The final stage in the interview process for an Assistant Financial Analyst at Caledonia Products involves a test of your understanding of basic financial concepts. You are given the following memorandum and asked to respond to the questions. Whether or not you are offered a position at Caledonia will depend on the accuracy of your response.
To: Applicants for the position of Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: A test of your understanding of basic financial concepts and of the Corporate Tax Code
Please respond to the following questions:
1. What are the differences between the goals of profit maximization and maximization of shareholder wealth? Which goal do you think is more appropriate?
Profit maximization emphasizes the efficient use of capital resources but it does not apply to a specific time frame where profits are to be measured. Firms have to learn to behave rationally in order to increase their profits. Nonetheless, it doesn’t apply the real-world complexities that financial managers have to address in making their decisions. Typically, this is the goal of the firm. On the other hand, maximization of shareholder wealth maximizes of the price of the existing common stocks. This is solely in the best interest of the shareholders because it will provide the most benefit to society.
2. What does the risk-return trade-off mean?
It is the principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if it is subject to the possibility of being lost.
3. Why are we interested in cash flows rather than accounting profits in determining the value of an asset?
We are more interested in cash flows...