Chapter 1
An Overview of Financial Management and
The Financial Environment
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization. That, in turn, means maximizing the PV of future free cash
flows.
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality. It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to
maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings. However, more debt means more risk. So, it’s necessary to
consider capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
dividends? The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals. It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society. However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so
on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
on businesses. That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
maximize profits. In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests. This point is discussed further below.
Answers and Solutions: 1- 1
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
,1-2 See the model for quantitative answers to this question. All of these valuations involve
applications of the basic valuation model:
N
CFt
Value .
t 0 (1 r) t
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the
maturity value, and N is the bond’s life. Other things held constant, the higher the going
interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs
are also high, and that increases the value of the bond. For a stock, the CFs are
dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in
essentially the same way. The Excel model goes into a little more detail on sensitivity
analysis. Much more comes later in the book.
1-3 The advantages of a corporate form of ownership are that investor liability is limited to
the amount invested, corporations can raise capital through public offerings of stock, and
ownership can be easily transferred from person to person by simply selling shares of
stock. In a sole proprietorship or partnership, on the other hand, the owner or owners are
exposed to potentially unlimited liability, it is difficult to raise equity capital since either
new partners must be found or the existing partners must put up additional capital, and it
is difficult to transfer ownership between partners or from a sole proprietor to someone
else.
The disadvantages of the corporate form are that there are numerous forms that must
be filled out and regulations that must be followed that are not required of a sole
proprietorship or a partnership, corporations are subject to double taxation of distributed
earnings in that the corporation first pays taxes on the pre-tax income, and then the
owners must pay tax on the dividend or capital gains income, and the separation of
ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
1-4 The cost of money is affected by (1) production opportunities, (2) the time preference for
consumption, (3) risk, and (4) inflation. When production opportunities are good, and
assets are earning high rates of return, then interest rates tend to be higher because there
is a larger demand for borrowing to finance these projects. Also, investors who are
considering lending money recognize that their alternative investments have a high
return, and so demand a high return on their investments. When investors have a strong
preference for current consumption, then they demand a higher return on their
investments to compensate them for having to defer current purchases, and so the cost of
money is higher. Investors demand a higher rate of return on riskier investments in order
to compensate them for the having to be exposed to more risk, and when investors expect
future inflation, then the cost of money increases so that investment returns better cover
this future price increase.
Answers and Solutions: 1- 2
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, If any of these factors change, then the cost of money will change, and hence the
yield and the price of a security will change as well. For example, if overall the time
preference for consumption increases, then overall interest rates will tend to increase and
the yield on debt instruments will tend to increase, and their prices will fall. If the
underlying level of inflation declines, as it did through the 1990s, then interest rates on
debt instruments will decline, driving up their prices. On the other hand, if a company
experiences financial problems, increasing the likelihood of default and bankruptcy and
becoming more risky, then the yield on its bonds will increase and their prices will fall.
1-5 Securitization is the process by which assets, such as mortgages held by banks, accounts
receivables held by companies, or credit card obligations held by banks and finance
companies, are packaged together and sold to investors. In the case of mortgages, a bank
or savings and loan (S&L) may have a portfolio of mortgages that it has originated (or
issued). Typically, a bank will have financed these mortgages with savings and checking
account deposits and CDs and once it has used up its loanable funds, it must either stop
making new loans, or raise more funds if it wants to make more loans. If the bank
packages these mortgages and sells them to investors, then it can make more loans with
the funds it receives. The idea is that bank acts as an intermediary in this case, analyzing
credit and making loans, and then selling them off so it can make more loans; consumers
get more loans, and banks get to do what they (supposedly) do best, which is to analyze
risk and originate loans.
If a bank doesn’t securitize its loans and, instead, holds them on its books, then it can
be exposed to a lot of interest rate risk. Back in the 1980s, S&Ls were raising money with
short-term CDs and lending it out long-term as 30-year fixed-rate mortgages. When
interest rates skyrocketed, the interest they had to pay on the CDs increased dramatically,
but since the mortgages were fixed-rate, the interest income the S&Ls received didn’t
increase. This caused hundreds of S&Ls to go bankrupt, and cost the federal government,
and ultimately, the U.S. taxpayers, hundreds of billions of dollars. If, instead, S&Ls
securitized the loans, they would no longer be exposed to the interest rate risk since they
would have sold off the loans shortly after originating them. Of course, the interest rate
risk doesn’t go away! Instead, the investors in the securitized mortgages now receive the
fixed interest payments. If these investors have themselves financed the investment with
short-term borrowing, then they will be exposed to interest rate risk!
Answers and Solutions: 1- 3
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 1-6 Just like the Great Depression that preceded it 80 years earlier, the causes of the Global
Economic Crisis that began in 2007 and lasted through 2009 will likely be the subject of
vigorous debate for years to come. As an example of one small aspect of the crisis,
consider how securitized mortgages end up in retirement portfolios, and how a decline in
housing prices in, say Florida, can bankrupt investors half a world away: A mortgage
company makes a bunch of loans to homeowners in Florida; a bank securitizes these
loans and creates tranches consisting interest payments, principal payments, other
combinations of payments, and the various tranches have different seniority levels—
some get paid first, others are residual claimants; a ratings agency rates some of these
pools as investment grade, so pension funds and even individual investors can purchase
them; and Norwegian investors purchase some of these to hold in their retirement
accounts because they offer good rates of return and were highly rated by the ratings
agency.
Now consider what happens when housing prices stop growing and begin to decline
in Florida. Many of these loans were floating rate loans with low “teaser rates” initially,
but much higher “reset” rates after 1, 2, or 3 years. The idea was when the low teaser rate
expired the homeowner would either sell the house or refinance it, in either case paying
off the loan. Importantly, the homeowner never intended, and frequently simply could not
afford, to pay the much higher “reset” rate. But with housing prices declining, the
homeowner can’t sell the house for as much as the outstanding loan. And since the
appraised value declines too, the homeowner can’t refinance the house! That leaves only
two options: staying in the house and paying the much-higher mortgage payment, or
defaulting on the loan if the homeowner can’t pay the higher mortgage payments. Many
homeowners choose to default. This causes two apparently independent, but ultimately
related problems. First, this stops (or slows down) the cash flows to the Norwegian
retirees. Second, it places a foreclosure notice on the house. With lots of houses in
foreclosure, other housing prices fall as well, forcing more foreclosures, and more
defaults. This still further reduces the payments to the Norwegian retirees. The rating
agency, seeing this decline in cash flows, downgrades the investments, which drops it
below investment-grade, so pension funds have to sell them off, which causes declines in
their values, ultimately bankrupting the retirement fund if it had too many of these
mortgage backed securities in its portfolio.
Answers and Solutions: 1- 4
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
An Overview of Financial Management and
The Financial Environment
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization. That, in turn, means maximizing the PV of future free cash
flows.
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality. It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to
maximize the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use? The
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings. However, more debt means more risk. So, it’s necessary to
consider capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
dividends? The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals. It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society. However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
output. They might also pollute the air and water, engage in unfair labor practices, and so
on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
on businesses. That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
maximize profits. In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests. This point is discussed further below.
Answers and Solutions: 1- 1
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
,1-2 See the model for quantitative answers to this question. All of these valuations involve
applications of the basic valuation model:
N
CFt
Value .
t 0 (1 r) t
Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the
maturity value, and N is the bond’s life. Other things held constant, the higher the going
interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs
are also high, and that increases the value of the bond. For a stock, the CFs are
dividends, and for a capital budgeting project, they are operating cash flows.
The main point to get across with this question is that all assets are valued in
essentially the same way. The Excel model goes into a little more detail on sensitivity
analysis. Much more comes later in the book.
1-3 The advantages of a corporate form of ownership are that investor liability is limited to
the amount invested, corporations can raise capital through public offerings of stock, and
ownership can be easily transferred from person to person by simply selling shares of
stock. In a sole proprietorship or partnership, on the other hand, the owner or owners are
exposed to potentially unlimited liability, it is difficult to raise equity capital since either
new partners must be found or the existing partners must put up additional capital, and it
is difficult to transfer ownership between partners or from a sole proprietor to someone
else.
The disadvantages of the corporate form are that there are numerous forms that must
be filled out and regulations that must be followed that are not required of a sole
proprietorship or a partnership, corporations are subject to double taxation of distributed
earnings in that the corporation first pays taxes on the pre-tax income, and then the
owners must pay tax on the dividend or capital gains income, and the separation of
ownership (by the shareholders) and control (by management) can result in management
taking actions that are not in the owners’ best interests.
1-4 The cost of money is affected by (1) production opportunities, (2) the time preference for
consumption, (3) risk, and (4) inflation. When production opportunities are good, and
assets are earning high rates of return, then interest rates tend to be higher because there
is a larger demand for borrowing to finance these projects. Also, investors who are
considering lending money recognize that their alternative investments have a high
return, and so demand a high return on their investments. When investors have a strong
preference for current consumption, then they demand a higher return on their
investments to compensate them for having to defer current purchases, and so the cost of
money is higher. Investors demand a higher rate of return on riskier investments in order
to compensate them for the having to be exposed to more risk, and when investors expect
future inflation, then the cost of money increases so that investment returns better cover
this future price increase.
Answers and Solutions: 1- 2
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, If any of these factors change, then the cost of money will change, and hence the
yield and the price of a security will change as well. For example, if overall the time
preference for consumption increases, then overall interest rates will tend to increase and
the yield on debt instruments will tend to increase, and their prices will fall. If the
underlying level of inflation declines, as it did through the 1990s, then interest rates on
debt instruments will decline, driving up their prices. On the other hand, if a company
experiences financial problems, increasing the likelihood of default and bankruptcy and
becoming more risky, then the yield on its bonds will increase and their prices will fall.
1-5 Securitization is the process by which assets, such as mortgages held by banks, accounts
receivables held by companies, or credit card obligations held by banks and finance
companies, are packaged together and sold to investors. In the case of mortgages, a bank
or savings and loan (S&L) may have a portfolio of mortgages that it has originated (or
issued). Typically, a bank will have financed these mortgages with savings and checking
account deposits and CDs and once it has used up its loanable funds, it must either stop
making new loans, or raise more funds if it wants to make more loans. If the bank
packages these mortgages and sells them to investors, then it can make more loans with
the funds it receives. The idea is that bank acts as an intermediary in this case, analyzing
credit and making loans, and then selling them off so it can make more loans; consumers
get more loans, and banks get to do what they (supposedly) do best, which is to analyze
risk and originate loans.
If a bank doesn’t securitize its loans and, instead, holds them on its books, then it can
be exposed to a lot of interest rate risk. Back in the 1980s, S&Ls were raising money with
short-term CDs and lending it out long-term as 30-year fixed-rate mortgages. When
interest rates skyrocketed, the interest they had to pay on the CDs increased dramatically,
but since the mortgages were fixed-rate, the interest income the S&Ls received didn’t
increase. This caused hundreds of S&Ls to go bankrupt, and cost the federal government,
and ultimately, the U.S. taxpayers, hundreds of billions of dollars. If, instead, S&Ls
securitized the loans, they would no longer be exposed to the interest rate risk since they
would have sold off the loans shortly after originating them. Of course, the interest rate
risk doesn’t go away! Instead, the investors in the securitized mortgages now receive the
fixed interest payments. If these investors have themselves financed the investment with
short-term borrowing, then they will be exposed to interest rate risk!
Answers and Solutions: 1- 3
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
, 1-6 Just like the Great Depression that preceded it 80 years earlier, the causes of the Global
Economic Crisis that began in 2007 and lasted through 2009 will likely be the subject of
vigorous debate for years to come. As an example of one small aspect of the crisis,
consider how securitized mortgages end up in retirement portfolios, and how a decline in
housing prices in, say Florida, can bankrupt investors half a world away: A mortgage
company makes a bunch of loans to homeowners in Florida; a bank securitizes these
loans and creates tranches consisting interest payments, principal payments, other
combinations of payments, and the various tranches have different seniority levels—
some get paid first, others are residual claimants; a ratings agency rates some of these
pools as investment grade, so pension funds and even individual investors can purchase
them; and Norwegian investors purchase some of these to hold in their retirement
accounts because they offer good rates of return and were highly rated by the ratings
agency.
Now consider what happens when housing prices stop growing and begin to decline
in Florida. Many of these loans were floating rate loans with low “teaser rates” initially,
but much higher “reset” rates after 1, 2, or 3 years. The idea was when the low teaser rate
expired the homeowner would either sell the house or refinance it, in either case paying
off the loan. Importantly, the homeowner never intended, and frequently simply could not
afford, to pay the much higher “reset” rate. But with housing prices declining, the
homeowner can’t sell the house for as much as the outstanding loan. And since the
appraised value declines too, the homeowner can’t refinance the house! That leaves only
two options: staying in the house and paying the much-higher mortgage payment, or
defaulting on the loan if the homeowner can’t pay the higher mortgage payments. Many
homeowners choose to default. This causes two apparently independent, but ultimately
related problems. First, this stops (or slows down) the cash flows to the Norwegian
retirees. Second, it places a foreclosure notice on the house. With lots of houses in
foreclosure, other housing prices fall as well, forcing more foreclosures, and more
defaults. This still further reduces the payments to the Norwegian retirees. The rating
agency, seeing this decline in cash flows, downgrades the investments, which drops it
below investment-grade, so pension funds have to sell them off, which causes declines in
their values, ultimately bankrupting the retirement fund if it had too many of these
mortgage backed securities in its portfolio.
Answers and Solutions: 1- 4
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
