Chapter 1 An Overview Of Financial Mangement 5z4o5h

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 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.

and

disadvantages

of

alternative

forms

of

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 ing, 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” automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

1-5

Even though firms follow generally accepted ing principles (GAAP), there is still sufficient margin for firms to use different procedures. Leasing and inventory ing (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 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 ing 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 against managerial decisions that reduce bond values:

themselves

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

OPPORTUNITY TO THE BUSINESS AS A FULL-FLEDGED PARTNER.

HER

THE

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: WHICH

DEALS

WITH

SECURITIES

(1) MONEY AND CAPITAL MARKETS,

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 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.] ADVANTAGES:

THE PROPRIETORSHIP HAS THREE IMPORTANT

(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: ORGANIZATION,

(1) UNLIMITED LIABILITY, (2) LIMITED LIFE OF THE

(3)

DIFFICULTY

OF

TRANSFERRING

DIFFICULTY OF RAISING LARGE AMOUNTS OF CAPITAL.

OWNERSHIP,

AND

(4)

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 TIMECONSUMING 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. A

POSITIVE

FURTHERMORE, MOST EXECUTIVES BELIEVE THAT THERE IS

CORRELATION

BETWEEN

ETHICS

AND

LONG-RUN

CONFLICTS OFTEN ARISE BETWEEN PROFITS AND ETHICS.

PROFITABILITY.

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 DECISIONMAKING 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

SHAREHOLDERS’ INTERESTS INCLUDE:

ENCOURAGE

MANAGERS

TO

ACT

IN

(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. ATTEMPTS

ARE

STOCKHOLDERS AGREEMENTS.

MADE, BY

CREDITORS

PLACING

WILL

RESTRICTIVE

PROTECT

SECOND, IF SUCH

THEMSELVES

COVENANTS

IN

AGAINST

FUTURE

DEBT

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

PERFORMANCE.

TODAY

THESE

THAT

ARE

EXPENDITURES

WILL

DESIGNED LIKELY

TO

IMPROVE

REDUCE

FUTURE

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.