Chapter 01: The Goals and Functions of Financial Management

Chapter 1
The Goals and Functions of Financial Management

Discussion Questions
1-1. How did the recession of 2007–2009 compare with other recessions since the
Great Depression in terms of length?

It was the longest.

1-2. What effect did the recession of 2007–2009 have on government regulation?

It was greatly increased.

1-3. What advantages does a sole proprietorship offer? What is a major drawback of
this type of organization?

A sole proprietorship offers the advantage of simplicity of decision making and

low organizational and operating costs. A major drawback is that there is
unlimited liability to the owner.

1-4. What form of partnership allows some of the investors to limit their liability?
Explain briefly.

A limited partnership allows some of the partners to limit their liability. Under
this arrangement, one or more partners are designated general partners and have
unlimited liability for the debts of the firm; other partners are designated limited
partners and are liable only for their initial contribution. The limited partners are
normally prohibited from being active in the management of the firm.

1-5. In a corporation, what group has the ultimate responsibility for protecting and
managing the stockholders' interests?

The board of directors.

1-6. What document is necessary to form a corporation?

The articles of incorporation.

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Chapter 01: The Goals and Functions of Financial Management

1-7. What issue does agency theory examine? Why is it important in a public
corporation rather than in a private corporation?

Agency theory examines the relationship between the owners of the firm and the
managers of the firm. In privately owned firms, management and the owners are
usually the same people. Management operates the firm to satisfy its own goals,
needs, financial requirements and the like. As a company moves from private to
public ownership, management now represents all owners. This places
management in the agency position of making decisions in the best interest of all
shareholders.

1-8. Why are institutional investors important in today's business world?

Because institutional investors such as pension funds and mutual funds own a
large percentage of major U.S. companies, they are having more to say about the
way publicly owned companies are managed. As a group, they have the ability to
vote large blocks of shares for the election of a board of directors, which is
supposed to run the company in an efficient, competitive manner. The threat of
being able to replace poor performing boards of directors makes institutional
investors quite influential. Since these institutions, like pension funds and mutual
funds, represent individual workers and investors, they have a responsibility to see
that the firm is managed in an efficient and ethical way.

1-9. Why is profit maximization, by itself, an inappropriate goal? What is meant by the
goal of maximization of shareholder wealth?

The problem with a profit maximization goal is that it fails to take account of risk,
the timing of the benefits is not considered, and profit measurement is a very
inexact process. The goal of shareholders’ wealth maximization implies that the
firm will attempt to achieve the highest possible total valuation in the
marketplace. It is the one overriding objective of the firm and should influence
every decision.

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 Chapter 01: The Goals and Functions of Financial Management

1-10. When does insider trading occur? What government agency is responsible for
protecting against the unethical practice of insider trading?

Insider trading occurs when anyone with non-public information buys or sells
securities to take advantage of that private information. The Securities and
Exchange Commission is responsible for protecting markets against insider
trading. In the past, people have gone to jail for trading on non-public
information. This has included company officers, investment bankers, printers
who have information before it is published, and even truck drivers who deliver
business magazines and read positive or negative articles about a company before
the magazine is on the newsstands and then place trades or have friends place
trades based on that information. The SEC has prosecuted anyone who profits
from inside information.

1-11. In terms of the life of the securities offered, what is the difference between money
and capital markets?

Money markets refer to those markets dealing with short-term securities that have
a life of one year or less. Capital markets refer to securities with a life of more
than one year.

1-12. What is the difference between a primary and a secondary market?

A primary market refers to the use of the financial markets to raise new funds for
the corporation. After the securities are sold to the public (institutions and
individuals), they trade in the secondary market between investors. It is in the
secondary market that prices are continually changing as investors buy and sell
securities based on the expectations of corporate prospects.

1-13. Assume you are looking at many companies with equal risk. Which ones will
have the highest stock prices?

Given companies with equal risk, those companies with expectations of high
return will have higher common stock prices relative to those companies with
expectations of poor returns.

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Chapter 01: The Goals and Functions of Financial Management

1-14. What changes can take place under restructuring? In recent times, what group of
investors has often forced restructuring to take place?

Restructuring can result in changes in the capital structure (liabilities and equity
on the balance sheet). It can also result in the selling of low-profit-margin
divisions with the proceeds reinvested in better investment opportunities, and
sometimes restructuring results in the removal of the current management team or
large reductions in the workforce. Restructuring has also included mergers and
acquisitions.

Institutional investors have been very influential in forcing restructuring to take

place in recent years.

1-15. How did the Sarbanes–Oxley Act impact corporations’ financial reports?

The Sarbanes–Oxley Act of 2002 set up a five-member Public Company

Accounting Oversight Board with the responsibility for establishing auditing
standards within companies, controlling the quality of audits, and setting rules
and standards for the independence of the auditors. It also puts great
responsibility on the internal audit committee of each publicly traded company to
enforce compliance with the act. The major focus of the act is to make sure that
publicly traded corporations accurately present their assets, liabilities, and equity
and income on their financial statements.

1-16. Name the departments, offices, or agencies that were created by the Dodd–Frank
legislation.

1) The act created the Financial Stability Oversight Council within the
Treasury Department.
2) The act created the Office of Financial Research within the Treasury
Department.
3) Dodd–Frank established the Federal Insurance Office within the Treasury
Department to oversee the insurance industry and streamline state-based
insurance regulation.
4) The act created the Bureau of Consumer Financial Protection. The
oversight given to the Bureau of Consumer Financial Protection allows it
to dictate the fees that banks charge and the types of products they offer.

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Chapter 01: The Goals and Functions of Financial Management

Harrod's Sporting Goods Case 1

Ratio Analysis
Purpose: The case allows the student to examine ratio analysis within the context of a customer-
banking arrangement. The firm has a disagreement with the bank over how much it should be
paying in relation to prime (no prior knowledge of banking is required for the case). An item of
particular interest is the impact of an extraordinary loss on the firm's income statement. It has a
major effect on the analysis of the company. Industry comparisons also are utilized.

Relation to Text: The case should follow Chapter 3.

Complexity: The case is moderately complex. It should require 1 to 1½ hours.

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Chapter 01: The Goals and Functions of Financial Management

Solutions

1 Ratios 2013 2014 2015

.
Net income
1. 4.52 5.42% 3.99%
    Sales

Net income
2a. 6.09% 7.23% 5.71%
Total assets

b. Net income sales x sales / total 4.52 x 1.35 5.42% x 1.33 3.99% x 1.43
assets

       Net income       
3a. 16.04% 18.55% 15.02%
Stockholder's equity

Net income / total assets   6.09%     7.23%     5.71%  

b.
(1 – debt / total assets) (1 – .620) (1 – .610) (1 – .620)

2 Harrod's has suffered a sharp decline in its profit margin, particularly between 2014 and 2015
. (5.42% down to 3.99%). Return on assets is also down, but not quite as much due to a slight
increase in asset turnover. Return on stockholders' equity is also down.
3 2013 2014 2015
.
Net income
1. 4.522 5.42% 6.19%
    Sales

Net income
2a. 6.09% 7.23% 8.85%
Total assets

b. Net income sales x sales / total 4.52 x 1.35 5.42% x 1.33 6.19% x 1.43
assets

       Net income       
3a. 16.04% 18.55% 23.30%
Stockholder's equity

Net income / total assets   6.09%     7.23%     8.85%  

b.
(1 – debt / total assets) (1 – .620) (1 – .610) (1 – .620)

4 After eliminating the effect of the nonrecurring extraordinary loss, the trend is clearly up over all
. three years. Particularly impressive is the increase in return on stockholders' equity from 16.04%
in 2013 to 23.30% in 2015 .

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Chapter 01: The Goals and Functions of Financial Management

5 Harrod has a clear superiority in the profit margin (6.19% vs. 4.51%). This is further enhanced by
. a more rapid asset turnover (1.43 vs. 1.13) to give an even more superior return on total assets
(8.85% vs. 5.1%). Finally, return on stockholders' equity greatly benefits from a higher debt ratio
(62% vs. 48%) to provide an even larger gap between the firm and the industry (23.30% vs.
9.80%). While debt is not necessarily good, it has hiked up the return on equity to well over twice
the industry figure.

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Chapter 01: The Goals and Functions of Financial Management

6 Ratios 2015 Industry

.
     Sales     
1. 6.31 5.75
Receivables

    Sales    
2. 4.75 3.01
Inventory

     Sales     
3. 2.77 3.20
Fixed assets

Harrod's is clearly superior to the industry in receivables turnover (6.31 vs. 5.75) and inventory
turnover (4.75 vs. 3.01) and this more than compensates for a lower sales to fixed assets ratio
(2.77 vs. 3.20).

7 Becky would appear to have strong grounds for a complaint. It appears that the banker was using
. unadjusted income statement numbers to arrive at the conclusion that Harrod's was on a
downward trend in terms of the profitability ratios. Also, using unadjusted data the profit margin
was below the industry average.
    However, the inferior performance was due to an extraordinary, nonrecurring loss. In terms of
normal operating performance, the company is clearly on an upward trend and well above the
industry averages on all counts. One percent over prime appears to be much more reasonable than
2½ percent over prime.

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of McGraw-Hill Education.