An Overview of Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1The primary goal is assumed to be shareholder wealth maximization, which translates to stock price maximization. That, in turn, means maximizing the PV of future free cash flows. Maximizing shareholder wealth requires that the firm produce things that customers want, and at the lowest cost consistent with high quality. It also means holding risk down, which will result in a relatively low cost of capital, which is necessary to maximize the PV of a given cash flow stream. This also gets into the issue of capital structure—how much debt should we use? The more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less dilution of earnings. However, more debt means more risk. So, it’s necessary to consider capital structure when attempting to maximize share prices. Dividend policy is also an issue—how much of its earnings should the firm pay out as dividends? The answer to that question depends on a number of factors, including the firm’s investment opportunities, its access to capital markets, its stockholders’ desires (and their tax rates), and the kind of signals stockholders get from dividend actions. Shareholder wealth maximization is partially consistent and partially inconsistent with generally accepted societal goals. It is consistent because well-run firms produce good products at low costs, sell them at competitive prices, employ people, pay taxes, and generally improve society. However, without constraints, firms would tend to form monopolies and end up charging prices that are too high and not producing enough output. They might also pollute the air and water, engage in unfair labor practices, and so on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed on businesses. That said, stock price maximization is consistent with a strong economy, economic progress, and “the good life” for most citizens. In standard introductory microeconomics courses, we assume that firms attempt to maximize profits. In more advanced econ courses, the goal is broadened to value maximizing, so finance and economics are indeed consistent. As WorldCom, Enron, and other corporate scandals demonstrated very clearly, managers do not always have stockholders’ interests as a primary goal—some managers have their own interests. This point is discussed further below.
1-2See the model for quantitative answers to this question. All of these valuations involve applications of the basic valuation model:
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the maturity value, and N is the bond’s life. Other things held constant, the higher the going interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs are also high, and that increases the value of the bond. For a stock, the CFs are dividends, and for a capital budgeting project, they are operating cash flows. The main point to get across with this question is that all assets are valued in essentially the same way. The Excel model goes into a little more detail on sensitivity analysis. Much more comes later in the book.
1-3An agency relationship exists when one party (the principal) delegates authority to some other party (the agent). Stockholders delegate authority to managers, and debtholders delegate authority to stockholders (who act through managers). Any conflict between principals and agents is called an agency problem, or agency conflict. A good example of an agency conflict between stockholders and managers is related to executive salaries. To some extent, top executives establish their own compensation, and if that compensation is “too high,” it adversely affects stockholders. The primary conflicts between stockholders and managers relate to (2)...