CERTIFIE
Chapter 1
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to:
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.
Discuss the importance of business ethics and the consequences of unethical behavior.
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.
Chapter 1: An Overview of Financial Management Learning Objectives 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 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 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 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 mid-term 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.
DAYS ON CHAPTER: 1 OF 58 DAYS (50-minute periods)
, Answers to End-of-Chapter Questions
1-1 When you purchase a stock, you expect to receive dividends plus capital gains. Not all
stocks pay dividends immediately, but those corporations that do, typically pay
dividends quarterly. Capital gains (losses) are received when the stock is sold. Stocks
are risky, so you would not be certain that your expectations would be met—as you
would if you had purchased a U.S. Treasury security, which offers a guaranteed
payment every 6 months plus repayment of the purchase price when the security
matures.
1-2 If investors are more confident that Company A’s cash flows will be closer to their
expected value than Company B’s cash flows, then investors will drive the stock price
up for Company A. Consequently, Company A will have a higher stock price than
Company B.
1-3 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.
1-4 Equilibrium is the situation where the actual market price equals the intrinsic value, so
investors are indifferent between buying or 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.
1-5 If the three intrinsic value estimates for Stock X were different, I 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.
1-6 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.
Chapter 2: Financial Markets and Institutions Learning Objectives 7
, 1-7 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 on the basis of 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 a number of 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.
1-8 The four forms of business organization are sole proprietorships, partnerships,
corporations, and limited liability corporations and partnerships. The advantages of
the first two include the ease and low cost of formation. The advantages of
corporations include limited liability, indefinite life, ease of ownership transfer, and
access to capital markets. Limited liability companies and partnerships have limited
liability like corporations.
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 time-
consuming. Among the disadvantages of limited liability corporations and partnerships
are difficulty in raising capital and the complexity of setting them up.
1-9 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.
1-10 Useful motivational tools that will aid in aligning stockholders’ and management’s
interests include: (1) reasonable compensation packages, (2) direct intervention by
shareholders, including firing managers who don’t perform well, and (3) the threat of
takeover.
The compensation package should be sufficient to attract and retain able managers
but not go beyond what is needed. Also, compensation packages should be structured
so that managers are rewarded on the basis of 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 a number of years so managers will have an
incentive to keep the stock price high over time. 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.
Stockholders can intervene directly with managers. Today, the majority of stock is
owned by institutional investors and these institutional money managers have the
Chapter 2: Financial Markets and Institutions Learning Objectives 8
Chapter 1
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to:
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.
Discuss the importance of business ethics and the consequences of unethical behavior.
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.
Chapter 1: An Overview of Financial Management Learning Objectives 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 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 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 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 mid-term 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.
DAYS ON CHAPTER: 1 OF 58 DAYS (50-minute periods)
, Answers to End-of-Chapter Questions
1-1 When you purchase a stock, you expect to receive dividends plus capital gains. Not all
stocks pay dividends immediately, but those corporations that do, typically pay
dividends quarterly. Capital gains (losses) are received when the stock is sold. Stocks
are risky, so you would not be certain that your expectations would be met—as you
would if you had purchased a U.S. Treasury security, which offers a guaranteed
payment every 6 months plus repayment of the purchase price when the security
matures.
1-2 If investors are more confident that Company A’s cash flows will be closer to their
expected value than Company B’s cash flows, then investors will drive the stock price
up for Company A. Consequently, Company A will have a higher stock price than
Company B.
1-3 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.
1-4 Equilibrium is the situation where the actual market price equals the intrinsic value, so
investors are indifferent between buying or 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.
1-5 If the three intrinsic value estimates for Stock X were different, I 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.
1-6 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.
Chapter 2: Financial Markets and Institutions Learning Objectives 7
, 1-7 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 on the basis of 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 a number of 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.
1-8 The four forms of business organization are sole proprietorships, partnerships,
corporations, and limited liability corporations and partnerships. The advantages of
the first two include the ease and low cost of formation. The advantages of
corporations include limited liability, indefinite life, ease of ownership transfer, and
access to capital markets. Limited liability companies and partnerships have limited
liability like corporations.
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 time-
consuming. Among the disadvantages of limited liability corporations and partnerships
are difficulty in raising capital and the complexity of setting them up.
1-9 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.
1-10 Useful motivational tools that will aid in aligning stockholders’ and management’s
interests include: (1) reasonable compensation packages, (2) direct intervention by
shareholders, including firing managers who don’t perform well, and (3) the threat of
takeover.
The compensation package should be sufficient to attract and retain able managers
but not go beyond what is needed. Also, compensation packages should be structured
so that managers are rewarded on the basis of 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 a number of years so managers will have an
incentive to keep the stock price high over time. 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.
Stockholders can intervene directly with managers. Today, the majority of stock is
owned by institutional investors and these institutional money managers have the
Chapter 2: Financial Markets and Institutions Learning Objectives 8
