INSTRUCTOR MANUAL
FUNDAMENTALS OF FINANCIAL MANAGEMENT
17TH EDITION
CHAPTER NO. 01: AN OVERVIEW OF FINANCIAL MANAGEMENT
TABLE OF CONTENTS
Learning Objectives
Lecture Suggestions
Answer to Self-Test Question
Answers to Questions
Answer to Financial Analytics Case
1-15 Pulling SEC Filings in Edgar
Case Solution
ANSWER TO SELF-TEST QUESTION
ST-1 Key Terms Define each of the following terms:
a. Sarbanes-Oxley Act
b. Proprietorship; partnership; corporation
c. S corporations; limited liability company (LLC); limited liability partnership (LLP)
d. Intrinsic value; market price
e. Marginal investor; equilibrium
f. Corporate governance
g. Corporate raiders; hostile takeover
h. Shareholder wealth maximization
i. Business ethics
j. Environmental, social, and governance (ESG) measures
Solutions:
a. Sarbanes-Oxley Act: A law passed by Congress that requires the CEO and CFO to
certify that their firms’ financial statements are accurate.
b. Proprietorship: An unincorporated business owned by one individual.
Partnership: An unincorporated business owned by two or more persons.
Corporation: A legal entity created by a state, separate and distinct from its owners
and managers, having unlimited life, easy transferability of ownership, and limited
liability.
, c. S corporations: A special designation that allows small businesses that meet
qualifications to be taxed as if they were a proprietorship or a partnership rather than
a corporation.
Limited liability company (LLC): A popular type of organization that is a hybrid
between a partnership and a corporation.
Limited liability partnership (LLP): Similar to an LLC but used for professional firms in
the fields of accounting, law, and architecture. It provides personal asset protection
from business debts and liabilities but is taxed as a partnership.
d. Intrinsic value: An estimate of a stock’s “true” value based on accurate risk and
return data. The intrinsic value can be estimated, but not measured precisely.
Market price: The stock value based on perceived but possibly incorrect information
as seen by the marginal investor.
e. Marginal investor: An investor whose views determine the actual stock price.
Equilibrium: The situation in which the actual market price equals the intrinsic value, so
investors are indifferent between buying and selling a stock.
f. Corporate governance: Establishment of rules and practices by Board of Directors to
ensure that managers act in shareholders’ interests while balancing the needs of
other key constituencies.
g. Corporate raiders: Individuals who target corporations for takeovers because they
are undervalued.
Hostile takeover: The acquisition of a company over the opposition of its management.
h. Shareholder wealth maximization: The primary financial goal for managers of publicly
owned companies implies that decisions should be made to maximize the long-run
value of the firm’s common stock.
i. Business ethics: A company’s attitude and conduct toward its employees, customers,
community, and stockholders.
j. Environmental, social, and governance (ESG) measures: Three main factors for
measuring social responsibility in a firm.
ANSWERS TO QUESTIONS
1-1 What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run
value more closely related to its intrinsic value or to its current price?
Solution:
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 When is a stock said to be in equilibrium? Why might a stock at any point in time not be
in equilibrium?
, Solution:
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, lead to deviations between the
actual prices and intrinsic values.
1-3 Suppose three honest individuals gave you their estimates of Stock X’s intrinsic value.
One person is your current roommate, the second person is a professional security
analyst with an excellent reputation on Wall Street, and the third person is Company X’s
CFO. If the three estimates differed, in which one would you have the most confidence?
Why?
Solution:
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 Is it better for a firm’s actual stock price in the market to be under, over, or equal to its
intrinsic value? Would your answer be the same from the standpoints of stockholders in
general and a CEO who is about to exercise a million dollars in options and then retire?
Explain.
Solution:
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 the 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 If a company’s board of directors wants management to maximize shareholder wealth,
should the CEO’s compensation be set as a fixed dollar amount, or should the
compensation depend on how well the firm performs? If it is to be based on
performance, how should performance be measured? Would it be easier to measure
, performance by the growth rate in reported profits or the growth rate in the stock’s
intrinsic value? Which would be the better performance measure? Why?
Solution:
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 based on 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 several 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 What are the various forms of business organization? What are the advantages and
disadvantages of each?
Solution:
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 the difficulty in raising capital and the complexity of setting them up.
1-7 Should stockholder wealth maximization be thought of as a long-term or a short-term
goal? For example, if one action increases a firm’s stock price from a current level of $20
to $25 in 6 months and then to $30 in 5 years, but another action keeps the stock at $20
for several years but then increases it to $40 in 5 years, which action would be better?
Think of some specific corporate actions that have these general tendencies.
FUNDAMENTALS OF FINANCIAL MANAGEMENT
17TH EDITION
CHAPTER NO. 01: AN OVERVIEW OF FINANCIAL MANAGEMENT
TABLE OF CONTENTS
Learning Objectives
Lecture Suggestions
Answer to Self-Test Question
Answers to Questions
Answer to Financial Analytics Case
1-15 Pulling SEC Filings in Edgar
Case Solution
ANSWER TO SELF-TEST QUESTION
ST-1 Key Terms Define each of the following terms:
a. Sarbanes-Oxley Act
b. Proprietorship; partnership; corporation
c. S corporations; limited liability company (LLC); limited liability partnership (LLP)
d. Intrinsic value; market price
e. Marginal investor; equilibrium
f. Corporate governance
g. Corporate raiders; hostile takeover
h. Shareholder wealth maximization
i. Business ethics
j. Environmental, social, and governance (ESG) measures
Solutions:
a. Sarbanes-Oxley Act: A law passed by Congress that requires the CEO and CFO to
certify that their firms’ financial statements are accurate.
b. Proprietorship: An unincorporated business owned by one individual.
Partnership: An unincorporated business owned by two or more persons.
Corporation: A legal entity created by a state, separate and distinct from its owners
and managers, having unlimited life, easy transferability of ownership, and limited
liability.
, c. S corporations: A special designation that allows small businesses that meet
qualifications to be taxed as if they were a proprietorship or a partnership rather than
a corporation.
Limited liability company (LLC): A popular type of organization that is a hybrid
between a partnership and a corporation.
Limited liability partnership (LLP): Similar to an LLC but used for professional firms in
the fields of accounting, law, and architecture. It provides personal asset protection
from business debts and liabilities but is taxed as a partnership.
d. Intrinsic value: An estimate of a stock’s “true” value based on accurate risk and
return data. The intrinsic value can be estimated, but not measured precisely.
Market price: The stock value based on perceived but possibly incorrect information
as seen by the marginal investor.
e. Marginal investor: An investor whose views determine the actual stock price.
Equilibrium: The situation in which the actual market price equals the intrinsic value, so
investors are indifferent between buying and selling a stock.
f. Corporate governance: Establishment of rules and practices by Board of Directors to
ensure that managers act in shareholders’ interests while balancing the needs of
other key constituencies.
g. Corporate raiders: Individuals who target corporations for takeovers because they
are undervalued.
Hostile takeover: The acquisition of a company over the opposition of its management.
h. Shareholder wealth maximization: The primary financial goal for managers of publicly
owned companies implies that decisions should be made to maximize the long-run
value of the firm’s common stock.
i. Business ethics: A company’s attitude and conduct toward its employees, customers,
community, and stockholders.
j. Environmental, social, and governance (ESG) measures: Three main factors for
measuring social responsibility in a firm.
ANSWERS TO QUESTIONS
1-1 What is a firm’s intrinsic value? Its current stock price? Is the stock’s “true” long-run
value more closely related to its intrinsic value or to its current price?
Solution:
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 When is a stock said to be in equilibrium? Why might a stock at any point in time not be
in equilibrium?
, Solution:
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, lead to deviations between the
actual prices and intrinsic values.
1-3 Suppose three honest individuals gave you their estimates of Stock X’s intrinsic value.
One person is your current roommate, the second person is a professional security
analyst with an excellent reputation on Wall Street, and the third person is Company X’s
CFO. If the three estimates differed, in which one would you have the most confidence?
Why?
Solution:
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 Is it better for a firm’s actual stock price in the market to be under, over, or equal to its
intrinsic value? Would your answer be the same from the standpoints of stockholders in
general and a CEO who is about to exercise a million dollars in options and then retire?
Explain.
Solution:
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 the 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 If a company’s board of directors wants management to maximize shareholder wealth,
should the CEO’s compensation be set as a fixed dollar amount, or should the
compensation depend on how well the firm performs? If it is to be based on
performance, how should performance be measured? Would it be easier to measure
, performance by the growth rate in reported profits or the growth rate in the stock’s
intrinsic value? Which would be the better performance measure? Why?
Solution:
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 based on 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 several 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 What are the various forms of business organization? What are the advantages and
disadvantages of each?
Solution:
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 the difficulty in raising capital and the complexity of setting them up.
1-7 Should stockholder wealth maximization be thought of as a long-term or a short-term
goal? For example, if one action increases a firm’s stock price from a current level of $20
to $25 in 6 months and then to $30 in 5 years, but another action keeps the stock at $20
for several years but then increases it to $40 in 5 years, which action would be better?
Think of some specific corporate actions that have these general tendencies.
