Chapter 1
An Overview of Financial Management and
The Financial Environment
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization. That, in turn, means maximizing the PV of future free cash
flows.
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality. It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to
maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings. However, more debt means more risk. So, it’s necessary to
consider capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
dividends? The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals. It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society. However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so
on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
on businesses. That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
maximize profits. In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
, As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests. This point is discussed further below.
,1-2 See the model for quantitative answers to this question. All of these valuations involve
applications of the basic valuation model:
N
CFt
Value = .
t =0 (1 + r )
t
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the
maturity value, and N is the bond’s life. Other things held constant, the higher the going
interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs
are also high, and that increases the value of the bond. For a stock, the CFs are
dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in
essentially the same way. The Excel model goes into a little more detail on sensitivity
analysis. Much more comes later in the book.
1-3 The advantages of a corporate form of ownership are that investor liability is limited to
the amount invested, corporations can raise capital through public offerings of stock, and
ownership can be easily transferred from person to person by simply selling shares of
stock. In a sole proprietorship or partnership, on the other hand, the owner or owners are
exposed to potentially unlimited liability, it is difficult to raise equity capital since either
new partners must be found or the existing partners must put up additional capital, and it
is difficult to transfer ownership between partners or from a sole proprietor to someone
else.
The disadvantages of the corporate form are that there are numerous forms that must
be filled out and regulations that must be followed that are not required of a sole
proprietorship or a partnership, corporations are subject to double taxation of distributed
earnings in that the corporation first pays taxes on the pre-tax income, and then the
owners must pay tax on the dividend or capital gains income, and the separation of
ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
, 1-4 The cost of money is affected by (1) production opportunities, (2) the time preference for
consumption, (3) risk, and (4) inflation. When production opportunities are good, and assets are
earning high rates of return, then interest rates tend to be higher because there is a larger demand
for borrowing to finance these projects. Also, investors who are considering lending money
recognize that their alternative investments have a high return, and so demand a high return on
their investments. When investors have a strong preference for current consumption, then they
demand a higher return on their investments to compensate them for having to defer current
purchases, and so the cost of money is higher. Investors demand a higher rate of return on riskier
investments in order to compensate them for the having to be exposed to more risk, and when
investors expect future inflation, then the cost of money increases so that investment returns
better cover this future price increase.
If any of these factors change, then the cost of money will change, and hence the yield and
the price of a security will change as well. For example, if overall the time preference for
consumption increases, then overall interest rates will tend to increase and the yield on debt
instruments will tend to increase, and their prices will fall. If the underlying level of inflation
declines, as it did through the 1990s, then interest rates on debt instruments will decline, driving
up their prices. On the other hand, if a company experiences financial problems, increasing the
likelihood of default and bankruptcy and becoming more risky, then the yield on its bonds will
increase and their prices will fall.
1-5 Securitization is the process by which assets, such as mortgages held by banks, accounts
receivables held by companies, or credit card obligations held by banks and finance companies,
are packaged together and sold to investors. In the case of mortgages, a bank or savings and loan
(S&L) may have a portfolio of mortgages that it has originated (or issued). Typically, a bank will
have financed these mortgages with savings and checking account deposits and CDs and once it
has used up its loanable funds, it must either stop making new loans, or raise more funds if it
wants to make more loans. If the bank packages these mortgages and sells them to investors, then
it can make more loans with the funds it receives. The idea is that bank acts as an intermediary in
this case, analyzing credit and making loans, and then selling them off so it can make more loans;
consumers get more loans, and banks get to do what they (supposedly) do best, which is to
analyze risk and originate loans.
An Overview of Financial Management and
The Financial Environment
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization. That, in turn, means maximizing the PV of future free cash
flows.
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality. It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to
maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings. However, more debt means more risk. So, it’s necessary to
consider capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
dividends? The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals. It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society. However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so
on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
on businesses. That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
maximize profits. In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
, As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests. This point is discussed further below.
,1-2 See the model for quantitative answers to this question. All of these valuations involve
applications of the basic valuation model:
N
CFt
Value = .
t =0 (1 + r )
t
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the
maturity value, and N is the bond’s life. Other things held constant, the higher the going
interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs
are also high, and that increases the value of the bond. For a stock, the CFs are
dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in
essentially the same way. The Excel model goes into a little more detail on sensitivity
analysis. Much more comes later in the book.
1-3 The advantages of a corporate form of ownership are that investor liability is limited to
the amount invested, corporations can raise capital through public offerings of stock, and
ownership can be easily transferred from person to person by simply selling shares of
stock. In a sole proprietorship or partnership, on the other hand, the owner or owners are
exposed to potentially unlimited liability, it is difficult to raise equity capital since either
new partners must be found or the existing partners must put up additional capital, and it
is difficult to transfer ownership between partners or from a sole proprietor to someone
else.
The disadvantages of the corporate form are that there are numerous forms that must
be filled out and regulations that must be followed that are not required of a sole
proprietorship or a partnership, corporations are subject to double taxation of distributed
earnings in that the corporation first pays taxes on the pre-tax income, and then the
owners must pay tax on the dividend or capital gains income, and the separation of
ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
, 1-4 The cost of money is affected by (1) production opportunities, (2) the time preference for
consumption, (3) risk, and (4) inflation. When production opportunities are good, and assets are
earning high rates of return, then interest rates tend to be higher because there is a larger demand
for borrowing to finance these projects. Also, investors who are considering lending money
recognize that their alternative investments have a high return, and so demand a high return on
their investments. When investors have a strong preference for current consumption, then they
demand a higher return on their investments to compensate them for having to defer current
purchases, and so the cost of money is higher. Investors demand a higher rate of return on riskier
investments in order to compensate them for the having to be exposed to more risk, and when
investors expect future inflation, then the cost of money increases so that investment returns
better cover this future price increase.
If any of these factors change, then the cost of money will change, and hence the yield and
the price of a security will change as well. For example, if overall the time preference for
consumption increases, then overall interest rates will tend to increase and the yield on debt
instruments will tend to increase, and their prices will fall. If the underlying level of inflation
declines, as it did through the 1990s, then interest rates on debt instruments will decline, driving
up their prices. On the other hand, if a company experiences financial problems, increasing the
likelihood of default and bankruptcy and becoming more risky, then the yield on its bonds will
increase and their prices will fall.
1-5 Securitization is the process by which assets, such as mortgages held by banks, accounts
receivables held by companies, or credit card obligations held by banks and finance companies,
are packaged together and sold to investors. In the case of mortgages, a bank or savings and loan
(S&L) may have a portfolio of mortgages that it has originated (or issued). Typically, a bank will
have financed these mortgages with savings and checking account deposits and CDs and once it
has used up its loanable funds, it must either stop making new loans, or raise more funds if it
wants to make more loans. If the bank packages these mortgages and sells them to investors, then
it can make more loans with the funds it receives. The idea is that bank acts as an intermediary in
this case, analyzing credit and making loans, and then selling them off so it can make more loans;
consumers get more loans, and banks get to do what they (supposedly) do best, which is to
analyze risk and originate loans.
