MAJOR ADVANTAGES:

(1) UNLIMITED LIFE, (2) EASY

TRANSFERABILITY OF OWNERSHIP INTEREST, AND

(3) LIMITED LIABILITY. WHILE THE CORPORATE

FORM OFFERS SIGNIFICANT ADVANTAGES OVER

PROPRIETORSHIPS AND PARTNERSHIPS, IT DOES

HAVE TWO PRIMARY DISADVANTAGES: (1)

CORPORATE EARNINGS MAY BE SUBJECT TO DOUBLE

TAXATION AND (2) SETTING UP A CORPORATION

AND FILING THE MANY REQUIRED STATE AND

FEDERAL REPORTS IS MORE COMPLEX AND TIME-

CONSUMING THAN FOR A PROPRIETORSHIP OR A

PARTNERSHIP.
E. WHAT IS THE PRIMARY GOAL OF THE

CORPORATION?

ANSWER: [SHOW S1-10 AND S1-11 HERE.] THE

CORPORATION’S PRIMARY GOAL IS STOCKHOLDER

WEALTH MAXIMIZATION, WHICH TRANSLATES TO

MAXIMIZING THE PRICE OF THE FIRM’S COMMON

STOCK.

E. 1. DO FIRMS HAVE ANY RESPONSIBILITIES TO

SOCIETY AT LARGE?

ANSWER: FIRMS HAVE AN ETHICAL RESPONSIBILITY TO

PROVIDE A SAFE WORKING ENVIRONMENT, TO

AVOID POLLUTING THE AIR OR WATER, AND TO


PRODUCE SAFE PRODUCTS. HOWEVER, THE MOST

SIGNIFICANT COST-INCREASING ACTIONS WILL

HAVE TO BE PUT ON A MANDATORY RATHER THAN A

VOLUNTARY BASIS TO ENSURE THAT THE BURDEN

FALLS UNIFORMLY ON ALL BUSINESSES.

E. 2. IS STOCK PRICE MAXIMIZATION GOOD OR BAD

FOR SOCIETY?

ANSWER: THE SAME ACTIONS THAT MAXIMIZE STOCK

PRICES ALSO BENEFIT SOCIETY. STOCK PRICE

MAXIMIZATION REQUIRES EFFICIENT, LOW-COST

OPERATIONS THAT PRODUCE HIGH-QUALITY GOODS

AND SERVICES AT THE LOWEST POSSIBLE COST.

STOCK PRICE MAXIMIZATION REQUIRES THE

DEVELOPMENT OF PRODUCTS AND SERVICES THAT


CONSUMERS WANT AND NEED, SO THE PROFIT

MOTIVE LEADS TO NEW TECHNOLOGY, TO NEW

PRODUCTS, AND TO NEW JOBS. ALSO, STOCK

PRICE MAXIMIZATION NECESSITATES EFFICIENT

AND COURTEOUS SERVICE, ADEQUATE STOCKS OF

MERCHANDISE, AND WELL-LOCATED BUSINESS

ESTABLISHMENTS--FACTORS THAT ARE ALL

NECESSARY TO MAKE SALES, WHICH ARE

NECESSARY FOR PROFITS.

E. 3. SHOULD FIRMS BEHAVE ETHICALLY?

ANSWER: YES. EXECUTIVES OF MOST MAJOR FIRMS IN

THE UNITED STATES BELIEVE THAT FIRMS DO TRY

TO MAINTAIN HIGH ETHICAL STANDARDS IN ALL

OF THEIR BUSINESS DEALINGS. FURTHERMORE,


MOST EXECUTIVES BELIEVE THAT THERE IS A

POSITIVE CORRELATION BETWEEN ETHICS AND

LONG-RUN PROFITABILITY. CONFLICTS OFTEN

ARISE BETWEEN PROFITS AND ETHICS.

COMPANIES MUST DEAL WITH THESE CONFLICTS ON

A REGULAR BASIS, AND A FAILURE TO HANDLE

THE SITUATION PROPERLY CAN LEAD TO HUGE

PRODUCT LIABILITY SUITS AND EVEN TO

BANKRUPTCY. THERE IS NO ROOM FOR UNETHICAL

BEHAVIOR IN THE BUSINESS WORLD.

F. WHAT IS AN AGENCY RELATIONSHIP?

ANSWER: [SHOW S1-12 HERE.] AN AGENCY

RELATIONSHIP EXISTS WHENEVER A “PRINCIPAL”


ENGAGES AN “AGENT” AND GRANTS THE AGENT

SOME DECISION-MAKING POWER.

F. 1. WHAT AGENCY RELATIONSHIPS EXIST WITHIN A

CORPORATION?

ANSWER: WITHIN THE FINANCIAL MANAGEMENT CONTEXT,

THE PRIMARY AGENCY RELATIONSHIPS ARE THOSE

(1) BETWEEN STOCKHOLDERS AND MANAGERS AND

(2) BETWEEN DEBTHOLDERS AND STOCKHOLDERS

(THROUGH MANAGERS).

F. 2. WHAT MECHANISMS EXIST TO INFLUENCE

MANAGERS TO ACT IN SHAREHOLDERS’ BEST

INTERESTS?
ANSWER: [SHOW S1-13 HERE.] TO REDUCE AGENCY

CONFLICTS, STOCKHOLDERS MUST INCUR AGENCY

COSTS, WHICH INCLUDE ALL COSTS BORNE BY

SHAREHOLDERS TO ENCOURAGE MANAGERS TO

MAXIMIZE THE FIRM’S STOCK PRICE RATHER THAN

ACT IN THEIR OWN SELF-INTERESTS.

SOME SPECIFIC MECHANISMS THAT ENCOURAGE

MANAGERS TO ACT IN SHAREHOLDERS’ INTERESTS

INCLUDE: (1) PERFORMANCE-BASED MANAGERIAL

COMPENSATION, (2) DIRECT INTERVENTION BY

SHAREHOLDERS, (3) THE THREAT OF FIRING, AND

(4) THE THREAT OF TAKEOVER.


F. 3. SHOULD SHAREHOLDERS (THROUGH MANAGERS)

TAKE ACTIONS THAT ARE DETRIMENTAL TO

BONDHOLDERS?

ANSWER: [SHOW S1-14 HERE.] NO. SUCH BEHAVIOR IS

UNETHICAL, AND THERE IS NO ROOM FOR

UNETHICAL BEHAVIOR IN THE BUSINESS WORLD.

SECOND, IF SUCH ATTEMPTS ARE MADE,

CREDITORS WILL PROTECT THEMSELVES AGAINST

STOCKHOLDERS BY PLACING RESTRICTIVE

COVENANTS IN FUTURE DEBT AGREEMENTS.

FINALLY, IF CREDITORS PERCEIVE THAT A

FIRM’S MANAGERS ARE TRYING TO TAKE

ADVANTAGE OF THEM, THEY WILL EITHER REFUSE

TO DEAL FURTHER WITH THE FIRM OR ELSE WILL

CHARGE A HIGHER THAN NORMAL INTEREST RATE

TO COMPENSATE FOR THE RISK OF POSSIBLE


EXPLOITATION. THUS, FIRMS THAT DEAL

UNFAIRLY WITH CREDITORS EITHER LOSE ACCESS

TO THE DEBT MARKETS OR ARE SADDLED WITH

HIGH INTEREST RATES AND RESTRICTIVE

COVENANTS, ALL OF WHICH ARE DETRIMENTAL TO

SHAREHOLDERS.

G. IS MAXIMIZING STOCK PRICE THE SAME THING AS

MAXIMIZING PROFIT?

ANSWER: NO. GENERALLY, THERE IS A HIGH

CORRELATION BETWEEN EPS, CASH FLOW, AND

STOCK PRICE, AND ALL OF THEM GENERALLY RISE

IF A FIRM’S SALES RISE. NEVERTHELESS,

STOCK PRICES DEPEND NOT JUST ON TODAY’S

EARNINGS AND CASH FLOWS--FUTURE CASH FLOWS


AND THE RISKINESS OF THE FUTURE EARNINGS

STREAM ALSO AFFECT STOCK PRICES. SOME

ACTIONS MAY INCREASE EARNINGS AND YET

REDUCE STOCK PRICES WHILE OTHER ACTIONS MAY

BOOST STOCK PRICE BUT REDUCE EARNINGS.

CONSIDER A COMPANY THAT UNDERTAKES LARGE

EXPENDITURES TODAY THAT ARE DESIGNED TO

IMPROVE FUTURE PERFORMANCE. THESE

EXPENDITURES WILL LIKELY REDUCE EARNINGS

PER SHARE, YET THE STOCK MARKET MAY RESPOND

POSITIVELY IF IT BELIEVES THAT THESE

EXPENDITURES WILL SIGNIFICANTLY ENHANCE

FUTURE EARNINGS. BY CONTRAST, A COMPANY

THAT UNDERTAKES ACTIONS TODAY TO ENHANCE

ITS EARNINGS MAY SEE A DROP IN ITS STOCK

PRICE, IF THE MARKET BELIEVES THAT THESE


ACTIONS COMPROMISE FUTURE EARNINGS AND/OR

DRAMATICALLY INCREASE THE FIRM’S RISK.

H. WHAT FACTORS AFFECT STOCK PRICES?

ANSWER: [SHOW S1-15 AND S1-16 HERE.] THE FIRM’S

STOCK PRICE IS DEPENDENT ON MANAGERIAL

ACTIONS, SUCH AS INVESTMENT DECISIONS,

FINANCING DECISIONS, DIVIDEND POLICY

DECISIONS, AND EXTERNAL FACTORS, INCLUDING

LEGAL CONSTRAINTS, THE GENERAL LEVEL OF

ECONOMIC ACTIVITY, TAX LAWS, AND CONDITIONS

IN THE STOCK MARKET. MANAGERS CAN ENHANCE

THEIR FIRM’S VALUE (AND ITS STOCK PRICE) BY

INCREASING THEIR FIRM’S EXPECTED CASH


FLOWS, SPEEDING UP CASH FLOWS, AND REDUCING

THEIR RISKINESS.

I. WHAT FACTORS AFFECT THE LEVEL AND RISKINESS

OF CASH FLOWS?

ANSWER: [SHOW S1-17 HERE.] MANAGERIAL ACTIONS,

SUCH AS INVESTMENT DECISIONS, FINANCING

DECISIONS, AND DIVIDEND POLICY DECISIONS

AFFECT THE LEVEL, TIMING, AND THE RISKINESS

OF THE FIRM’S CASH FLOWS.