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 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 accept an investment project 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,
The Financial Manager and the Firm
Before You Go On Questions and Answers
Section 1.1
1. What are the three most basic 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 accept an investment project 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,
