Chapter 1
The Financial Manager and the Firm
Before You Go On Questions and Answers
Section 1.1
1. What are the three most basic types of financial decisions managers must make?
The three most basic decisions each business must make are the capital budgeting decision, the
financing decision, and the working capital management decision. These decisions determine which
productive assets to buy, how to pay for or finance these purchases, and how to manage the day-to-
day financial matters so the company can pay its bills.
2. Explain why you would make an investment if the value of the expected cash flows exceeds the
cost of the project.
You would accept an investment project whose cash flows exceed the cost of the project because such
projects will increase the value of the firm, making the owners wealthier. Most people start a business
to increase their wealth.
1. Why are capital budgeting decisions among the most important decisions in the life of a firm?
The capital budgeting decisions are considered the most important in the life of the firm because these
decisions determine which productive assets the firm purchases and these assets generate most of the
firm’s cash flows. Furthermore, capital decisions are long-term decisions and if you make a mistake
in selecting a productive asset, you are stuck with the decision for a long time.
,Section 1.2
1. Why are many businesses operated as sole proprietorships or partnerships?
Many businesses elect to operate as sole proprietorships or partnerships because of the small
operating scale and capital base of their firms. Both of these forms of business organization are fairly
easy to start and impose few regulations on the owners.
2. What are some advantages and disadvantages of operating as a public corporation?
The main advantages of operating as a public corporation are the access to the public securities
markets, which makes it easier to raise large amounts of capital, and the ease of ownership transfer.
All the shareholders have to do is to call their broker to buy or sell shares of stock. And because a
public corporation usually has many shares outstanding, large blocks of securities can be purchased or
sold without an appreciable impact on the price of the stock. The major disadvantage of corporations
is the tax situation. Not only must the corporation pay taxes on its income, but the owners of the
corporation get taxed again when dividends are paid to them. This is referred to as double taxation.
3. Explain why professional partnerships such as physicians’ groups organize as limited liability
partnerships.
Professional partnerships such as physicians’ groups desire to organize as limited liability
partnerships (LLPs) to take advantage of the tax arrangements of partnerships combined with the
advantages of the limited liability of a corporation. By operating as an LLP, the partnership is able to
avoid a potential financial disaster resulting from the misconduct of one partner.
Section 1.3
1. What are the major responsibilities of the CFO?
, The major responsibilities of a CFO are recommendation and financial analysis of financial decisions.
Although all top managers in a firm participate in these decisions, the final report and analysis is
ultimately the responsibility of the CFO.
2. Identify three financial officers who typically report to the CFO and describe their duties.
The financial officers discussed in the chapter who report to the CFO are the controller, the treasurer,
and the internal auditor. The controller is the firm’s chief accounting officer, and thus prepares the
financial statements and taxes. This position also requires close cooperation with the external
auditors. The treasurer’s responsibility is the collection and disbursement of cash, investing excess
cash, raising new capital, handling foreign exchange, and overseeing the company’s pension fund
management. He also assists the CFO in handling important Wall Street relationships. Finally, the
internal auditor is responsible for conducting risk assessment and for performing audits of high-risk
areas.
3. Why does the internal auditor report to both the CFO and the board of directors?
The internal auditor reports to the CFO on a day-to-day basis but is ultimately accountable for
reporting any accounting irregularities to the board of directors. The dual reporting system serves as a
check to ensure that there are no discrepancies in the company’s financial statements.
Section 1.4
1. Why is profit maximization an unsatisfactory goal for managing a firm?
Profit maximization is not a satisfactory goal when managing a firm because it is rather difficult to
define profits since accountants can apply and interpret the same accounting principles differently.
Also, profit maximization does not define the size, the uncertainty, and the timing of cash flows; it
ignores the time value of money concept.
, 2. Explain why maximizing the current market price of a firm’s stock is an appropriate goal for
the firm’s management.
Maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s
management because it is an unambiguous objective and it is easy to measure. One can simply look at
the value of the company’s stock on any given day to determine whether it went up or down.
3. What is the fundamental determinant of an asset’s value?
The fundamental determinant of an asset’s value is the future cash flow the asset is expected to
generate. Other factors that may help determine the price of an asset are internal decisions, such as the
company’s expansion strategy, as well as external stimulants, such as the state of the economy.
Section 1.5
1. What are agency conflicts?
An agency conflict occurs when the goals of the principals are not aligned with the goals of the
agents. Management is often more concerned with pursuing its own self-interest, and so the
maximization of shareholder value is pushed to the side.
2. What are corporate raiders?
Corporate raiders can make the economy more efficient by keeping the top managers on their toes.
Top managers know that if the company’s performance declines and its stock slips, it makes itself
vulnerable to takeovers by corporate raiders who are just waiting to temporarily acquire a company,
turn it around, and sell it for profit. Therefore, the role of the corporate raiders in the economy is
twofold: first, the fear of takeovers pushes managers to do a better job, and second, if the managers
are not performing up to expectations, the company can be rescued and restructured into a contributor
again.
The Financial Manager and the Firm
Before You Go On Questions and Answers
Section 1.1
1. What are the three most basic types of financial decisions managers must make?
The three most basic decisions each business must make are the capital budgeting decision, the
financing decision, and the working capital management decision. These decisions determine which
productive assets to buy, how to pay for or finance these purchases, and how to manage the day-to-
day financial matters so the company can pay its bills.
2. Explain why you would make an investment if the value of the expected cash flows exceeds the
cost of the project.
You would accept an investment project whose cash flows exceed the cost of the project because such
projects will increase the value of the firm, making the owners wealthier. Most people start a business
to increase their wealth.
1. Why are capital budgeting decisions among the most important decisions in the life of a firm?
The capital budgeting decisions are considered the most important in the life of the firm because these
decisions determine which productive assets the firm purchases and these assets generate most of the
firm’s cash flows. Furthermore, capital decisions are long-term decisions and if you make a mistake
in selecting a productive asset, you are stuck with the decision for a long time.
,Section 1.2
1. Why are many businesses operated as sole proprietorships or partnerships?
Many businesses elect to operate as sole proprietorships or partnerships because of the small
operating scale and capital base of their firms. Both of these forms of business organization are fairly
easy to start and impose few regulations on the owners.
2. What are some advantages and disadvantages of operating as a public corporation?
The main advantages of operating as a public corporation are the access to the public securities
markets, which makes it easier to raise large amounts of capital, and the ease of ownership transfer.
All the shareholders have to do is to call their broker to buy or sell shares of stock. And because a
public corporation usually has many shares outstanding, large blocks of securities can be purchased or
sold without an appreciable impact on the price of the stock. The major disadvantage of corporations
is the tax situation. Not only must the corporation pay taxes on its income, but the owners of the
corporation get taxed again when dividends are paid to them. This is referred to as double taxation.
3. Explain why professional partnerships such as physicians’ groups organize as limited liability
partnerships.
Professional partnerships such as physicians’ groups desire to organize as limited liability
partnerships (LLPs) to take advantage of the tax arrangements of partnerships combined with the
advantages of the limited liability of a corporation. By operating as an LLP, the partnership is able to
avoid a potential financial disaster resulting from the misconduct of one partner.
Section 1.3
1. What are the major responsibilities of the CFO?
, The major responsibilities of a CFO are recommendation and financial analysis of financial decisions.
Although all top managers in a firm participate in these decisions, the final report and analysis is
ultimately the responsibility of the CFO.
2. Identify three financial officers who typically report to the CFO and describe their duties.
The financial officers discussed in the chapter who report to the CFO are the controller, the treasurer,
and the internal auditor. The controller is the firm’s chief accounting officer, and thus prepares the
financial statements and taxes. This position also requires close cooperation with the external
auditors. The treasurer’s responsibility is the collection and disbursement of cash, investing excess
cash, raising new capital, handling foreign exchange, and overseeing the company’s pension fund
management. He also assists the CFO in handling important Wall Street relationships. Finally, the
internal auditor is responsible for conducting risk assessment and for performing audits of high-risk
areas.
3. Why does the internal auditor report to both the CFO and the board of directors?
The internal auditor reports to the CFO on a day-to-day basis but is ultimately accountable for
reporting any accounting irregularities to the board of directors. The dual reporting system serves as a
check to ensure that there are no discrepancies in the company’s financial statements.
Section 1.4
1. Why is profit maximization an unsatisfactory goal for managing a firm?
Profit maximization is not a satisfactory goal when managing a firm because it is rather difficult to
define profits since accountants can apply and interpret the same accounting principles differently.
Also, profit maximization does not define the size, the uncertainty, and the timing of cash flows; it
ignores the time value of money concept.
, 2. Explain why maximizing the current market price of a firm’s stock is an appropriate goal for
the firm’s management.
Maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s
management because it is an unambiguous objective and it is easy to measure. One can simply look at
the value of the company’s stock on any given day to determine whether it went up or down.
3. What is the fundamental determinant of an asset’s value?
The fundamental determinant of an asset’s value is the future cash flow the asset is expected to
generate. Other factors that may help determine the price of an asset are internal decisions, such as the
company’s expansion strategy, as well as external stimulants, such as the state of the economy.
Section 1.5
1. What are agency conflicts?
An agency conflict occurs when the goals of the principals are not aligned with the goals of the
agents. Management is often more concerned with pursuing its own self-interest, and so the
maximization of shareholder value is pushed to the side.
2. What are corporate raiders?
Corporate raiders can make the economy more efficient by keeping the top managers on their toes.
Top managers know that if the company’s performance declines and its stock slips, it makes itself
vulnerable to takeovers by corporate raiders who are just waiting to temporarily acquire a company,
turn it around, and sell it for profit. Therefore, the role of the corporate raiders in the economy is
twofold: first, the fear of takeovers pushes managers to do a better job, and second, if the managers
are not performing up to expectations, the company can be rescued and restructured into a contributor
again.
