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After reading this chapter, students should be
able to:
Explain the career opportunities available
within the three interrelated areas of
finance.
Identify some of the forces that will affect
financial management in the new millennium.
Describe the advantages and disadvantages of
alternative forms of business organization.
Learning Objectives: 1 - 1
Chapter 1
An Overview of Financial Management
LEARNING OBJECTIVES
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.
Define an agency relationship, give some
examples of potential agency problems, and
identify possible solutions.
Identify major factors that determine the
price of a company’s stock, including those
that managers have control over and those
that they do not.
Discuss whether financial managers should
concentrate strictly on cash flow and ignore
the impact of their decisions on EPS.
Learning Objectives: 1 - 3
Chapter 1 covers some important concepts, and
discussing them in class can be interesting.
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
LECTURE SUGGESTIONS
other goals, hence that it is useful to tie
executive compensation to stockholder-oriented
performance measures. 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. We also put copies of
the various versions 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 time value of money
concepts. If students learn how to use 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.
DAYS ON CHAPTER: 1 OF 58 DAYS (50-minute
periods)
Lecture Suggestions: 1 - 6
1-1 The three principal forms of business
organization are sole proprietorship,
partnership, and corporation. The advantages
of the first two include the ease and low
cost of formation. The advantages of the
corporation include 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. The
disadvantages of a partnership are (1)
Answers and Solutions: 1 - 8
ANSWERS TO END-OF-CHAPTER QUESTIONS
unlimited liability, (2) limited life, (3)
difficulty of transferring ownership, and (4)
difficulty of raising large amounts of
capital. 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.
1-2 No. 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, and consequently the
stockholders, prosper by management making
decisions that will produce long-term
earnings increases. Actions that are
continually shortsighted often “catch 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
“gas guzzler” automobiles because they had
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. Competitive
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
themselves uncompetitive.
1-7 Profit maximization abstracts from (1) the
timing of profits and (2) the riskiness of
different operating plans. However, both of
these factors are reflected in stock price
maximization. Thus, profit maximization
would not necessarily lead to stock price
maximization.
Answers and Solutions: 1 - 12
1-8 The president of a large, publicly owned
corporation should maximize shareholders’
wealth or he risks losing his job. Many have
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 firm) serve to keep
management’s focus on stockholders’
interests.
Answers and Solutions: 1 - 13
1-9 a. 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. Thus,
stock price could decrease.
b. Companies must make investments in the
current period in order to generate future
cash flows. Stockholders should be aware
Answers and Solutions: 1 - 14
of this, and assuming a correct analysis
has been performed, they should react
positively to the decision. The Mexican
plant is in this category. 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
future.
c. Provided that the rate of return on
assets exceeds the interest rate on debt,
greater use of debt will raise the expected
rate of return on stockholders’ equity.
Also, the interest on debt is tax
deductible and this provides a further
advantage. However, (1) greater 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. The effects of
debt usage, called “financial leverage,”
are spelled out in detail in the chapter
titled, “Capital Structure and Leverage.”
d. Today (2003), nuclear generation of
electricity is regarded as being quite
risky. If the company has a heavy
investment in nuclear generators, its risk
will be high, and its stock price will be
adversely affected unless its costs are
much lower, hence its profits are much
higher.
Answers and Solutions: 1 - 16
Answers and Solutions: 1 - 17
e. The company will be retaining more
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. This topic will be discussed in
greater detail in the chapter titled,
“Distributions to Shareholders: Dividends
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. The
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 profitability and the company’s
stock price. Consequently, the board may
want to rely more on stock options and less
on performance shares that are tied to
accounting performance.
1-11 As the stock market becomes more volatile,
the link between the stock price and the
management ability of senior executives is
weakened. Therefore, in this environment
companies may choose to de-emphasize the
awarding of stock and stock options and rely
more on bonuses and performance shares that
are tied to other performance measures
besides the company’s stock price. Moreover,
in this environment it may be harder to
attract or retain top talent if the
compensation is tied too much to the
company’s stock price.
1-12 a. No, TIAA-CREF is not an ordinary
shareholder. Because it is one 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 “shareholder” in
effect consists of many individual
shareholders whose pensions are invested
with this group.
b. The owners of TIAA-CREF are the
individual teachers whose pensions are
invested with this group.
c. 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. In so doing, the
individual teachers whose pensions are
invested in the fund have in effect
determined the fund’s voting practices.
1-13 a. 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. Subsequently,
if management’s analysis of the project
proves to be correct, the value of the
firm’s bonds should increase.
b. Dividends are paid from earnings 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, shareholders receive more
dividends so the net effect on stock price
is indeterminate. If the firm’s stock
price increases as current management
believes it will, this may cause some
bondholders to sell their 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.
c. Yes, assuming that management has
performed the correct analysis it should
undertake projects/actions that will
increase the firm’s stock price.
Stockholder wealth maximization is the goal
of management.
d. Bondholders can take the following
actions to protect themselves against
managerial decisions that reduce bond
values:
1. Place restrictive covenants in debt
agreements.
2. Charge a higher-than-normal interest
rate to compensate for the risk of
possible exploitation.
3. Refuse to deal with management
entirely.
Firms that deal 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.
1-14 a. Increasing corporate tax rates and
reducing individual tax rates will cause
the firm to remain as an unincorporated
partnership. In addition to higher
corporate tax rates, corporations are
exposed to double taxation.
b. By increasing environmental and labor
regulations to include firms with 50+
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.
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 impact in the short run.
However, the company’s stock price should
increase due to the significant cost savings
expected in the future.
Take a Dive
Financial Management Overview
CINTEGRATED CASE
1-1 KATO SUMMERS OPENED TAKE A DIVE 17 YEARS
AGO; THE STORE IS LOCATED IN MALIBU,
CALIFORNIA, AND SELLS SURFING-RELATED
EQUIPMENT. TODAY, TAKE 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. ALTHOUGH KATO’S FORMAL
BUSINESS TRAINING IS LIMITED, AMBER WILL
SOON GRADUATE WITH A DEGREE IN FINANCE.
KATO HAS OFFERED HER THE OPPORTUNITY TO
JOIN THE BUSINESS AS A FULL-FLEDGED
PARTNER. AMBER IS INTERESTED, BUT SHE IS
ALSO CONSIDERING OTHER CAREER OPPORTUNITIES
IN FINANCE.
RIGHT NOW, AMBER IS LEANING TOWARD
STAYING WITH THE FAMILY BUSINESS, PARTLY
BECAUSE SHE THINKS IT FACES A NUMBER OF
INTERESTING CHALLENGES AND OPPORTUNITIES.
AMBER IS PARTICULARLY INTERESTED IN FURTHER
EXPANDING THE BUSINESS AND THEN
INCORPORATING IT. 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 AND PLEASURE. HE IS WORRIED THAT
THESE GOALS WILL BE COMPROMISED IF 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. AMBER, WHO IS HIGHLY
ORGANIZED, HAS OUTLINED A SERIES OF
QUESTIONS FOR THEM TO ADDRESS:
A. WHAT KINDS OF CAREER OPPORTUNITIES ARE OPEN
TO FINANCE MAJORS?
ANSWER: [SHOW S1-1 AND S1-2 HERE.] CAREER
OPPORTUNITIES FOR FINANCE MAJORS EXIST IN
THREE INTERRELATED AREAS: (1) MONEY AND
CAPITAL MARKETS,
WHICH DEALS WITH SECURITIES MARKETS AND
FINANCIAL INSTITUTIONS;
(2) INVESTMENTS, WHICH FOCUSES ON THE
DECISIONS OF BOTH INDIVIDUAL AND
INSTITUTIONAL INVESTORS AS THEY CHOOSE
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 INSTITUTIONS, INCLUDING BANKS,
INSURANCE COMPANIES, MUTUAL FUNDS, AND
INVESTMENT BANKING FIRMS. FINANCE
GRADUATES WHO GO INTO INVESTMENTS OFTEN
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 THE FIRM SHOULD
CARRY, HOW MUCH CASH TO KEEP ON HAND,
WHETHER TO ACQUIRE OTHER FIRMS, AND HOW
MUCH OF THE FIRM’S EARNINGS TO PLOW BACK
INTO THE BUSINESS VERSUS TO PAY OUT AS
DIVIDENDS.
B. WHAT ARE THE PRIMARY RESPONSIBILITIES OF A
CORPORATE FINANCIAL STAFF?
ANSWER: [SHOW S1-3 AND S1-4 HERE.] THE FINANCIAL
MANAGER’S TASK IS TO ACQUIRE AND USE FUNDS
SO AS TO MAXIMIZE THE FIRM’S VALUE.
SPECIFIC ACTIVITIES INCLUDE: (1)
FORECASTING AND PLANNING, (2) MAKING MAJOR
INVESTMENT AND FINANCING DECISIONS, (3)
COORDINATING AND CONTROLLING, (4) DEALING
WITH THE FINANCIAL MARKETS, AND (5)
MANAGING RISK.
C. WHAT ARE THE MOST IMPORTANT FINANCIAL
MANAGEMENT ISSUES TODAY?
ANSWER: [SHOW S1-5 AND S1-6 HERE.] THE FOCUS ON
VALUE MAXIMIZATION CONTINUES AS WE BEGIN
THE 21st CENTURY. HOWEVER, TWO OTHER
TRENDS HAVE BECOME INCREASINGLY IMPORTANT
IN RECENT YEARS: THE GLOBALIZATION OF
BUSINESS AND THE INCREASED USE OF
INFORMATION TECHNOLOGY. THESE TRENDS WILL
UNDOUBTEDLY CONTINUE IN THE YEARS AHEAD.
D. 1. WHAT ARE THE ALTERNATIVE FORMS OF
BUSINESS ORGANIZATION?
ANSWER: [SHOW S1-7 HERE.] THE THREE MAIN FORMS
OF BUSINESS ORGANIZATION ARE
(1) SOLE PROPRIETORSHIPS, (2) PARTNERSHIPS,
AND (3) CORPORATIONS.
D. 2. WHAT ARE THEIR ADVANTAGES AND
DISADVANTAGES?
ANSWER: [SHOW S1-8 AND S1-9 HERE.] THE
PROPRIETORSHIP HAS THREE IMPORTANT
ADVANTAGES: (1) IT IS EASILY AND
INEXPENSIVELY FORMED, (2) IT IS SUBJECT TO
FEW GOVERNMENT REGULATIONS, AND (3) THE
BUSINESS PAYS NO CORPORATE INCOME TAXES.
THE PROPRIETORSHIP ALSO HAS THREE IMPORTANT
LIMITATIONS: (1) IT IS DIFFICULT FOR A
PROPRIETORSHIP TO OBTAIN LARGE SUMS OF
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. THE
DISADVANTAGES ARE SIMILAR TO THOSE
ASSOCIATED WITH PROPRIETORSHIPS: (1)
UNLIMITED LIABILITY, (2) LIMITED LIFE OF THE
ORGANIZATION, (3) DIFFICULTY OF TRANSFERRING
OWNERSHIP, AND (4) DIFFICULTY OF RAISING
LARGE AMOUNTS OF CAPITAL. THE TAX TREATMENT
OF A PARTNERSHIP IS SIMILAR TO THAT FOR
PROPRIETORSHIPS, WHICH IS OFTEN AN
ADVANTAGE.
THE CORPORATE FORM OF BUSINESS HAS THREE
MAJOR ADVANTAGES:
(1) UNLIMITED LIFE, (2) EASY
TRANSFERABILITY OF OWNERSHIP INTEREST, AND
(3) LIMITED LIABILITY. WHILE THE CORPORATE
FORM OFFERS SIGNIFICANT 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 TIME-
CONSUMING THAN FOR A PROPRIETORSHIP OR A
PARTNERSHIP.
E. WHAT IS THE PRIMARY GOAL OF THE
CORPORATION?
ANSWER: [SHOW S1-10 AND S1-11 HERE.] THE
CORPORATION’S PRIMARY GOAL IS STOCKHOLDER
WEALTH MAXIMIZATION, WHICH TRANSLATES TO
MAXIMIZING THE PRICE OF THE FIRM’S COMMON
STOCK.
E. 1. DO FIRMS HAVE ANY RESPONSIBILITIES TO
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. HOWEVER, THE MOST
SIGNIFICANT COST-INCREASING ACTIONS WILL
HAVE TO BE PUT ON A MANDATORY RATHER THAN A
VOLUNTARY BASIS TO ENSURE THAT THE BURDEN
FALLS UNIFORMLY ON ALL BUSINESSES.
E. 2. IS STOCK PRICE MAXIMIZATION GOOD OR BAD
FOR SOCIETY?
ANSWER: THE SAME ACTIONS THAT MAXIMIZE STOCK
PRICES ALSO BENEFIT SOCIETY. STOCK PRICE
MAXIMIZATION REQUIRES EFFICIENT, 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
CONSUMERS WANT AND NEED, SO THE PROFIT
MOTIVE LEADS TO NEW TECHNOLOGY, TO NEW
PRODUCTS, AND TO NEW JOBS. ALSO, STOCK
PRICE MAXIMIZATION NECESSITATES EFFICIENT
AND COURTEOUS SERVICE, ADEQUATE STOCKS OF
MERCHANDISE, AND WELL-LOCATED BUSINESS
ESTABLISHMENTS--FACTORS THAT ARE ALL
NECESSARY TO MAKE SALES, WHICH ARE
NECESSARY FOR PROFITS.
E. 3. SHOULD FIRMS BEHAVE ETHICALLY?
ANSWER: YES. 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,
MOST EXECUTIVES BELIEVE THAT THERE IS A
POSITIVE CORRELATION BETWEEN ETHICS AND
LONG-RUN PROFITABILITY. CONFLICTS OFTEN
ARISE BETWEEN PROFITS AND ETHICS.
COMPANIES MUST DEAL WITH THESE CONFLICTS ON
A REGULAR BASIS, AND A FAILURE TO HANDLE
THE SITUATION PROPERLY CAN LEAD TO HUGE
PRODUCT LIABILITY SUITS AND EVEN TO
BANKRUPTCY. THERE IS NO ROOM FOR UNETHICAL
BEHAVIOR IN THE BUSINESS WORLD.
F. WHAT IS AN AGENCY RELATIONSHIP?
ANSWER: [SHOW S1-12 HERE.] AN AGENCY
RELATIONSHIP EXISTS WHENEVER A “PRINCIPAL”
ENGAGES AN “AGENT” AND GRANTS THE AGENT
SOME DECISION-MAKING POWER.
F. 1. WHAT AGENCY RELATIONSHIPS EXIST WITHIN A
CORPORATION?
ANSWER: WITHIN THE FINANCIAL MANAGEMENT CONTEXT,
THE PRIMARY AGENCY RELATIONSHIPS ARE THOSE
(1) BETWEEN STOCKHOLDERS AND MANAGERS AND
(2) BETWEEN DEBTHOLDERS AND STOCKHOLDERS
(THROUGH MANAGERS).
F. 2. WHAT MECHANISMS EXIST TO INFLUENCE
MANAGERS TO ACT IN SHAREHOLDERS’ BEST
INTERESTS?
ANSWER: [SHOW S1-13 HERE.] TO REDUCE AGENCY
CONFLICTS, STOCKHOLDERS MUST INCUR AGENCY
COSTS, WHICH INCLUDE ALL COSTS BORNE BY
SHAREHOLDERS TO ENCOURAGE MANAGERS 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
COMPENSATION, (2) DIRECT INTERVENTION BY
SHAREHOLDERS, (3) THE THREAT OF FIRING, AND
(4) THE THREAT OF TAKEOVER.
F. 3. SHOULD SHAREHOLDERS (THROUGH MANAGERS)
TAKE ACTIONS THAT ARE DETRIMENTAL TO
BONDHOLDERS?
ANSWER: [SHOW S1-14 HERE.] NO. SUCH BEHAVIOR IS
UNETHICAL, AND THERE IS NO ROOM FOR
UNETHICAL BEHAVIOR IN THE BUSINESS WORLD.
SECOND, IF SUCH ATTEMPTS ARE MADE,
CREDITORS WILL PROTECT THEMSELVES AGAINST
STOCKHOLDERS BY PLACING RESTRICTIVE
COVENANTS IN FUTURE DEBT AGREEMENTS.
FINALLY, IF CREDITORS PERCEIVE THAT A
FIRM’S MANAGERS ARE TRYING TO TAKE
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
EXPLOITATION. THUS, FIRMS THAT DEAL
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.
G. IS MAXIMIZING STOCK PRICE THE SAME THING AS
MAXIMIZING PROFIT?
ANSWER: NO. GENERALLY, THERE IS A HIGH
CORRELATION BETWEEN EPS, CASH FLOW, AND
STOCK PRICE, AND ALL OF THEM GENERALLY RISE
IF A FIRM’S SALES RISE. NEVERTHELESS,
STOCK PRICES DEPEND NOT JUST ON TODAY’S
EARNINGS AND CASH FLOWS--FUTURE CASH FLOWS
AND THE RISKINESS OF THE FUTURE EARNINGS
STREAM ALSO AFFECT STOCK PRICES. SOME
ACTIONS MAY INCREASE EARNINGS AND YET
REDUCE STOCK PRICES WHILE OTHER ACTIONS MAY
BOOST STOCK PRICE BUT REDUCE EARNINGS.
CONSIDER A COMPANY THAT UNDERTAKES LARGE
EXPENDITURES TODAY THAT ARE DESIGNED TO
IMPROVE FUTURE PERFORMANCE. THESE
EXPENDITURES WILL LIKELY REDUCE EARNINGS
PER SHARE, YET THE STOCK MARKET MAY RESPOND
POSITIVELY IF IT BELIEVES THAT THESE
EXPENDITURES WILL SIGNIFICANTLY ENHANCE
FUTURE EARNINGS. BY CONTRAST, A COMPANY
THAT UNDERTAKES 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.
H. WHAT FACTORS AFFECT STOCK PRICES?
ANSWER: [SHOW S1-15 AND S1-16 HERE.] THE FIRM’S
STOCK PRICE IS DEPENDENT ON MANAGERIAL
ACTIONS, SUCH AS INVESTMENT DECISIONS,
FINANCING DECISIONS, DIVIDEND 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.
I. WHAT FACTORS AFFECT THE LEVEL AND RISKINESS
OF CASH FLOWS?
ANSWER: [SHOW S1-17 HERE.] MANAGERIAL ACTIONS,
SUCH AS INVESTMENT DECISIONS, FINANCING
DECISIONS, AND DIVIDEND POLICY DECISIONS
AFFECT THE LEVEL, TIMING, AND THE RISKINESS
OF THE FIRM’S CASH FLOWS.