Solutions Manual

CHAPTER 1

NATURE, PURPOSE, AND

SCOPE OF FINANCIAL MANAGEMENT

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. The goal of financial management is to make

money and add value for the owner. The kinds of
activities that financial management deals with
relate the three financial decisions that finance
managers must make namely, investing, financing
and dividend decisions.

2. Refer to page 8 – Relationship between Financial

Management and Accounting.

3. The owners’ perspective holds that the only

appropriate goal is “to maximize shareholder
wealth”. The competing viewpoint is from the
stakeholders’ perspective, which emphasizes
social responsibility over profitability. This view
maintains that managers must maximize the total
satisfaction of all stakeholders in a business.
While strong arguments speak in favor of both

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Chapter 1 Nature, Purpose and Scope of Financial Management

perspectives, financial practitioners and

academics now tend to believe that the manager’s
primary responsibility should be to maximize
shareholder wealth and give only secondary
consideration to other stakeholders’ welfare. The
invisible hand of the market, acting through
compensation and the free price system, would
ensure that only those activities most efficient and
beneficial to society as a whole would survive in
the long run. Thus, those same activities would
also profit the individual most. When companies
try to implement a goal other than profit
maximization, their efforts tend to backfire.
Consider the firm that tries to maximize
employment, the high number of employees raises
costs. Soon the firm will find that its costs are too
high to allow it to compete against more efficient
firms, especially in a global business
environment. When the firm fails, all employees
are let go and employment ends up being
minimized, not maximized.

4. Financially stable firms are good for stakeholders,

such as employees, managers, customers and local
communities.

5. Theoretically, managers work for shareholders. In

reality, because shareholders aren’t involved in

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day-to-day firm activities, managers control the

firm. Managers might be tempted to operate the
firm in such a way as to benefit themselves more
than the shareholders. Corporate governance is the
system of incentives and monitors that tries to
overcome this agency problem. Shareholders can
align managers’ interest with stockholder interests
by making managers part owners of the firm.
Then, various monitors follow the firm and report
on its activities.

6. Capital budgeting (deciding whether to expand a

manufacturing plant), capital structure (deciding
whether to issue new equity and use the proceeds
to retire outstanding debt), and working capital
management (modifying the firm’s credit
collection policy with its customers).

7. To maximize the current market value (share

price) of the equity of the firm (whether it’s
publicly-traded or not).

II. Multiple Choice Questions

1. C
2. B
3. B
Chapter 1 Nature, Purpose and Scope of Financial Management

4. C
5. D

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