,Solution Manual & Test Bank for Financial Management
Theory & Practice 16th Edition by Eugene F.
Brigham
Chapter 1
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to do the following:
◆ Explain the role of finance and the different types of jobs in finance.
◆ Identify the advantages and disadvantages of different forms of business organization.
◆ Explain the links between stock price, intrinsic value, and executive compensation.
◆ Identify the potential conflicts that arise within the firm between stockholders and managers and
between stockholders and bondholders, and discuss the techniques that firms can use to mitigate these
potential conflicts.
◆ Discuss the importance of business ethics and the consequences of unethical behavior.
Chapter 1: An Overview of Financial Management Learning Objectives 1
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, 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 spend 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 briefly discuss 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 exam.
One point we emphasize in the first class is that students should print a copy of the PowerPoint
slides for each chapter covered and purchase 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. Students will need to learn
how to use their calculators before time value of money concepts are covered in Chapter 5. It is important
for students to grasp these concepts early as many of the remaining chapters build on the TVM 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-10BII+ or 17BII+. Please see the “Lecture Suggestions” for Chapter 5 for more on calculators.
2 Lecture Suggestions Chapter 1: An Overview of Financial Management
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Answers to End-of-Chapter Questions
1-1 A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return
data. It can be estimated but not measured precisely. A stock’s current price is its market price—
the value based on perceived but possibly incorrect information as seen by the marginal investor.
From these definitions, you can see that a stock’s “true” long-run value is more closely related to its
intrinsic value rather than its current price.
1-2 Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are
indifferent between buying and selling a stock. If a stock is in equilibrium then there is no
fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time,
most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium.
However, at times stock prices and equilibrium values are different, so stocks can be temporarily
undervalued or overvalued. Investor optimism and pessimism, along with imperfect knowledge
about the true intrinsic value, leads to deviations between the actual prices and intrinsic values.
1-3 If the three intrinsic value estimates for Stock X were different, you would have the most
confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different
analysts with different data and different views of the future will form different estimates of the
intrinsic value for any given stock. However, a firm’s managers have the best information about
the company’s future prospects, so managers’ estimates of intrinsic value are generally better than
the estimates of outside investors.
1-4 If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is
no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two
be equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximize
the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the
average price over the long run but not necessarily the current price at each point in time. So,
stockholders in general would probably expect the firm’s market price to be under the intrinsic
value—realizing that if management is doing its job that current price at any point in time would
not necessarily be maximized. However, the CEO would prefer that the market price be high—
since it is the current price that he will receive when exercising his stock options. In addition, he
will be retiring after exercising those options, so there will be no repercussions to him (with respect
to his job) if the market price drops—unless he did something illegal during his tenure as CEO.
1-5 The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded based on the
stock’s performance over the long run, not the stock’s price on an option exercise date. This
means that options (or direct stock awards) should be phased in over several years so the CEO will
have an incentive to keep the stock price high over time. If the intrinsic value could be measured
in an objective and verifiable manner, then performance pay could be based on changes in intrinsic
value. However, it is easier to measure the growth rate in reported profits than the intrinsic value,
although reported profits can be manipulated through aggressive accounting procedures and
intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must
be based on the stock’s market price—but the price used should be an average over time rather
than on a specific date.
1-6 The different forms of business organization are proprietorships, partnerships, corporations, and
limited liability corporations and partnerships. The advantages of the first two include the ease and
Chapter 1: An Overview of Financial Management Answers and Solutions 3
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Theory & Practice 16th Edition by Eugene F.
Brigham
Chapter 1
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to do the following:
◆ Explain the role of finance and the different types of jobs in finance.
◆ Identify the advantages and disadvantages of different forms of business organization.
◆ Explain the links between stock price, intrinsic value, and executive compensation.
◆ Identify the potential conflicts that arise within the firm between stockholders and managers and
between stockholders and bondholders, and discuss the techniques that firms can use to mitigate these
potential conflicts.
◆ Discuss the importance of business ethics and the consequences of unethical behavior.
Chapter 1: An Overview of Financial Management Learning Objectives 1
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, 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 spend 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 briefly discuss 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 exam.
One point we emphasize in the first class is that students should print a copy of the PowerPoint
slides for each chapter covered and purchase 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. Students will need to learn
how to use their calculators before time value of money concepts are covered in Chapter 5. It is important
for students to grasp these concepts early as many of the remaining chapters build on the TVM 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-10BII+ or 17BII+. Please see the “Lecture Suggestions” for Chapter 5 for more on calculators.
2 Lecture Suggestions Chapter 1: An Overview of Financial Management
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Answers to End-of-Chapter Questions
1-1 A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return
data. It can be estimated but not measured precisely. A stock’s current price is its market price—
the value based on perceived but possibly incorrect information as seen by the marginal investor.
From these definitions, you can see that a stock’s “true” long-run value is more closely related to its
intrinsic value rather than its current price.
1-2 Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are
indifferent between buying and selling a stock. If a stock is in equilibrium then there is no
fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time,
most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium.
However, at times stock prices and equilibrium values are different, so stocks can be temporarily
undervalued or overvalued. Investor optimism and pessimism, along with imperfect knowledge
about the true intrinsic value, leads to deviations between the actual prices and intrinsic values.
1-3 If the three intrinsic value estimates for Stock X were different, you would have the most
confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different
analysts with different data and different views of the future will form different estimates of the
intrinsic value for any given stock. However, a firm’s managers have the best information about
the company’s future prospects, so managers’ estimates of intrinsic value are generally better than
the estimates of outside investors.
1-4 If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is
no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two
be equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximize
the firm’s intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the
average price over the long run but not necessarily the current price at each point in time. So,
stockholders in general would probably expect the firm’s market price to be under the intrinsic
value—realizing that if management is doing its job that current price at any point in time would
not necessarily be maximized. However, the CEO would prefer that the market price be high—
since it is the current price that he will receive when exercising his stock options. In addition, he
will be retiring after exercising those options, so there will be no repercussions to him (with respect
to his job) if the market price drops—unless he did something illegal during his tenure as CEO.
1-5 The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded based on the
stock’s performance over the long run, not the stock’s price on an option exercise date. This
means that options (or direct stock awards) should be phased in over several years so the CEO will
have an incentive to keep the stock price high over time. If the intrinsic value could be measured
in an objective and verifiable manner, then performance pay could be based on changes in intrinsic
value. However, it is easier to measure the growth rate in reported profits than the intrinsic value,
although reported profits can be manipulated through aggressive accounting procedures and
intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must
be based on the stock’s market price—but the price used should be an average over time rather
than on a specific date.
1-6 The different forms of business organization are proprietorships, partnerships, corporations, and
limited liability corporations and partnerships. The advantages of the first two include the ease and
Chapter 1: An Overview of Financial Management Answers and Solutions 3
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
