Chapter 1
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to do the following:
◆ 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.
◆ 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.
◆ Discuss the importance of business ethics and the consequences of unethical behavior.
,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
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 56 DAYS (50-minute periods)
,Answers to End-of-Chapter Questions
1-1 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.
1-2 Equilibrium is the situation where the actual market price equals the intrinsic value, so
investors are indifferent between buying and 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. Investor optimism and
pessimism, along with imperfect knowledge about the true intrinsic value, leads to
deviations between the actual prices and intrinsic values.
1-3 If the three intrinsic value estimates for Stock X were different, you 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.
1-4 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.
1-5 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.
1-6 The different forms of business organization are 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 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.
1-7 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-
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to do the following:
◆ 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.
◆ 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.
◆ Discuss the importance of business ethics and the consequences of unethical behavior.
,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
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 56 DAYS (50-minute periods)
,Answers to End-of-Chapter Questions
1-1 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.
1-2 Equilibrium is the situation where the actual market price equals the intrinsic value, so
investors are indifferent between buying and 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. Investor optimism and
pessimism, along with imperfect knowledge about the true intrinsic value, leads to
deviations between the actual prices and intrinsic values.
1-3 If the three intrinsic value estimates for Stock X were different, you 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.
1-4 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.
1-5 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.
1-6 The different forms of business organization are 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 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.
1-7 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-
