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.

• Describe the advantages and disadvantages of alternative forms of

business organization.

• 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 - 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 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 - 2
 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 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 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” auto-
mobiles 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.

1-6 The management of an oligopolistic firm would be more likely to engage

voluntarily in “socially conscious” practices. Competitive firms would

Answers and Solutions: 1 - 3

 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
management’s 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.
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
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 - 4

Answers and Solutions: 1 - 5
 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
 CINTEGRATED CASE

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

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.