Chapter 1

An Overview of Financial Management

Learning Objectives
After reading this chapter, students should be able to:
Explain the role of finance, and the different types of jobs in finance.
Identify the advantages and disadvantages of different forms of business organization.
Explain the links beteen stock price, intrinsic value, and executive compensation.
!iscuss the importance of business ethics and the conse"uences of unethical behavior.
Identify the potential conflicts that arise ithin the firm beteen stockholders and managers and
beteen stockholders and bondholders and discuss the techni"ues that firms can use to mitigate these
potential conflicts.
Chapter 1: An Overview of Financial Management Learning Objectives 1
Lecture Suggestions
#hapter $ covers some important concepts, and discussing them in class can be interesting. %oever,
students can read the chapter on their on, so it can be assigned but not covered in class.
&e spend the first day going over the syllabus and discussing grading and other mechanics relating
to the course. 'o the extent that time permits, e talk about the topics that ill be covered in the course and
the structure of the book. &e also discuss briefly the fact that it is assumed that managers try to maximize
stock prices, but that they may have other goals, hence that it is useful to tie executive compensation to
stockholder(oriented performance measures. If time permits, e think it)s orthhile to spend at least a full
day on the chapter. If not, e ask students to read it on their on, and to keep them honest, e ask one or
to "uestions about the material on the first mid(term exam.
*ne point e emphasize in the first class is that students should print a copy of the PowerPoint
slides for each chapter covered and purchase a financial calculator immediately, and bring both to class
regularly. &e also put copies of the various versions of our +,rief #alculator -anual,. hich in about $/
pages explains ho to use the most popular calculators, in the copy center. 0tudents ill need to learn ho
to use their calculators before time value of money concepts are covered in #hapter 1. It is important for
students to grasp these concepts early as many of the remaining chapters build on the '2- concepts.
&e are often asked hat calculator students should buy. If they already have a financial calculator
that can find I33s, e tell them that it ill do, but if they do not have one, e recommend either the
%4($5,II or $6,II. 4lease see the +7ecture 0uggestions. for #hapter 1 for more on calculators.
DAS O! C"A#$%&: 1 OF '( DAS )'*+minute perio,s-
. Lecture Suggestions Chapter 1: An Overview of Financial Management
Answers to %n,+of+Chapter /uestions
1+1 &hen you purchase a stock, you expect to receive dividends plus capital gains. 8ot all stocks pay
dividends immediately, but those corporations that do, typically pay dividends "uarterly. #apital
gains 9losses: are received hen the stock is sold. 0tocks are risky, so you ould not be certain
that your expectations ould be met;as you ould if you had purchased a <.0. 'reasury security,
hich offers a guaranteed payment every = months plus repayment of the purchase price hen the
security matures.
1+. If investors are more confident that #ompany A)s cash flos ill be closer to their expected value
than #ompany ,)s cash flos, then investors ill drive the stock price up for #ompany A.
#onse"uently, #ompany A ill have a higher stock price than #ompany ,.
1+0 A firm)s intrinsic value is an estimate of a stock)s +true. value based on accurate risk and return
data. It can be estimated but not measured precisely. A stock)s current price is its market price;
the value based on perceived but possibly incorrect information as seen by the marginal investor.
>rom these definitions, you can see that a stock)s +true long(run value. is more closely related to its
intrinsic value rather than its current price.
1+1 E"uilibrium is the situation here the actual market price e"uals the intrinsic value, so investors are
indifferent beteen buying or selling a stock. If a stock is in e"uilibrium then there is no
fundamental imbalance, hence no pressure for a change in the stock)s price. At any given time,
most stocks are reasonably close to their intrinsic values and thus are at or close to e"uilibrium.
%oever, at times stock prices and e"uilibrium values are different, so stocks can be temporarily
undervalued or overvalued.
1+' If the three intrinsic value estimates for 0tock ? ere different, I ould have the most confidence in
#ompany ?)s #>*)s estimate. Intrinsic values are strictly estimates, and different analysts ith
different data and different vies of the future ill form different estimates of the intrinsic value for
any given stock. %oever, a firm)s managers have the best information about the company)s future
prospects, so managers) estimates of intrinsic value are generally better than the estimates of
outside investors.
1+2 If a stock)s market price and intrinsic value are e"ual, then the stock is in e"uilibrium and there is no
pressure 9buying@selling: to change the stock)s price. 0o, theoretically, it is better that the to be
e"ualA hoever, intrinsic value is a long(run concept. -anagement)s goal should be to maximize
the firm)s intrinsic value, not its current price. 0o, maximizing the intrinsic value ill maximize the
average price over the long run but not necessarily the current price at each point in time. 0o,
stockholders in general ould probably expect the firm)s market price to be under the intrinsic value
;realizing that if management is doing its job that current price at any point in time ould not
necessarily be maximized. %oever, the #E* ould prefer that the market price be high;since it
is the current price that he ill receive hen exercising his stock options. In addition, he ill be
retiring after exercising those options, so there ill be no repercussions to him 9ith respect to his
job: if the market price drops;unless he did something illegal during his tenure as #E*.
1+3 'he board of directors should set #E* compensation dependent on ho ell the firm performs.
'he compensation package should be sufficient to attract and retain the #E* but not go beyond
hat is needed. #ompensation should be structured so that the #E* is rearded on the basis of
the stock)s performance over the long run, not the stock)s price on an option exercise date. 'his
means that options 9or direct stock aards: should be phased in over a number of years so the
#E* ill have an incentive to keep the stock price high over time. If the intrinsic value could be
Chapter 1: An Overview of Financial Management Answers and Solutions 0
measured in an objective and verifiable manner, then performance pay could be based on changes
in intrinsic value. %oever, it is easier to measure the groth rate in reported profits than the
intrinsic value, although reported profits can be manipulated through aggressive accounting
procedures and intrinsic value cannot be manipulated. 0ince intrinsic value is not observable,
compensation must be based on the stock)s market price;but the price used should be an average
over time rather than on a specific date.
1+( 'he four forms of business organization are sole proprietorships, partnerships, corporations, and
limited liability corporations and partnerships. 'he advantages of the first to include the ease and
lo cost of formation. 'he advantages of corporations include limited liability, indefinite life, ease of
onership transfer, and access to capital markets. 7imited liability companies and partnerships
have limited liability like corporations.
'he disadvantages of a sole proprietorship are 9$: difficulty in obtaining large sums of capitalA
9/: unlimited personal liability for business debtsA and 9B: limited life. 'he disadvantages of a
partnership are 9$: unlimited liability, 9/: limited life, 9B: difficulty of transferring onership, and 9C:
difficulty of raising large amounts of capital. 'he disadvantages of a corporation are 9$: double
taxation of earnings and 9/: setting up a corporation and filing re"uired state and federal reports,
hich are complex and time(consuming. Among the disadvantages of limited liability corporations
and partnerships are difficulty in raising capital and the complexity of setting them up.
1+4 0tockholder ealth maximization is a long(run goal. #ompanies, and conse"uently the
stockholders, prosper by management making decisions that ill produce long(term earnings
increases. Actions that are continually shortsighted often +catch up. ith a firm and, as a result, it
may find itself unable to compete effectively against its competitors. 'here has been much criticism
in recent years that <.0. firms are too short(run profit(oriented. A prime example is the <.0. auto
industry, hich has been accused of continuing to build large +gas guzzler. automobiles because
they had higher profit margins rather than retooling for smaller, more fuel(efficient models.
1+1* <seful motivational tools that ill aid in aligning stockholders) and management)s interests include:
9$: reasonable compensation packages, 9/: direct intervention by shareholders, including firing
managers ho don)t perform ell, and 9B: the threat of takeover.
'he compensation package should be sufficient to attract and retain able managers but not go
beyond hat is needed. Also, compensation packages should be structured so that managers are
rearded on the basis of the stock)s performance over the long run, not the stock)s price on an
option exercise date. 'his means that options 9or direct stock aards: should be phased in over a
number of years so managers ill have an incentive to keep the stock price high over time. 0ince
intrinsic value is not observable, compensation must be based on the stock)s market price;but the
price used should be an average over time rather than on a specific date.
0tockholders can intervene directly ith managers. 'oday, the majority of stock is oned by
institutional investors and these institutional money managers have the clout to exercise
considerable influence over firms) operations. >irst, they can talk ith managers and make
suggestions about ho the business should be run. In effect, these institutional investors act as
lobbyists for the body of stockholders. 0econd, any shareholder ho has oned D/,555 of a
company)s stock for one year can sponsor a proposal that must be voted on at the annual
stockholders) meeting, even if management opposes the proposal. Although shareholder(
sponsored proposals are non(binding, the results of such votes are clearly heard by top
management.
If a firm)s stock is undervalued, then corporate raiders ill see it to be a bargain and ill attempt
to capture the firm in a hostile takeover. If the raid is successful, the target)s executives ill almost
certainly be fired. 'his situation gives managers a strong incentive to take actions to maximize their
stock)s price.
1+11 a5 #orporate philanthropy is alays a sticky issue, but it can be justified in terms of helping to
create a more attractive community that ill make it easier to hire a productive ork force. 'his
1 Answers and Solutions Chapter 1: An Overview of Financial Management
corporate philanthropy could be received by stockholders negatively, especially those
stockholders not living in its head"uarters city. 0tockholders 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. 'hus, stock price could
decrease.
b5 #ompanies must make investments in the current period in order to generate future cash flos.
0tockholders should be aare of this, and assuming a correct analysis has been performed,
they should react positively to the decision. 'he #hinese plant is in this category. #apital
budgeting is covered in depth in 4art I2 of the text. Assuming that the correct capital budgeting
analysis has been made, the stock price should increase in the future.
c5 <.0. 'reasury bonds are considered safe investments, hile common stocks are far more risky.
If the company ere to sitch the emergency funds from 'reasury bonds to stocks,
stockholders should see this as increasing the firm)s risk because stock returns are not
guaranteed;sometimes they increase and sometimes they decline. 'he firm might need the
funds hen the prices of their investments ere lo and not have the needed emergency
funds. #onse"uently, the firm)s stock price ould probably fall.
1+1. a5 8o, 'IAA(#3E> is not an ordinary shareholder. ,ecause it is one of the largest institutional
shareholders in the <nited 0tates and it controls nearly D/E5 billion in pension funds, its voice
carries a lot of eight. 'his +shareholder. in effect consists of many individual shareholders
hose pensions are invested ith this group.
b5 >or 'IAA(#3E> to be effective in ielding its eight, 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 ishes. In so doing, the
individual teachers hose pensions are invested in the fund have, in effect, determined the
fund)s voting practices.
1+10 Earnings per share in the current year ill decline due to the cost of the investment made in the
current year and no significant performance impact in the short run. %oever, the company)s stock
price should increase due to the significant cost savings expected in the future.
1+11 'he board of directors should set #E* compensation dependent on ho ell the firm performs.
'he compensation package should be sufficient to attract and retain the #E* but not go beyond
hat is needed. #ompensation should be structured so that the #E* is rearded on the basis of
the stock)s performance over the long run, not the stock)s price on an option exercise date. 'his
means that options 9or direct stock aards: should be phased in over a number of years so the
#E* ill have an incentive to keep the stock price high over time. If the intrinsic value could be
measured in an objective and verifiable manner, then performance pay could be based on changes
in intrinsic value. 0ince intrinsic value is not observable, compensation must be based on the
stock)s market price;but the price used should be an average over time rather than on a specific
date. 'he board should probably set the #E*)s compensation as a mix beteen a fixed salary and
stock options. 'he vice president of #ompany ?)s actions ould be different than if he ere #E* of
some other company.
1+1' 0etting the compensation policy for three division managers ould be different than setting the
compensation policy for a #E* because performance of each of these managers could be more
easily observed. >or a #E* an aard based on stock price performance makes sense, hile
basing the compensation for division managers on stock price performance doesn)t make sense.
Each of the managers could still be given stock aardsA hoever, rather than the aard being
based on stock price it could be determined from some observable measure like increased gas
Chapter 1: An Overview of Financial Management Answers and Solutions '
output, oil output, etc.
2 Answers and Solutions Chapter 1: An Overview of Financial Management