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Problems and Questions: Management Objectives

1. The objective of decision making in corporate finance is


(a) to maximize earnings
(b) to maximize cash flows
(c) to maximize the size of the firm
(d) to maximize market share
(e) to maximize firm value / stock prices.
. !or maximization of stock prices to be the sole objective in decision making" and to
be sociall# desirable" the following assumption or assumptions have to hold true.
(a) $anagers act in the best interests of stockholders.
(b) There is no conflict of interest between stockholders and bondholders.
(c) !inancial markets are efficient.
(d) There are no costs that are created b# the firm that cannot be traced back
and
charged to the firm.
(e) %ll of the above.
&. There is a conflict of interest between stockholders and managers. 'n theor#"
stockholders are expected to exercise control over managers through the annual
meeting or the board of directors. 'n practice" wh# might these disciplinar#
mechanisms not work(
). *tockholders can transfer wealth from bondholders through a variet# of actions.
+ow would the following actions b# stockholders transfer wealth from bondholders(
(a) %n increase in dividends
(b) % leveraged bu#out
(c) %c,uiring a risk# business
+ow would bondholders protect themselves against these actions(
-. !inancial market prices are much too volatile" for financial markets to be efficient.
.omment.
/. $aximizing stock prices does not make sense because investors focus on short term
results" and not on the long term conse,uences. .omment.
0. There are some corporate strategists who have suggested that firms focus on
maximizing market share rather than market prices. 1hen might this strateg# work"
and when might it fail(
2. %nti3takeover amendments can be in the best interests of stockholders. 4nder what
conditions is this likel# to be true(
1. The objective of decision making in corporate finance is
(e) to maximize firm value / stock prices.
. !or maximization of stock prices to be the sole objective in decision making" and to
be sociall# desirable" the following assumption or assumptions have to hold true.
(e) All of the above.
&. There is a conflict of interest between stockholders and managers. 'n theor#"
stockholders are expected to exercise control over managers through the annual
meeting or the board of directors. 'n practice" wh# might these disciplinar#
mechanisms not work(
Annual Meeting: Stockholders may not show up at annual meetins or be
provided with enouh information to have effective oversiht over
incumbent manaement. !n addition" the corporate charter is often tilted to
provide incumbent manaers with the advantae" if there is a context at the
annual meetin.
Board of Directors: #irectors are often chosen by the incumbent manaers
(rather than by stockholders)" own few shares and lack the
expertise/information to ask touh $uestions of incumbent manaers.
). *tockholders can transfer wealth from bondholders through a variet# of actions.
+ow would the following actions b# stockholders transfer wealth from bondholders(
(a) An increase in dividends: %ake existin debt riskier and reduce its
value. &ondholders can protect themselves by constrainin dividend policy.
(b) A leveraed buyout: !f the existin debt is not refinanced at the 'new(
interest rate" existin bondholders will find the value of their holdins are
lower after the )&*. &ondholders can protect themselves by insertin
protective puts into their debt" allowin them to put the bonds back to the
firm and receive face value.
(c) Ac$uirin a risky business: !f a risky business is ac$uired" existin
bondholders may find themselves worse off since the underlyin debt is
now riskier. &ondholders can protect themselves by restrictin investment
policy.
-. !inancial market prices are much too volatile" for financial markets to be efficient.
.omment.
+he fact that markets are volatile" by itself" does not imply that they are not
efficient. !f the underlyin value of the investments traded in the market is
chanin a lot from period to period" prices should be volatile. ,ven if the
underlyin value is not movin as much as prices are" the fact that markets
make mistakes (which is what the noise is) does not imply that the prices
are not unbiased estimates of value.
/. $aximizing stock prices does not make sense because investors focus on short term
results" and not on the long term conse,uences. .omment.
+he empirical evidence does not support the notion that all investors focus
on short term results. !n particular" the evidence that hih rowth stocks
are able to command hih price-earnins multiples" and that stock prices o
up" on averae" on the announcement of ./# and ma0or investments can be
viewed as consistent with a market where some investors at least focus on
the lon term.
0. There are some corporate strategists who have suggested that firms focus on
maximizing market share rather than market prices. 1hen might this strateg# work"
and when might it fail(
+his stratey is likely to work if hiher market share leads to hiher profits
and cash flows in the lon term. !f" on the other hand" the hiher market
share is obtained by cuttin prices and sacrificin lon-term profitability"
the stratey is unlikely to work.
2. %nti3takeover amendments can be in the best interests of stockholders. 4nder what
conditions is this likel# to be true(
!f the incumbent manaement is efficient and runs the firm for the benefit
of existin stockholders" anti-takeover amendments will help in two ways 1
(2) it may relieve them of the distraction of unwanted takeover attempts and
allow them to focus on maximizin cash flows and value" and
(3) it may allow incumbent manaers to extract a much hiher price in the
case of a hostile takeover.