CHAPTER 1

THE ROLE AND OBJECTIVE OF

FINANCIAL MANAGEMENT
ANSWERS TO QUESTIONS:
1. Shareholder wealth is defined as the present value of the expected future returns to the owners
(that is, shareholders) of the firm. These returns can take the form of periodic dividend payments
and/or proceeds from the sale of the stock. Shareholder wealth is measured by the market value
(that is, the price that the stock trades in the marketplace) of the firms common stock.
!. Profit maximization typically is defined as a more static concept than shareholder wealth
maximi"ation. The profit maximi"ation ob#ective from economic theory does not normally
consider the time dimension or the risk dimension in the measurement of profits. $n contrast, the
shareholder wealth maximi"ation ob#ective provides a convenient framework for evaluatin% both
the timin% and the risks associated with various investment and financin% strate%ies.
The mar%inal decision rules derived from economic theory are extremely useful to a wealth
maximi"in% firm. &ny decision, either in the short run or the lon% run, that results in mar%inal
revenues exceedin% the mar%inal costs of the decision will be consistent with wealth
maximi"ation. 'hen a decision has conse(uences extendin% beyond a year in time, the mar%inal
benefits and mar%inal costs of that decision must be evaluated in a present value framework.
). & closely held firm is more likely to be a wealth maximi"er than a corporation with wide
ownership. $n the closely held firm, the owners and the mana%ers will share the same ob#ectives
because the owners are the mana%ers. $n a widely*held corporation, where the ownership and
mana%ement functions are separate, it is likely that mana%ers may pursue ob#ectives that are more
self*servin% than owner*servin%. +xamples of alternative ob#ectives that mi%ht be pursued in this
situation are extreme risk*averse behavior, si"e maximi"ation, satisficin%, or personal utility
function maximi"ation. & more complete discussion of alternative ob#ectives may be found in
,c-ui%an, ,oyer, and .arris, Managerial Economics, /th edition (South*'estern, l000),
1hapter l.
2. The %oal of shareholder wealth maximi"ation is a lon%*term %oal. Shareholder wealth is a
function of all the future returns to the shareholders. .ence, in makin% decisions that maximi"e
shareholder wealth, mana%ement must consider the lon%*run impact on the firm and not #ust focus
on short*run (i.e., current period) effects. 3or example, a firm could increase short*run earnin%s
and dividends by eliminatin% all research and development expenditures. .owever, this decision
would reduce lon%*run earnin%s and dividends, and hence shareholder wealth, because the firm
would be unable to develop new products to produce and sell.
4. +n%a%in% in social responsibility activities can be #ustified on the basis that these activities help to
create an environment in which the %oal of shareholder wealth maximi"ation more easily can be
pursued.
1
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>. The separation of ownership and control in corporations may result in mana%ement pursuin%
%oals other than shareholder wealth maximi"ation, such as maximi"ation of their own personal
welfare (utility). 1oncern for their own self*interests may lead mana%ement to make decisions
that promote their lon%*run survival (#ob security), such as minimi"in% (or limitin%) the amount of
risk incurred by the firm.
?. &n agency relationship occurs when one or more individuals (the principals) hire another
individual (the a%ent) to perform a service on behalf of the principals. Two of the most important
a%ency relationships in finance are between the stockholders (principals) and mana%ement
(a%ent), and between the owners (a%ents) and creditors (principals). Agency costs are incurred
when attemptin% to control a%ency problems. Agency problems arise when the a%ent makes
decisions consistent with the maximi"ation of his or her own utility rather than the maximi"ation
of the utility of the principals.
/. +xamples of a%ency costs incurred by shareholders include

@ +xpenditures to structure the or%ani"ation in a way that will minimi"e the incentives for
mana%ement to take actions contrary to shareholder interests, such as providin% a portion of
compensation in the form of the stock in the company .
@ +xpenditures to monitor mana%ements performance, such as internal and external audits.
@ ;ondin% expenditures to protect a%ainst mana%erial dishonesty.
@ 8ost profits (opportunity costs) of complex or%ani"ational structures.
0. 1reditors (the principal) have a fixed financial claim on the resources of the firm whereas owners
(a%ents) have a residual claim on the firms resources. &s a conse(uence, owners may attempt to
increase the riskiness of the firms investments in hopes of earnin% hi%her returns. 1reditors suffer
from this type of behavior because they do not have an opportunity to share in these hi%her
potential returns, yet they suffer from the increased risk.
1A. The controller usually has responsibility for all accountin% related functions, such as financial
accountin%, cost accountin%, and accountin% information systems. The treasurer normally has
responsibility for the ac(uisition, custody, and expenditure of funds, includin% cash and
marketable securities mana%ement, capital bud%etin% analysis, financial, and pension fund
mana%ement, and financial plannin%. ;ecause not all companies divide the responsibilities in this
manner, the actual functions performed by the controller and treasurer will vary from company to
company.
11. a 3inancial mana%ement employs the mar%inal revenue ** mar%inal cost relationships of
microeconomics in makin% lon%*term investment (capital bud%etin%) decisions and short*term
investment (workin% capital) decisions.
b. 3inancial mana%ement re(uires an understandin% of macroeconomic concepts dealin% with
monetary and fiscal policy. Bnowled%e of these concepts is necessary in makin% company
sales forecasts and in raisin% funds in the money and capital markets.
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1!. +arnin%s per share fi%ures can be misleadin% because factors such as (1) reductions in the number
of sharesC (!) a decline in the return bein% earned on the companys e(uityC and ()) an increase in
the risk of the firm, all could lead to increased earnin%s per share, but not necessarily to an
increase in the value of the firms shares in the marketplace.
1). The bondholders in the 6<6 9abisco takeover case wanted to block the transaction because the
takeover was to be financed with substantial increases in the amount of debt, and therefore
increases in the risk of default. The case of the bondholders was re#ected in the courts because, it
was ar%ued, these knowled%eable investors knew they were exposed to this type of event risk
when they purchased the bonds, and presumably were compensated for the expected risk in the
form of the risk premium earned on the bonds.
12. The three ma#or factors that determine the market value of a firms stock are (1) the amount of the
cash flows expected to be %enerated for the benefit of stockholdersC (!) the timin% of these cash
flowsC and ()) the risk of the cash flows.
14. The net present value of an investment represents the contribution of that investment to the value
of the firm and, accordin%ly, to the wealth of shareholders. Thus, net present value is a decision
criterion that assists mana%ers in achievin% the ob#ective of shareholder wealth maximi"ation.
1>. The marketDs reaction may have reflected (1) an expectation that there would ultimately be a
splittin% up and spinoff of the natural resources business from the steel business, thereby assurin%
that cash flows %enerated by ,arathon 7il would not be wasted on reinvestment in the low return
steel businessC or (!) the potential that this separation would make it more difficult for the steel
se%ment of ESF to tap the cash flows of ,arathon 7il.
1?. ;y declarin% bankruptcy, 5olaroid hoped to protect itself from the claims of creditors while it
sou%ht a way to either sell or restructure its assets. 5resumably, the mana%ement at 5olaroid
thou%ht that the bankruptcy declaration would provide it with an opportunity to restructure itself,
while it was protected from the pressures of makin% burdensome interest and other payments to
creditors.
1/. 3irms that expect their employees to act accordin% to a hi%h standard of ethical behavior can
expect to experience lower liti%ation costs. 1ustomers, suppliers, and investors can be expected to
value a firm committed to maintainin% hi%h ethical standards in the conduct of its business, and
thereby build lon%*term loyalties and business relationships.
10. Sole proprietorships are characteri"ed by the virtual non*existence of a%ency problems between
owners and mana%ers, because the owner and mana%er are usually one and the same. 7f course,
there still is the potential a%ency conflict between creditors and owners. .owever, even in this
case the risk to creditors is reduced because the owner has unlimited personal liability for the
debts of the firm. The ma#or shortcomin% of the proprietorship form of or%ani"ation is the limited
ability of the owner to raise capital, because the owner is the sole source of e(uity and the owner
is personally liable for all of the firms debts.
Partnerships provide a %reater potential for raisin% capital because there is more than one owner*
mana%er. The capital raisin% potential of partnerships is limited to the number of partners of the
firm. 7wner*mana%er a%ency problems assume increased importance in a partnership because
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each partner only bears a fractional portion of the cost of his/her actions. .ence, if a partner
consumes excessive per(uisites, the partner will only pay a fractional share of the cost of this
wasteful behavior. The lar%er the partnership, the %reater is this potential problem.
Corporations have the %reatest potential for owner*mana%er a%ency problems because of the
separation of ownership from control. 7ffsettin% this corporate disadvanta%e is the nearly
unlimited ability of corporations to raise capital, both debt and e(uity. The capital raisin% ability
of corporations can be attributed lar%ely to the limited liability feature of common stock
ownership.
This limited liability feature %ives rise to increased a%ency cost problems between owners and
creditors.