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After reading this chapter, students should be able to:
Explain within finance.
available areas of
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.
examples of potential
identify possible solutions.
price of a company’s stock, including those that managers have control over and those
Learning Objectives: 1 - 2
that they do not.
concentrate strictly on cash flow and ignore the impact of their decisions on EPS.
Learning Objectives: 1 - 3
important can be
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
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. the various versions of
We also put copies 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 If students time learn value how to of money 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.
Lecture Suggestions: 1 - 6
ANSWERS TO END-OF-CHAPTER QUESTIONS
proprietorship, The advantages
partnership, and corporation.
of the first two include the ease and low cost of formation. corporation include The advantages of the 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. disadvantages
Answers and Solutions: 1 - 8
unlimited liability, (2)
difficulty of transferring ownership, and (4) difficulty capital. of raising large amounts of
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.
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, prosper will and by consequently management produce Actions often the
stockholders, decisions earnings
long-term that “catch are 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 had
“gas guzzler” automobiles
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.
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
1-7 Profit maximization abstracts
timing of profits and (2) the riskiness of different operating plans. However, both of
these factors are reflected in stock price maximization. would not Thus, profit lead to maximization stock price
Answers and Solutions: 1 - 12
shareholders’ Many have
wealth or he risks losing his job.
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 focus firm) on serve to keep
Answers and Solutions: 1 - 13
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. stock price could decrease. Thus,
current period in order to generate future cash flows.
Answers and Solutions: 1 - 14
Stockholders should be aware
of this, and assuming a correct analysis has been performed, they should react
positively to the decision. plant is in this category.
The Mexican 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
assets exceeds the interest rate on debt, greater use of debt will raise the expected rate Also, of return on stockholders’ on debt a equity. is tax
interest and this
further 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. debt usage, called
The effects of leverage,”
are spelled out in detail in the chapter titled, “Capital Structure and Leverage.”
(2003), is the
nuclear regarded company
generation as being a
electricity risky. If
investment in nuclear generators, its risk will be high, and its stock price will be adversely much affected hence unless its its costs are are much
Answers and Solutions: 1 - 16
Answers and Solutions: 1 - 17
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. greater This topic will be discussed in detail in the chapter titled, Dividends
“Distributions to Shareholders: 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.
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 stock profitability and the the company’s board may
want to rely more on stock options and less on performance shares that are tied to
1-11 As the stock market becomes more volatile, the link between the stock price and the is
management ability of weakened. companies Therefore, may choose
senior executives in to this
awarding of stock and stock options and rely more on bonuses and performance shares that are tied to other performance measures Moreover, harder if to to the the
besides the company’s stock price. in this environment or retain is tied it top too may be
company’s stock price.
not it is
ordinary 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 of “shareholder” many in
with this group.
invested with this group.
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. individual invested teachers in the In so doing, the pensions in are
determined the fund’s voting practices.
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. if management’s to be analysis of Subsequently, the value project of the
firm’s bonds should increase.
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, dividends shareholders so the net receive effect on more stock
price is indeterminate. stock price increases it
If the firm’s as current this may
management cause some
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.
has should will price.
performed undertake increase
projects/actions the firm’s
Stockholder wealth maximization is the goal of management.
following against bond
agreements. 2. Charge a higher-than-normal interest to compensate for the risk of
possible exploitation. 3. Refuse to deal with management
either lose access to the debt markets or are saddled with high interest rates and
detrimental to shareholders.
corporate tax as
reducing the firm
individual to remain In
unincorporated to higher are
partnership. corporate tax
exposed to double taxation.
environmental include firms
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 However, the impact in the stock short price run. should
increase due to the significant cost savings expected in the future.
Take a Dive Financial Management Overview
KATO SUMMERS OPENED TAKE A DIVE 17 YEARS AGO; THE STORE AND TODAY, IS LOCATED IN MALIBU,
SURFING-RELATED 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. BUSINESS SOON KATO JOIN ALTHOUGH IS A KATO’S FORMAL WILL
LIMITED, DEGREE THE AS
GRADUATE HAS THE
AMBER IS INTERESTED, BUT SHE IS
ALSO CONSIDERING OTHER CAREER OPPORTUNITIES IN FINANCE. RIGHT STAYING NOW, WITH AMBER THE IS LEANING BUSINESS, TOWARD PARTLY
BECAUSE SHE THINKS IT FACES A NUMBER OF INTERESTING CHALLENGES AND OPPORTUNITIES.
AMBER IS PARTICULARLY INTERESTED IN FURTHER EXPANDING THE BUSINESS AND THEN
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 THESE AND PLEASURE. WILL BE HE IS WORRIED IF THAT 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. HAS AMBER, OUTLINED WHO A IS HIGHLY OF
QUESTIONS FOR THEM TO ADDRESS:
WHAT KINDS OF CAREER OPPORTUNITIES ARE OPEN TO FINANCE MAJORS?
OPPORTUNITIES FOR FINANCE MAJORS EXIST IN THREE INTERRELATED AREAS: CAPITAL WHICH DEALS WITH MARKETS, SECURITIES MARKETS AND (1) MONEY AND
INDIVIDUAL AS THEY
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 INSURANCE INVESTMENT GRADUATES
INSTITUTIONS, COMPANIES, BANKING WHO GO INTO
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 CASH TO THE FIRM ON SHOULD HAND, HOW
MUCH OF THE FIRM’S EARNINGS TO PLOW BACK INTO THE BUSINESS VERSUS TO PAY OUT AS
WHAT ARE THE PRIMARY RESPONSIBILITIES OF A CORPORATE FINANCIAL STAFF?
ANSWER: [SHOW S1-3 AND S1-4 HERE.]
MANAGER’S TASK IS TO ACQUIRE AND USE FUNDS SO AS TO MAXIMIZE ACTIVITIES THE FIRM’S INCLUDE: VALUE. (1)
FORECASTING AND PLANNING, (2) MAKING MAJOR INVESTMENT AND FINANCING DECISIONS, (3)
COORDINATING AND CONTROLLING, (4) DEALING WITH THE FINANCIAL MARKETS, AND (5)
MANAGEMENT ISSUES TODAY?
ANSWER: [SHOW S1-5 AND S1-6 HERE.] VALUE THE MAXIMIZATION 21st CENTURY. CONTINUES
THE FOCUS ON AS WE TWO BEGIN OTHER
TRENDS HAVE BECOME INCREASINGLY IMPORTANT IN RECENT YEARS: AND THE THE GLOBALIZATION USE OF OF
THESE TRENDS WILL
UNDOUBTEDLY CONTINUE IN THE YEARS AHEAD.
ANSWER: [SHOW S1-7 HERE.] OF BUSINESS
THE THREE MAIN FORMS ARE
(1) SOLE PROPRIETORSHIPS, (2) PARTNERSHIPS, AND (3) CORPORATIONS.
AND HAS (1)
THREE IT IS
IMPORTANT EASILY AND
INEXPENSIVELY FORMED, (2) IT IS SUBJECT TO FEW GOVERNMENT PAYS REGULATIONS, NO CORPORATE AND (3) THE
THE PROPRIETORSHIP ALSO HAS THREE IMPORTANT
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. DISADVANTAGES ASSOCIATED ARE SIMILAR TO THE THOSE (1)
UNLIMITED LIABILITY, (2) LIMITED LIFE OF THE ORGANIZATION, (3) DIFFICULTY OF TRANSFERRING OWNERSHIP, AND (4) DIFFICULTY OF RAISING
LARGE AMOUNTS OF CAPITAL. OF A PARTNERSHIP
THE TAX TREATMENT TO THAT FOR
THE CORPORATE FORM OF BUSINESS HAS THREE MAJOR (1) UNLIMITED ADVANTAGES: LIFE, (2) EASY
TRANSFERABILITY OF OWNERSHIP INTEREST, AND (3) LIMITED LIABILITY. FORM OFFERS WHILE THE CORPORATE 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 TIMECONSUMING THAN FOR A PROPRIETORSHIP OR A PARTNERSHIP.
CORPORATION’S PRIMARY GOAL IS STOCKHOLDER WEALTH MAXIMIZATION, WHICH TRANSLATES TO
MAXIMIZING THE PRICE OF THE FIRM’S COMMON STOCK.
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. SIGNIFICANT
HOWEVER, THE MOST ACTIONS WILL
HAVE TO BE PUT ON A MANDATORY RATHER THAN A VOLUNTARY BASIS TO ENSURE THAT THE BURDEN FALLS UNIFORMLY ON ALL BUSINESSES.
IS STOCK PRICE MAXIMIZATION GOOD OR BAD
PRICES ALSO BENEFIT SOCIETY. MAXIMIZATION REQUIRES
STOCK PRICE 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
PROFIT TO NEW
PRODUCTS, AND TO NEW JOBS. PRICE MAXIMIZATION
ALSO, STOCK EFFICIENT
AND COURTEOUS SERVICE, ADEQUATE STOCKS OF MERCHANDISE, AND WELL-LOCATED THAT SALES, BUSINESS ARE WHICH ALL ARE
ESTABLISHMENTS--FACTORS NECESSARY TO MAKE
NECESSARY FOR PROFITS.
SHOULD FIRMS BEHAVE ETHICALLY?
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,
POSITIVE LONG-RUN ARISE
PROFITABILITY. BETWEEN PROFITS
COMPANIES MUST DEAL WITH THESE CONFLICTS ON A REGULAR BASIS, AND A FAILURE TO HANDLE THE SITUATION PROPERLY CAN LEAD AND TO EVEN HUGE TO
BANKRUPTCY. THERE IS NO ROOM FOR UNETHICAL BEHAVIOR IN THE BUSINESS WORLD.
WHAT IS AN AGENCY RELATIONSHIP?
RELATIONSHIP EXISTS WHENEVER A “PRINCIPAL”
SOME DECISION-MAKING POWER.
WHAT AGENCY RELATIONSHIPS EXIST WITHIN A
ANSWER: WITHIN THE FINANCIAL MANAGEMENT CONTEXT, THE PRIMARY AGENCY RELATIONSHIPS ARE THOSE (1) BETWEEN STOCKHOLDERS AND MANAGERS AND (2) BETWEEN DEBTHOLDERS AND STOCKHOLDERS
MECHANISMS TO ACT
CONFLICTS, STOCKHOLDERS MUST INCUR AGENCY COSTS, WHICH INCLUDE TO ALL COSTS BORNE BY 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 (2) DIRECT INTERVENTION BY
SHAREHOLDERS, (3) THE THREAT OF FIRING, AND (4) THE THREAT OF TAKEOVER.
ANSWER: [SHOW S1-14 HERE.] UNETHICAL, AND
NO. SUCH BEHAVIOR IS IS NO ROOM FOR
UNETHICAL BEHAVIOR IN THE BUSINESS WORLD. SECOND, IF SUCH ATTEMPTS ARE MADE,
CREDITORS WILL PROTECT THEMSELVES AGAINST STOCKHOLDERS COVENANTS FINALLY, FIRM’S IN IF BY PLACING DEBT RESTRICTIVE AGREEMENTS. THAT TO A
FUTURE CREDITORS ARE
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
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.
IS MAXIMIZING STOCK PRICE THE SAME THING AS MAXIMIZING PROFIT?
STOCK PRICE, AND ALL OF THEM GENERALLY RISE IF A FIRM’S PRICES SALES DEPEND RISE. NOT NEVERTHELESS, JUST ON TODAY’S
EARNINGS AND CASH FLOWS--FUTURE CASH FLOWS
AND THE RISKINESS OF THE FUTURE EARNINGS STREAM ACTIONS ALSO MAY AFFECT STOCK PRICES. AND SOME YET
REDUCE STOCK PRICES WHILE OTHER ACTIONS MAY BOOST STOCK A PRICE COMPANY TODAY BUT THAT THAT REDUCE EARNINGS. LARGE TO
PERFORMANCE. LIKELY REDUCE
PER SHARE, YET THE STOCK MARKET MAY RESPOND POSITIVELY EXPENDITURES IF IT WILL BELIEVES THAT THESE ENHANCE
FUTURE EARNINGS. THAT UNDERTAKES
BY CONTRAST, A COMPANY 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.
WHAT FACTORS AFFECT STOCK PRICES?
ANSWER: [SHOW S1-15 AND S1-16 HERE.] STOCK PRICE IS DEPENDENT AS ON
THE FIRM’S MANAGERIAL DECISIONS, 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.
WHAT FACTORS AFFECT THE LEVEL AND RISKINESS OF CASH FLOWS?
ANSWER: [SHOW S1-17 HERE.] SUCH AS INVESTMENT AND
MANAGERIAL ACTIONS, DECISIONS, POLICY FINANCING DECISIONS
AFFECT THE LEVEL, TIMING, AND THE RISKINESS OF THE FIRM’S CASH FLOWS.
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