An Overview of Financial Management
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.
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 in¬crease 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, uncer¬tainty 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 man¬agement 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” 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 prin¬ciples (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 be less able to engage in such prac¬tices 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. How¬ever, both of these factors are reflected in stock price maximiza¬tion. Thus, profit maximization would not necessar¬ily 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 op¬tion 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 stockhold¬ers’ 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 advan¬tage. 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.
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 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.