Chapter 1

An Overview of Financial Management

Learning Objectives
After reading this chapter, students should be able to:
Explain the role of fnance, and the diferent types of jobs in fnance.
Identify the advantages and disadvantages of diferent forms of business organiation.
Explain the lin!s bet"een stoc! price, intrinsic value, and executive compensation.
#iscuss the importance of business ethics and the conse$uences of unethical behavior.
Identify the potential con%icts that arise "ithin the frm bet"een stoc!holders and
managers and bet"een stoc!holders and bondholders and discuss the techni$ues that
frms can use to mitigate these potential con%icts.
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.
(o"ever, students can read the chapter on their o"n, so it can be assigned but not covered in
class.
)e spend the frst day going over the syllabus and discussing grading and other
mechanics relating to the course. *o the extent that time permits, "e tal! about the topics
that "ill be covered in the course and the structure of the boo!. )e also discuss brie%y the
fact that it is assumed that managers try to maximie stoc! prices, but that they may have
other goals, hence that it is useful to tie executive compensation to stoc!holder+oriented
performance measures. If time permits, "e thin! it,s "orth"hile to spend at least a full day on
the chapter. If not, "e as! students to read it on their o"n, and to !eep them honest, "e as!
one or t"o $uestions about the material on the frst mid+term exam.
-ne point "e emphasie in the frst class is that students should print a copy of the
PowerPoint slides for each chapter covered and purchase a fnancial calculator immediately,
and bring both to class regularly. )e also put copies of the various versions of our ./rief
&alculator 0anual,1 "hich in about '2 pages explains ho" to use the most popular calculators,
in the copy center. 3tudents "ill need to learn ho" to use their calculators before time value
of money concepts are covered in &hapter 4. It is important for students to grasp these
concepts early as many of the remaining chapters build on the *50 concepts.
)e are often as!ed "hat calculator students should buy. If they already have a
fnancial calculator that can fnd I66s, "e tell them that it "ill do, but if they do not have one,
"e recommend either the
(7+'8/II or '9/II. 7lease see the .:ecture 3uggestions1 for &hapter 4 for more on calculators.
DAS O! C"A#$%&: 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 stoc!, you expect to receive dividends plus capital gains. ;ot all
stoc!s pay dividends immediately, but those corporations that do, typically pay
dividends $uarterly. &apital gains <losses= are received "hen the stoc! is sold. 3toc!s
are ris!y, so you "ould not be certain that your expectations "ould be met>as you
"ould if you had purchased a ?.3. *reasury security, "hich ofers a guaranteed
payment every @ months plus repayment of the purchase price "hen the security
matures.
1+. If investors are more confdent that &ompany A,s cash %o"s "ill be closer to their
expected value than &ompany /,s cash %o"s, then investors "ill drive the stoc! price
up for &ompany A. &onse$uently, &ompany A "ill have a higher stoc! price than
&ompany /.
1+0 A frm,s intrinsic value is an estimate of a stoc!,s .true1 value based on accurate ris!
and return data. It can be estimated but not measured precisely. A stoc!,s current
price is its mar!et price>the value based on perceived but possibly incorrect
information as seen by the marginal investor. Arom these defnitions, you can see that
a stoc!,s .true long+run value1 is more closely related to its intrinsic value rather than
its current price.
1+1 E$uilibrium is the situation "here the actual mar!et price e$uals the intrinsic value, so
investors are indiferent bet"een buying or selling a stoc!. If a stoc! is in e$uilibrium
then there is no fundamental imbalance, hence no pressure for a change in the stoc!,s
price. At any given time, most stoc!s are reasonably close to their intrinsic values and
thus are at or close to e$uilibrium. (o"ever, at times stoc! prices and e$uilibrium
values are diferent, so stoc!s can be temporarily undervalued or overvalued.
1+' If the three intrinsic value estimates for 3toc! B "ere diferent, I "ould have the most
confdence in &ompany B,s &A-,s estimate. Intrinsic values are strictly estimates, and
diferent analysts "ith diferent data and diferent vie"s of the future "ill form diferent
estimates of the intrinsic value for any given stoc!. (o"ever, a frm,s managers have
the best information about the company,s future prospects, so managers, estimates of
intrinsic value are generally better than the estimates of outside investors.
1+2 If a stoc!,s mar!et price and intrinsic value are e$ual, then the stoc! is in e$uilibrium
and there is no pressure <buyingCselling= to change the stoc!,s price. 3o, theoretically,
it is better that the t"o be e$ualD ho"ever, intrinsic value is a long+run concept.
0anagement,s goal should be to maximie the frm,s intrinsic value, not its current
price. 3o, maximiing the intrinsic value "ill maximie the average price over the long
run but not necessarily the current price at each point in time. 3o, stoc!holders in
general "ould probably expect the frm,s mar!et price to be under the intrinsic value>
realiing that if management is doing its job that current price at any point in time
"ould not necessarily be maximied. (o"ever, the &E- "ould prefer that the mar!et
price be high>since it is the current price that he "ill receive "hen exercising his stoc!
options. In addition, he "ill be retiring after exercising those options, so there "ill be
no repercussions to him <"ith respect to his job= if the mar!et price drops>unless he
did something illegal during his tenure as &E-.
Chapter 1: An Overview of Financial Management Answers and Solutions 0
1+3 *he board of directors should set &E- compensation dependent on ho" "ell the frm
performs. *he compensation pac!age should be suEcient to attract and retain the
&E- but not go beyond "hat is needed. &ompensation should be structured so that
the &E- is re"arded on the basis of the stoc!,s performance over the long run, not the
stoc!,s price on an option exercise date. *his means that options <or direct stoc!
a"ards= should be phased in over a number of years so the &E- "ill have an incentive
to !eep the stoc! price high over time. If the intrinsic value could be measured in an
objective and verifable manner, then performance pay could be based on changes in
intrinsic value. (o"ever, it is easier to measure the gro"th rate in reported profts
than the intrinsic value, although reported profts can be manipulated through
aggressive accounting procedures and intrinsic value cannot be manipulated. 3ince
intrinsic value is not observable, compensation must be based on the stoc!,s mar!et
price>but the price used should be an average over time rather than on a specifc
date.
1+( *he four forms of business organiation are sole proprietorships, partnerships,
corporations, and limited liability corporations and partnerships. *he advantages of
the frst t"o include the ease and lo" cost of formation. *he advantages of
corporations include limited liability, indefnite life, ease of o"nership transfer, and
access to capital mar!ets. :imited liability companies and partnerships have limited
liability li!e corporations.
*he disadvantages of a sole proprietorship are <'= diEculty in obtaining large sums
of capitalD <2= unlimited personal liability for business debtsD and <F= limited life. *he
disadvantages of a partnership are <'= unlimited liability, <2= limited life, <F= diEculty of
transferring o"nership, and <G= diEculty of raising large amounts of capital. *he
disadvantages of a corporation are <'= double taxation of earnings and <2= setting up a
corporation and fling re$uired state and federal reports, "hich are complex and time+
consuming. Among the disadvantages of limited liability corporations and partnerships
are diEculty in raising capital and the complexity of setting them up.
1+4 3toc!holder "ealth maximiation is a long+run goal. &ompanies, and conse$uently the
stoc!holders, prosper by management ma!ing decisions that "ill produce long+term
earnings increases. Actions that are continually shortsighted often .catch up1 "ith a
frm and, as a result, it may fnd itself unable to compete efectively against its
competitors. *here has been much criticism in recent years that ?.3. frms are too
short+run proft+oriented. A prime example is the ?.3. auto industry, "hich has been
accused of continuing to build large .gas guler1 automobiles because they had
higher proft margins rather than retooling for smaller, more fuel+eEcient models.
1+1* ?seful motivational tools that "ill aid in aligning stoc!holders, and management,s
interests include: <'= reasonable compensation pac!ages, <2= direct intervention by
shareholders, including fring managers "ho don,t perform "ell, and <F= the threat of
ta!eover.
*he compensation pac!age should be suEcient to attract and retain able managers
but not go beyond "hat is needed. Also, compensation pac!ages should be structured
so that managers are re"arded on the basis of the stoc!,s performance over the long
run, not the stoc!,s price on an option exercise date. *his means that options <or direct
stoc! a"ards= should be phased in over a number of years so managers "ill have an
incentive to !eep the stoc! price high over time. 3ince intrinsic value is not
observable, compensation must be based on the stoc!,s mar!et price>but the price
used should be an average over time rather than on a specifc date.
3toc!holders can intervene directly "ith managers. *oday, the majority of stoc! is
o"ned by institutional investors and these institutional money managers have the
1 Answers and Solutions Chapter 1: An Overview of Financial Management
clout to exercise considerable in%uence over frms, operations. Airst, they can tal! "ith
managers and ma!e suggestions about ho" the business should be run. In efect,
these institutional investors act as lobbyists for the body of stoc!holders. 3econd, any
shareholder "ho has o"ned H2,888 of a company,s stoc! for one year can sponsor a
proposal that must be voted on at the annual stoc!holders, 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 frm,s stoc! is undervalued, then corporate raiders "ill see it to be a bargain
and "ill attempt to capture the frm in a hostile ta!eover. If the raid is successful, the
target,s executives "ill almost certainly be fred. *his situation gives managers a
strong incentive to ta!e actions to maximie their stoc!,s price.
1+11 a5 &orporate philanthropy is al"ays a stic!y issue, but it can be justifed in terms of
helping to create a more attractive community that "ill ma!e it easier to hire a
productive "or! force. *his corporate philanthropy could be received by
stoc!holders negatively, especially those stoc!holders not living in its head$uarters
city. 3toc!holders are interested in actions that maximie share price, and if
competing frms are not ma!ing similar contributions, the .cost1 of this
philanthropy has to be borne by someone++the stoc!holders. *hus, stoc! price
could decrease.
b5 &ompanies must ma!e investments in the current period in order to generate
future cash %o"s. 3toc!holders should be a"are of this, and assuming a correct
analysis has been performed, they should react positively to the decision. *he
&hinese plant is in this category. &apital budgeting is covered in depth in 7art I5 of
the text. Assuming that the correct capital budgeting analysis has been made, the
stoc! price should increase in the future.
c5 ?.3. *reasury bonds are considered safe investments, "hile common stoc!s are far
more ris!y. If the company "ere to s"itch the emergency funds from *reasury
bonds to stoc!s, stoc!holders should see this as increasing the frm,s ris! because
stoc! returns are not guaranteed>sometimes they increase and sometimes they
decline. *he frm might need the funds "hen the prices of their investments "ere
lo" and not have the needed emergency funds. &onse$uently, the frm,s stoc!
price "ould probably fall.
1+1. a5 ;o, *IAA+&6EA is not an ordinary shareholder. /ecause it is one of the largest
institutional shareholders in the ?nited 3tates and it controls nearly H2I8 billion in
pension funds, its voice carries a lot of "eight. *his .shareholder1 in efect consists
of many individual shareholders "hose pensions are invested "ith this group.
b5 Aor *IAA+&6EA to be efective 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 .votes1 on the fund,s practices, and from those .votes1 act on
the majority,s "ishes. In so doing, the individual teachers "hose pensions are
invested in the fund have, in efect, 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 signifcant performance impact in the short run.
(o"ever, the company,s stoc! price should increase due to the signifcant cost savings
expected in the future.
Chapter 1: An Overview of Financial Management Answers and Solutions '
1+11 *he board of directors should set &E- compensation dependent on ho" "ell the frm
performs. *he compensation pac!age should be suEcient to attract and retain the
&E- but not go beyond "hat is needed. &ompensation should be structured so that
the &E- is re"arded on the basis of the stoc!,s performance over the long run, not the
stoc!,s price on an option exercise date. *his means that options <or direct stoc!
a"ards= should be phased in over a number of years so the &E- "ill have an incentive
to !eep the stoc! price high over time. If the intrinsic value could be measured in an
objective and verifable manner, then performance pay could be based on changes in
intrinsic value. 3ince intrinsic value is not observable, compensation must be based on
the stoc!,s mar!et price>but the price used should be an average over time rather
than on a specifc date. *he board should probably set the &E-,s compensation as a
mix bet"een a fxed salary and stoc! options. *he vice president of &ompany B,s
actions "ould be diferent than if he "ere &E- of some other company.
1+1' 3etting the compensation policy for three division managers "ould be diferent than
setting the compensation policy for a &E- because performance of each of these
managers could be more easily observed. Aor a &E- an a"ard based on stoc! price
performance ma!es sense, "hile basing the compensation for division managers on
stoc! price performance doesn,t ma!e sense. Each of the managers could still be
given stoc! a"ardsD ho"ever, rather than the a"ard being based on stoc! price it could
be determined from some observable measure li!e increased gas output, oil output,
etc.
2 Answers and Solutions Chapter 1: An Overview of Financial Management