Chapter 1

An Overview of Financial Management

LEARNING OBJECTIVES

After reading this chapter, students should be able to:

Explain the career opportunities
interrelated areas of finance.

available

within

the

three

Identify some of the forces that will affect financial management in

the new millennium.
Briefly explain the responsibilities of the financial staff within
an organization.
Describe the advantages and disadvantages of alternative forms of
business organization.
State the primary goal in a publicly traded firm, and explain how
social responsibility and business ethics fit in.
Define an agency relationship, give some examples
agency problems, and identify possible solutions.

of

potential

Identify major factors that determine the price of a companys

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.

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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 its
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:

2 OF 58 DAYS (50-minute periods)

Lecture Suggestions: 1 - 2

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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 timeconsuming.

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
managers 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 automobiles 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.

Harcourt, Inc.

Answers and Solutions: 1 - 3

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 practices unless they were costjustified, 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 managements 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. This is covered in depth in Part IV 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 companys 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 Chapter 13.
d. Today (2001), 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

Answers and Solutions: 1 - 4

Harcourt, Inc.

adversely affected unless

profits are much higher.

its

costs

are

much

lower,

hence

its

e. The company will be retaining more earnings, so its growth rate

should go up, 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.
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 companys 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 companys 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 companys stock price.

1-12

a. No, the TIAA-CREF is not an ordinary shareholder. Because it is the

largest institutional shareholder in the United States and it
controls nearly $250 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 the TIAA-CREF to be effective in wielding its weight, it must
act as a coordinated unit. In order to do this, the funds managers
should solicit from the individual shareholders their votes on the
funds practices, and from those votes act on the majoritys
wishes.
In so doing, the individual teachers whose pensions are
invested in the fund have in effect determined the funds voting
practices.

1-13

a. If the capital markets perceive the project as risky and therefore

increasing the firms risk, the value of the firms outstanding
bonds
will
decline--hurting
the
firms
existing
bondholders.
Subsequently, if managements analysis of the project proves to be
correct, the value of the firms bonds should increase.

Harcourt, Inc.

Answers and Solutions: 1 - 5

b. Dividends are paid from earnings after bondholders and the

government have been paid. A dividend increase decreases the firms
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 firms stock price
increases as current manage-ment believes it will, this may cause
some bondholders to sell their bonds and buy the firms stock to
earn a higher return. So, the proposed dividend increase may cause
a decline in the value of the firms bonds.
c. Yes, assuming that management has performed the correct analysis it
should undertake projects/actions that will increase the firms
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, the corporation is 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 companys stock price should
increase due to the significant cost savings expected in the future.

Answers and Solutions: 1 - 6

Harcourt, Inc.

CINTEGRATED
CYBERPROBLEM
CASE

1-1

The detailed solution for the cyberproblem is available on the

instructors side of the Harcourt College Publishers web site,
http://www.
harcourtcollege.com/finance/brigham.

Take a Dive
Financial Management Overview
1-2

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.
KATOS BUSINESS HAS BOOMED IN RECENT YEARS, AND HE IS LOOKING FOR
NEW WAYS TO TAKE ADVANTAGE OF HIS INCREASING BUSINESS OPPORTUNITIES.
ALTHOUGH KATOS FORMAL BUSINESS TRAINING IS LIMITED, AMBER WILL SOON
GRADUATE

WITH

DEGREE

IN

FINANCE.

KATO

HAS

OFFERED

HER

OPPORTUNITY TO JOIN THE BUSINESS AS A FULL-FLEDGED PARTNER.

IS

INTERESTED,

BUT

SHE

IS

ALSO

CONSIDERING

OTHER

THE

AMBER
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.
THESE

GOALS

WILL

BE

COMPROMISED

IF

THE

HE IS WORRIED THAT

COMPANY

INCORPORATES

AND

BRINGS IN OUTSIDE SHAREHOLDERS.

Harcourt, Inc.

Computer/Internet Applications: 1 - 7

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

COMPANIES,

FINANCIAL
MUTUAL

INSTITUTIONS,

FUNDS,

AND

INCLUDING

INVESTMENT

BANKS,

BANKING

INSURANCE

FIRMS.

FINANCE

GRADUATES WHO GO INTO INVESTMENTS OFTEN WORK FOR A BROKERAGE HOUSE

EITHER IN SALES OR AS A SECURITY ANALYST.
MUTUAL

FUNDS,

OR

INSURANCE

COMPANIES

IN

OTHERS WORK FOR BANKS,

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.
JOB

OPPORTUNITIES

DECISIONS

IN

REGARDING

FINANCIAL

PLANT

MANAGEMENT

EXPANSIONS

TO

RANGE

CHOOSING

FROM
WHAT

THE

MAKING

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 FIRMS 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 HERE.]

THE FINANCIAL MANAGERS TASK IS TO ACQUIRE AND

USE FUNDS SO AS TO MAXIMIZE THE FIRMS 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

S1-4

AND

S1-5

HERE.]

THE

FOCUS

CONTINUES AS WE BEGIN THE 21st CENTURY.

HAVE

BECOME

INCREASINGLY

GLOBALIZATION
TECHNOLOGY.

OF

BUSINESS

THE

VALUE

MAXIMIZATION

HOWEVER, TWO OTHER TRENDS

IMPORTANT
AND

ON

IN

RECENT

INCREASED

USE

YEARS:
OF

THE

INFORMATION

THESE TRENDS WILL UNDOUBTEDLY CONTINUE IN THE YEARS

AHEAD.
D.

1. WHAT ARE THE ALTERNATIVE FORMS OF BUSINESS ORGANIZATION?

ANSWER:

[SHOW S1-6 HERE.]

THE THREE MAIN FORMS OF BUSINESS ORGANIZATION ARE

(1) SOLE PROPRIETORSHIPS, (2) PARTNERSHIPS, AND (3) CORPORATIONS. IN

ADDITION, SEVERAL HYBRID FORMS ARE GAINING POPULARITY.
FORMS

ARE

THE

LIMITED

PARTNERSHIP,

THE

THESE HYBRID

LIMITED

LIABILITY

PARTNERSHIP, THE PROFESSIONAL CORPORATION, AND THE S CORPORATION.

D.

2. WHAT ARE THEIR ADVANTAGES AND DISADVANTAGES?

ANSWER:

[SHOW

S1-7,

S1-8,

AND

IMPORTANT ADVANTAGES:

S1-9

HERE.]

THE

PROPRIETORSHIP

HAS

THREE

(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 BUSINESSS 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,

(3)

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

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.
Harcourt, Inc.

Computer/Internet Applications: 1 - 9

THE CORPORATE FORM OF BUSINESS HAS THREE MAJOR ADVANTAGES:

(1) UNLIMITED LIFE, (2) EASY TRANSFERABILITY OF OWNERSHIP INTEREST,
AND

(3)

LIMITED

SIGNIFICANT

LIABILITY.

ADVANTAGES

OVER

WHILE

THE

CORPORATE

PROPRIETORSHIPS

DOES HAVE TWO PRIMARY DISADVANTAGES:

AND

FORM

OFFERS

PARTNERSHIPS,

IT

(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.
IN A LIMITED PARTNERSHIP, THE LIMITED PARTNERS ARE LIABLE ONLY
FOR THE AMOUNT OF THEIR INVESTMENT IN THE PARTNERSHIP; HOWEVER, THE
LIMITED PARTNERS TYPICALLY HAVE NO CONTROL.
PARTNERSHIP

(LLP)

FORM

OF

ORGANIZATION

THE LIMITED LIABILITY

COMBINES

THE

LIMITED

LIABILITY ADVANTAGE OF A CORPORATION WITH THE TAX ADVANTAGES OF A

PARTNERSHIP.

PROFESSIONAL CORPORATIONS PROVIDE MOST OF THE BENEFITS

OF INCORPORATION BUT DO NOT RELIEVE THE PARTICIPANTS OF PROFESSIONAL

LIABILITY.

CORPORATIONS

ARE

SIMILAR

IN

MANY

WAYS

TO

LIMITED

LIABILITY PARTNERSHIPS, BUT LLPs FREQUENTLY OFFER MORE FLEXIBILITY

AND BENEFITS TO THEIR OWNERS.

E.

WHAT IS THE PRIMARY GOAL OF THE CORPORATION?

ANSWER:

[SHOW S1-10 HERE.]

THE CORPORATIONS PRIMARY GOAL IS STOCKHOLDER

WEALTH MAXIMIZATION, WHICH TRANSLATES TO MAXIMIZING THE PRICE OF THE

FIRMS COMMON STOCK.

E.

1. DO FIRMS HAVE ANY RESPONSIBILITIES TO SOCIETY AT LARGE?

ANSWER:

FIRMS

HAVE

AN

ETHICAL

RESPONSIBILITY

TO

PROVIDE

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

S1-11

HERE.]

AN

AGENCY

RELATIONSHIP

EXISTS

WHENEVER

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?

Harcourt, Inc.

Computer/Internet Applications: 1 - 11

ANSWER:

[SHOW S1-12 HERE.]

TO REDUCE AGENCY CONFLICTS, STOCKHOLDERS MUST

INCUR AGENCY COSTS, WHICH INCLUDE ALL COSTS BORNE BY SHAREHOLDERS TO

ENCOURAGE MANAGERS TO MAXIMIZE THE FIRMS STOCK PRICE RATHER THAN
ACT IN THEIR OWN SELF-INTERESTS.
SOME

SPECIFIC

MECHANISMS

THAT

SHAREHOLDERS INTERESTS INCLUDE:

COMPENSATION,

(2)

DIRECT

ENCOURAGE

MANAGERS

TO

ACT

IN

(1) PERFORMANCE-BASED MANAGERIAL

INTERVENTION

BY

SHAREHOLDERS,

(3)

THE

THAT

ARE

THREAT OF FIRING, AND (4) THE THREAT OF TAKEOVER.

F.

3. SHOULD

SHAREHOLDERS

(THROUGH

MANAGERS)

TAKE

ACTIONS

DETRIMENTAL TO BONDHOLDERS?
ANSWER:

[SHOW S1-13 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 FIRMS 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:

[SHOW S1-14 HERE.]

NO.

GENERALLY, THERE IS A HIGH CORRELATION

BETWEEN EPS, CASH FLOW, AND STOCK PRICE, AND ALL OF THEM GENERALLY
RISE IF A FIRMS SALES RISE.

NEVERTHELESS, STOCK PRICES DEPEND NOT

JUST ON TODAYS 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

REDUCE

FUTURE

EARNINGS

PERFORMANCE.

PER

SHARE,

YET

THESE
THE

EXPENDITURES
STOCK

MARKET

WILL
MAY

LIKELY
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 FIRMS RISK.

H.

WHAT FACTORS AFFECT STOCK PRICES?

ANSWER:

[SHOW

S1-15

HERE.]

THE

MANAGERIAL

ACTIONS,

SUCH

DECISIONS,

DIVIDEND

POLICY

FIRMS
AS

STOCK

PRICE

INVESTMENT
DECISIONS,

IS

DEPENDENT

DECISIONS,
AND

EXTERNAL

ON

FINANCING
FACTORS,

INCLUDING LEGAL CONSTRAINTS, THE GENERAL LEVEL OF ECONOMIC ACTIVITY,

TAX LAWS, AND CONDITIONS IN THE STOCK MARKET.

MANAGERS CAN ENHANCE

THEIR FIRMS VALUE (AND ITS STOCK PRICE) BY INCREASING THEIR FIRMS
EXPECTED

CASH

FLOWS,

SPEEDING

UP

CASH

FLOWS,

AND

REDUCING

THEIR

RISKINESS.

Harcourt, Inc.

Computer/Internet Applications: 1 - 13

I.

WHAT FACTORS AFFECT THE LEVEL AND RISKINESS OF CASH FLOWS?

ANSWER:

[SHOW

S1-16

HERE.]

MANAGERIAL

ACTIONS,

SUCH

AS

INVESTMENT

DECISIONS, FINANCING DECISIONS, AND DIVIDEND POLICY DECISIONS AFFECT

THE LEVEL, TIMING, AND THE RISKINESS OF THE FIRMS CASH FLOWS.