Chapter 1

An Overview of Financial Management

LEARNING OBJECTIVES

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.

Briefly explain the responsibilities of the financial staff within

an organization.

Describe the advantages and disadvantages of alternative forms of

business organization.

State the primary goal in a publicly traded firm, and explain how
social responsibility and business ethics fit in.

Define an agency relationship, give some examples of potential

agency problems, and identify possible solutions.

Identify major factors that determine the price of a companys

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.

Harcourt, Inc. Learning Objectives: 1 - 1

 LECTURE SUGGESTIONS

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 other goals, hence that it is useful to tie executive compensation to
stockholder-oriented performance measures. If time permits, we think its
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: 2 OF 58 DAYS (50-minute periods)

Lecture Suggestions: 1 - 2 Harcourt, Inc.

 ANSWERS TO END-OF-CHAPTER QUESTIONS

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) 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.

1-3 An increase in the inflation rate would most likely increase the
relative importance of the financial manager. Virtually all of the
managers 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 itself unable to compete effectively against its competi-
tors. 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.

Harcourt, Inc. Answers and Solutions: 1 - 3

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.

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 managements focus on stockholders interests.

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 philanthropy could be received by stockholders negatively,
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 of this,
and assuming a correct analysis has been performed, they should
react positively to the decision. The Mexican plant is in this
category. This is covered in depth in Part IV 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 debt will have a negative impact on the stockholders
if the companys 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 Chapter 13.

d. Today (2001), 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

Answers and Solutions: 1 - 4 Harcourt, Inc.

 adversely affected unless its costs are much lower, hence its
profits are much higher.

e. The company will be retaining more earnings, so its growth rate

should go up, 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.

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 companys 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 companys 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 companys stock price.

1-12 a. No, the TIAA-CREF is not an ordinary shareholder. Because it is the

largest institutional shareholder in the United States and it
controls nearly $250 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 the TIAA-CREF to be effective in wielding its weight, it must

act as a coordinated unit. In order to do this, the funds managers
should solicit from the individual shareholders their votes on the
funds practices, and from those votes act on the majoritys
wishes. In so doing, the individual teachers whose pensions are
invested in the fund have in effect determined the funds voting
practices.

1-13 a. If the capital markets perceive the project as risky and therefore
increasing the firms risk, the value of the firms outstanding
bonds will decline--hurting the firms existing bondholders.
Subsequently, if managements analysis of the project proves to be
correct, the value of the firms bonds should increase.

Harcourt, Inc. Answers and Solutions: 1 - 5

 b. Dividends are paid from earnings after bondholders and the
government have been paid. A dividend increase decreases the firms
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 firms stock price
increases as current manage-ment believes it will, this may cause
some bondholders to sell their bonds and buy the firms stock to
earn a higher return. So, the proposed dividend increase may cause
a decline in the value of the firms bonds.

c. Yes, assuming that management has performed the correct analysis it

should undertake projects/actions that will increase the firms
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, the corporation is 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 companys stock price should
increase due to the significant cost savings expected in the future.

Answers and Solutions: 1 - 6 Harcourt, Inc.

 CINTEGRATED
CYBERPROBLEM
CASE

1-1 The detailed solution for the cyberproblem is available on the

instructors side of the Harcourt College Publishers web site,
http://www.
harcourtcollege.com/finance/brigham.

Take a Dive
Financial Management Overview

1-2 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.
KATOS BUSINESS HAS BOOMED IN RECENT YEARS, AND HE IS LOOKING FOR
NEW WAYS TO TAKE ADVANTAGE OF HIS INCREASING BUSINESS OPPORTUNITIES.
ALTHOUGH KATOS 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.

Harcourt, Inc. Computer/Internet Applications: 1 - 7

 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 FIRMS 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 HERE.] THE FINANCIAL MANAGERS TASK IS TO ACQUIRE AND
USE FUNDS SO AS TO MAXIMIZE THE FIRMS 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 S1-4 AND S1-5 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 S1-6 HERE.] THE THREE MAIN FORMS OF BUSINESS ORGANIZATION ARE
(1) SOLE PROPRIETORSHIPS, (2) PARTNERSHIPS, AND (3) CORPORATIONS. IN
ADDITION, SEVERAL HYBRID FORMS ARE GAINING POPULARITY. THESE HYBRID
FORMS ARE THE LIMITED PARTNERSHIP, THE LIMITED LIABILITY
PARTNERSHIP, THE PROFESSIONAL CORPORATION, AND THE S CORPORATION.

D. 2. WHAT ARE THEIR ADVANTAGES AND DISADVANTAGES?

ANSWER: [SHOW S1-7, 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 BUSINESSS 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.

Harcourt, Inc. Computer/Internet Applications: 1 - 9

 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.
IN A LIMITED PARTNERSHIP, THE LIMITED PARTNERS ARE LIABLE ONLY
FOR THE AMOUNT OF THEIR INVESTMENT IN THE PARTNERSHIP; HOWEVER, THE
LIMITED PARTNERS TYPICALLY HAVE NO CONTROL. THE LIMITED LIABILITY
PARTNERSHIP (LLP) FORM OF ORGANIZATION COMBINES THE LIMITED
LIABILITY ADVANTAGE OF A CORPORATION WITH THE TAX ADVANTAGES OF A
PARTNERSHIP. PROFESSIONAL CORPORATIONS PROVIDE MOST OF THE BENEFITS
OF INCORPORATION BUT DO NOT RELIEVE THE PARTICIPANTS OF PROFESSIONAL
LIABILITY. S CORPORATIONS ARE SIMILAR IN MANY WAYS TO LIMITED
LIABILITY PARTNERSHIPS, BUT LLPs FREQUENTLY OFFER MORE FLEXIBILITY
AND BENEFITS TO THEIR OWNERS.

E. WHAT IS THE PRIMARY GOAL OF THE CORPORATION?

ANSWER: [SHOW S1-10 HERE.] THE CORPORATIONS PRIMARY GOAL IS STOCKHOLDER

WEALTH MAXIMIZATION, WHICH TRANSLATES TO MAXIMIZING THE PRICE OF THE
FIRMS 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 S1-11 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?

Harcourt, Inc. Computer/Internet Applications: 1 - 11

ANSWER: [SHOW S1-12 HERE.] TO REDUCE AGENCY CONFLICTS, STOCKHOLDERS MUST
INCUR AGENCY COSTS, WHICH INCLUDE ALL COSTS BORNE BY SHAREHOLDERS TO
ENCOURAGE MANAGERS TO MAXIMIZE THE FIRMS 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 S1-13 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 FIRMS 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: [SHOW S1-14 HERE.] NO. GENERALLY, THERE IS A HIGH CORRELATION

BETWEEN EPS, CASH FLOW, AND STOCK PRICE, AND ALL OF THEM GENERALLY
RISE IF A FIRMS SALES RISE. NEVERTHELESS, STOCK PRICES DEPEND NOT
JUST ON TODAYS 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 FIRMS RISK.

H. WHAT FACTORS AFFECT STOCK PRICES?

ANSWER: [SHOW S1-15 HERE.] THE FIRMS 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 FIRMS VALUE (AND ITS STOCK PRICE) BY INCREASING THEIR FIRMS
EXPECTED CASH FLOWS, SPEEDING UP CASH FLOWS, AND REDUCING THEIR
RISKINESS.

Harcourt, Inc. Computer/Internet Applications: 1 - 13

I. WHAT FACTORS AFFECT THE LEVEL AND RISKINESS OF CASH FLOWS?

ANSWER: [SHOW S1-16 HERE.] MANAGERIAL ACTIONS, SUCH AS INVESTMENT

DECISIONS, FINANCING DECISIONS, AND DIVIDEND POLICY DECISIONS AFFECT
THE LEVEL, TIMING, AND THE RISKINESS OF THE FIRMS CASH FLOWS.