Finance Review BUS 3360

CHAPTER 1 1.1. Problems with using profit maximization as the goal of the firm? How does the goal of maximization of shareholder wealth deal with those problems? (a) Microeconomists usually assign profit maximization as a theoretical goal, which ignores real life problems such as uncertainty and timing. Microeconomic theory doesn’t address risk in a way that measures the risk of one project over another, but risk is immediately tied to returns; thus, this theoretical approach can lead to improper decision making. Profit maximization also ignores the timing of project returns, by tending toward immediate over long-term financial revenues or vice versa. (b) Maximization of shareholder wealth is maximization of the market value of the existing shareholders’ common stock. It modifies the goal of profit maximization to deal with the complexities of the operating environment, because the effects of all financial decisions are thereby included. This approach focuses decisions on what the stock price should be if everything else— market, economy, politics, etc.—were held constant. (Shareholders are the legal owners of the firm.) 1.2. Compare and contrast the goals of profit maximization and maximization of shareholder wealth PM: increase profits; focuses on profits for a discrete period in time, rather than other factors that might contribute to the value of the company; can be detrimental to the company in the future MSW: increase price of stock; takes into account more of the cause-and-effect relationship between decisions and company benefit; more secure for company in short- and long-term; takes into account the operating environment 1.3. Do projects that do not directly result in profits contradict the goal of maximization of shareholder wealth? Why or why not? No, because shareholder wealth is not tied to profits; rather, it is tied to the value/price of the stock. Supporting programs such as PBS is esteemed by some investors, encouraging investment in the stock and, thusly, the price of the stock. Also, depending on the program, the company’s patronage may contribute to the company’s publicity and public interest in the stock. 1.4. Relationship between financial decision making and risk and return? Would all financial managers view risk-return trade-offs similarly? (a) The risk-return relationship is crucial to financial decision making; because investors expect a greater return for the greater risks in their investment, financial managers must consider the