Chapter 1: Goals and Governance

Question 1

What are the two major decisions made by financial managers? (LO1-1)

Answer 1

Financial management can be broken down into (1) the investment or capital budgeting decision and (2) the financing decision. The firm has to decide (1) which real assets to invest in and (2) how to raise the funds necessary to pay for those investments.

Question 2

What does “real asset” mean? (LO1-2)

Answer 2

Real assets include all assets used in the production or sale of the firms’ products or services. They can be tangible (plant and equipment, for example) or intangible (patents or trademarks, for example). In contrast, financial assets (such as stocks or bonds) are claims on the income generated by real assets.

Question 3

What are the advantages and disadvantages of forming a corporation? (LO1-3)

Answer 3

Corporations are distinct, permanent legal entities. They allow for separation of ownership and control, and they can continue operating without disruption even as management or ownership changes. They provide limited liability to their owners. On the other hand, managing the corporation’s legal machinery is costly. Also, corporations are subject to double taxation because they pay taxes on their profits and the shareholders are taxed again when they receive dividends or sell their shares at a profit.

Question 4

Who are the principal financial managers in a corporation? (LO1-4)

Answer 4

Almost all managers are involved to some degree in investment decisions, but some man- agers specialize in finance, for example, the treasurer, controller, and CFO. The treasurer is most directly responsible for raising capital and maintaining relationships with banks and investors that hold the firm’s securities. The controller is responsible for preparing financial statements and managing budgets. In large firms, a chief financial officer oversees both the treasurer and the controller and is involved in financial policymaking and corporate planning.

Question 5

Why does it make sense for corporations to maximize shareholder wealth? (LO1-5)

Answer 5

Value maximization is the natural financial goal of the firm. Shareholders can invest or consume the increased wealth as they wish, provided that they have access to well-functioning financial markets.

Question 6

What is the fundamental trade-off in investment decisions? (LO1-5)

Answer 6

Companies either can invest in real assets or can return the cash to shareholders, who can invest it for themselves. The return that shareholders can earn for themselves is called the opportunity cost of capital. Companies create value for shareholders whenever they can earn a higher return on their investments than the opportunity cost of capital.

Question 7

How do corporations ensure that managers act in the interest of stockholders? (LO1-6)

Answer 7

Conflicts of interest between managers and stockholders can lead to agency problems and agency costs. Agency problems are kept in check by financial controls, by well-designed compensation packages for managers, and by effective corporate governance.

Question 8

Is value maximization ethical? (LO1-7)

Answer 8

Shareholders do not want the maximum possible stock price; they want the maximum honest price. But there need be no conflict between value maximization and ethical behavior. The surest route to maximum value starts with products and services that satisfy customers. A good reputation with customers, employees, and other stakeholders is important for the firm’s long-run profitability and value.