BFN3104

Chapter 1
Questions
1.

What is finance? What is corporate financial management? What are the

three major questions that financial managers address?
Finance is a discipline concerned with determining value and making decisions. The
finance function allocates resources, which includes acquiring, investing and
managing the resources.
Financial management is an area of finance that applies financial principles within an
organization to create and maintain value through decision making and proper
resource management.
The first major question that financial managers deal with is investment decisions.
These decisions are primarily concerned with the asset (left) side of the balance sheet.
They answer such questions as should we buy new computers or a new warehouse?
The second major question deals with financial decisions. These decisions are
primarily concerned with the liabilities and stockholders equity (right) side of the
balance sheet. They answer such questions as how much debt should we have and
should the debt be short or long term or should we borrow in foreign currency? The
third major question deals with managerial decisions. These decisions are primarily
concerned with firms policies and day-to-day operating and financial decisions. They
answer such questions as how large should the firm be, and how fast should it grow?

2.

What are three problems associated with using profit maximization as the
goal of the firm? What is shareholder wealth maximization? How does
shareholder wealth maximization deal with these three problems?
The three problems associated with using profit maximization as the goal of the firm
are the following:
First, profit maximization is vague. Profit has many different definitions such as
accounting profit based on book value or economic profit based on market value.
Second, profit maximization ignores differences in when we get the money. It does
not distinguish between getting a dollar today and getting a dollar one year from
today. The time value of money plays an important role in valuing an asset or liability.
Third, profit maximization ignores risk differences among alternative courses of
action. When given a choice between two alternatives that have the same return but
different risk, must people will take the less risky one. This makes the less risky one
more valuable. Profit maximization ignores such differences in value
Shareholder wealth maximization is maximizing the value of the firm to its owners.
The ownership value of the firm is the market value of shares owned. Shareholders
wealth maximization deals with these three problems by focusing profit motives

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squarely on the owners. First, shareholders wealth is unambiguous. It is based on the
present value of the future cash flows that are expected to come to the shareholders,
rather than an ambiguous notion of profit or other revenues. Second, shareholders
wealth depends explicitly on timing of future cash flows. Finally, our process for
measuring shareholders wealth accounts for risk differences.
3.

Distinguish between investing decisions and financing decisions within the

area of corporate financial management. Give one example of each.
Investment decisions are primarily concerned with the asset or left side of the balance
sheet. Such decisions include whether to introduce a new product.
Financial decisions are primarily concerned with the liabilities and stockholders
equity or right side of the balance sheet. Such decisions include whether to issue new
stock in the firm.

4.

Explain the four rights of common stockholders. Which of the four rights is often
missing in modern corporations?
The four types of common stockholders right are:
Dividend right Shareholders get an identical per share amount of any dividends
Voting right Shareholders have the right to vote on certain matters, such as the
election of directors.
Liquidation right Shareholders have the right to a proportional share of the firms
residual value in the event of liquidation. The residual value is what remains after all
of the corporations other obligations have been settled.
Preemptive right In some corporations, shareholders have the right to subscribe
proportionately to any new issue of the corporations shares. Such offerings are called
rights offering.
Preemptive rights are often left out of modern corporate charters.

Problems
1. Consider the fictionalized account of Henrys car firm.
a. Describe some of the conflicts of interest between Henry and the bank.
If Henry makes late or less than full payments, it will be costly to the bank, and
yet it may not be worth it to sue Henry for the loss. If Henry runs off with the
money the bank may not ever get rapid. If Henry borrows a great deal off
additional money from a different bank, it may be difficult to repay the first bank.
If Henry invests in an entirely different line of business that is much riskier than

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making cars, the banks risk will be increased, which will decrease the value of its
claim.
b. Describe some of the conflicts of interest between Henry and the other
shareholders.
If Henry uses an expense account to pay personal expenses (such as meals and dry
cleaning clothes), the cost decrease the value of the others shareholders = claim. If
Henry takes unnecessary trips at firm expense, the cost decreases the value of the
others shareholders claim. If Henry doesnt put in much effort running the
business, the value of the other shareholders claim will be decreased.
c.

Describe some of the conflicts of interest between the mangers and Henry.
If the managers-pay themselves an excessive salary, the other shareholders bear
the cost. If mangers travel in excessively expensive style (such as staying in more
expensive than reasonable hotels), the others shareholders bear the cost. If the
mangers have excessively fancy offices, the other shareholders bear part of the
cost.

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