Chapter 1: Goals and Governance of the Firm (excercises)

Question 1

1. Vocabulary Check. Choose the term within the parentheses that best matches each of the fol- lowing descriptions.
   a. Expenditure on research and development (financing decision / investment decision)
   b. A bank loan (real asset / financial asset)
   c. Listed on a stock exchange (closely held corporation / public corporation)
   d. Has limited liability (partnership / corporation)
   e. Responsible for bank relationships (the treasurer / the controller)
   f. Agency cost (the cost resulting from conflicts of interest between managers and shareholders / the amount charged by a company’s agents such as the auditors and lawyers)

Answer 1

a. Investment decision
b. Financial asset
c. Public corporation
d. Corporation
e. Treasurer
f. The cost resulting from conflicts of interest between managers and shareholders

Question 2

2. Financial Decisions. Which of the following are investment decisions, and which are financing decisions? (LO1-1)
   a. Should we stock up with inventory ahead of the holiday season?
   b. Do we need a bank loan to help buy the inventory?
   c. Should we develop a new software package to manage our inventory?
   d. With a new automated inventory management system, it may be possible to sell off our Birdlip warehouse.
   e. With the savings we make from our new inventory system, it may be possible to increase our dividend.
   f. Alternatively, we can use the savings to repay some of our long-term debt.

Answer 2

Investment decisions, typically called capital budgeting, relate to investments in tangible and intangible assets. Financing decisions relate to the raising of money through debt and equity. Repayment of that money as well as interest and dividends are also financing decisions.
a. Investment decision
b. Financing decision
c. Investment decision
d. Investment decision
e. Financing decision
f. Financing decision: On the surface, this may appear similar to a dividend decision,
but in reality retiring debt is a change in capital structure and more closely aligned
with a financing decision.

Question 3

3. Financial Decisions. What is the difference between capital budgeting decisions and capital structure decisions?

Answer 3

Both capital budgeting decisions and capital structure decisions are long-term financial decisions. However, capital budgeting decisions are long-term investment decisions, while capital structure decisions are long-term financing decisions. Capital structure decisions essentially involve selecting between equity financing and long-term debt financing.

Question 4

4. Real versus Financial Assets. Which of the following are real assets, and which are financial?
   a. A share of stock
   b. A personal IOU
   c. A trademark
   d. A truck
   e. Undeveloped land
   f. The balance in the firm’s checking account
   g. An experienced and hardworking sales force
   h. A bank loan agreement

Answer 4

a. A share of stock = financial
b. A personal IOU = financial
c. A trademark = real
d. A truck = real
e. Undeveloped land = real
f. The balance in the firm’s checking account = financial
g. An experienced and hardworking sales force = real
h. A bank loan agreement = financial

Question 5

5. Real and Financial Assets. Read the following passage and fit each of the following terms into the most appropriate space:
   financing, real, bonds, investment, executive airplanes, financial, capital budgeting, brand names.

Companies usually buy _____ assets. These include both tangible assets such as _____ and intangible assets such as _____. To pay for these assets, they sell _____ assets such as _____. The decision about which assets to buy is usually termed the _____ or _____ decision. The decision about how to raise the money is usually termed the _____ decision.

Answer 5

“Companies usually buy real assets. These include both tangible assets such as executive airplanes and intangible assets such as brand names. To pay for these assets, they sell financial assets such as bonds. The decision about which assets to buy is usually termed the capital budgeting or investment decision. The decision about how to raise the money is usually termed the financing decision.”

Question 6

6. Corporations. Choose in each case the type of company that best fits the description.
   a. The business is owned by a small group of investors. (private corporation / public corporation)
   b. The business does not pay income tax. (private corporation / partnership)
   c. The business has limited liability. (sole proprietorship / public corporation)
   d. The business is owned by its shareholders. (partnership / public corporation)

Answer 6

a. Private corporation
b. Partnership
c. Public corporation
d. Public corporation

Question 7

7. Corporations. What do we mean when we say that corporate income is subject to double taxation?

Answer 7

Double taxation means that a corporation’s income is taxed first at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at each shareholder’s personal tax rate.

Question 8

8. Corporations. Which of the following statements always apply to corporations?
   a. Unlimited liability
   b. Limited life
   c. Ownership can be transferred without affecting operations
   d. Managers can be fired with no effect on ownership

Answer 8

C. Ownership can be transferred without affecting operations and D. Managers can be fired with no effect on ownership.

Question 9

9. Corporations. What is limited liability, and who benefits from it?

Answer 9

The individual stockholders of a corporation (i.e., the owners) are legally distinct from the corporation itself, which is a separate legal entity. Consequently, the stockholders are not personally liable for the debts of the corporation; the stockholders’ liability for the debts of the corporation is limited to the investment each stockholder has made in the shares of the corporation.

Question 10

10. Corporations. Which of the following are correct descriptions of large corporations?
    a. Managers no longer have the incentive to act in their own interests.
    b. The corporation survives even if managers are dismissed.
    c. Shareholders can sell their holdings without disrupting the business.
    d. Corporations, unlike sole proprietorships, do not pay tax; instead, shareholders are taxed on any dividends they receive.

Answer 10

B. The corporation survives even if managers are dismissed and C. Shareholders can sell their holdings without disrupting the business.

Question 11

11. Corporations. Is limited liability always an advantage for a corporation and its shareholders? (Hint: Could limited liability reduce a corporation’s access to financing?)

Answer 11

Limited liability is generally advantageous to large corporations. Large corporations would not be able to obtain financing from thousands or even millions of shareholders if those shareholders were not protected by the fact that the corporation is a distinct legal entity, conferring the benefit of limited liability on its shareholders. On the other hand, lenders do not view limited liability as advantageous to them. In some situations, lenders are not willing to lend to a corporation without personal guarantees from shareholders, promising repayment of a loan in the event that the corporation does not have the financial resources to repay the loan. Typically, these situations involve small corporations, with only a few shareholders; often these corporations can obtain debt financing only if the shareholders provide these personal guarantees.

Question 12

12. Financial Managers. Which of the following statements more accurately describes the treasurer than the controller?
    a. Monitors capital expenditures to make sure that they are not misappropriated
    b. Responsible for investing the firm’s spare cash
    c. Responsible for arranging any issue of common stock
    d. Responsible for the company’s tax affairs

Answer 12

B. Responsible for investing the firm’s spare cash and C. Responsible for arranging any issue of common stock.

Question 13

13. Financial Managers. Explain the differences between the CFO’s responsibilities and the treasurer’s and controller’s responsibilities.

Answer 13

The responsibilities of the treasurer include the following: supervising cash management, raising capital, and banking relationships. The controller’s responsibilities include supervision of accounting, preparation of financial statements, and tax matters. The CFO of a large corporation supervises both the treasurer and the controller. The CFO is responsible for large-scale corporate planning and financial policy.

Question 14

14. Goals of the Firm. Give an example of an action that might increase short-run profits but at the same time reduce stock price and the market value of the firm.

Answer 14

A corporation might cut its labor force dramatically, which could reduce immediate expenses and increase profits in the short term. Over the long term, however, the firm might not be able to serve its customers properly, or it might alienate its remaining workers; if so, future profits will decrease, and the stock price, and the market value of the firm, will decrease in anticipation of these problems.
Similarly, a corporation can boost profits over the short term by using less costly materials even if this reduces the quality of the product. Once customers catch on, sales will decrease and profits will fall in the future. The stock price will fall.
The moral of these examples is that, because stock prices reflect present and future profitability, the corporation should not necessarily sacrifice future prospects for short- term gains.

Question 15

15. Cost of Capital. Why do financial managers refer to the opportunity cost of capital? How would you find the opportunity cost of capital for a safe investment?

Answer 15

Financial managers refer to the opportunity cost of capital because corporations increase value for their shareholders only by accepting all investment projects that earn more than this rate. If the company earns below this rate, the market value of the company’s stock falls and stockholders look for other places to invest.
To find the opportunity cost of capital for a safe investment, managers and investors look at current interest rates on safe debt securities, such as U.S. Treasury debt.

Question 16

16. Goals of the Firm. You may have heard big business criticized for focusing on short-term performance at the expense of long-term results. Explain why a firm that strives to maximize stock price should be less subject to an overemphasis on short-term results than one that simply maximizes profits.

Answer 16

The stock price reflects the value of both current and future dividends that the shareholders expect to receive. In contrast, profits reflect performance in the current year only. Profit maximizers may try to improve this year’s profits at the expense of future profits. But stock-price maximizers will take account of the entire stream of cash flows that the firm can generate. They are more apt to be forward-looking.

Question 17

17. Goals of the Firm. Fritz is risk-averse and is content with a relatively low but safe return on his investments. Frieda is risk-tolerant and seeks a very high rate of return on her invested savings. Yet both shareholders will applaud a high-risk capital investment if it offers an attractive rate of return. Why? What is meant by “attractive”? (

Answer 17

In this situation, a “superior” rate of return is a rate greater than the rate of return investors could earn elsewhere in the financial markets from alternative investments with risk equal to that of the “high-risk capital investment” described in the problem. Fritz (who is risk-averse) will likely sell the investment since he is risk averse. Frieda (who is risk-tolerant) will likely keep her shares since it matches her risk tolerance.

Question 18

18. Goals of the Firm. We claim that the goal of the firm is to maximize current market value. Could the following actions be consistent with that goal?
    a. The firm adds a cost-of-living adjustment to the pensions of its retired employees.
    b. The firm reduces its dividend payment, choosing to reinvest more earnings in the business. c. The firm buys a corporate jet for its executives.
    d. The firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5.

Answer 18

a. This action might appear, superficially, to be a grant to former employees and thus not consistent with value maximization. However, such “benevolent” actions might enhance the firm’s reputation as a good place to work, might result in greater loyalty on the part of current employees, and might contribute to the firm’s recruiting efforts. Therefore, from a broader perspective, the action may be value-maximizing.

b. The reduction in dividends, in order to allow increased reinvestment, can be consistent with maximization of current market value. If the firm has attractive investment opportunities, and wants to save the expenses associated with issuing new shares to the public, then it could make sense to reduce the dividend in order to free up capital for the additional investments.

c. The corporate jet would have to generate benefits in excess of its costs in order to be considered stock-price enhancing. Such benefits might include time savings for executives and greater convenience and flexibility in travel.

d. Although the drilling appears to be a bad bet, with a low probability of success, the project may be value-maximizing if a successful outcome (although unlikely) is potentially sufficiently profitable. A one-in-five chance of success is acceptable if the payoff conditional on finding an oil field is 10 times the costs of exploration.

Question 19

19. Goals of the Firm. Fill in the blanks in the following passage by choosing the most appropriate term from the following list (some of the terms may be used more than once or not used at all):
    expected return, financial assets, lower, market value, higher, opportunity cost of capital, real assets, dividend, shareholders.

Shareholders want managers to maximize the _____ of their investments. The firm faces a trade-off. Either it can invest its cash in _____ or it can give the cash back to _____ in the form of a(n) _____ and they can invest it in _____. Shareholders want the company to invest in _____ only if the _____ is _____ than they could earn for themselves in equivalent risk invest- ments. The return that shareholders could earn for themselves is therefore the _____ for the firm.

Answer 19

Shareholders want managers to maximize the market value of their investments. The firm faces a trade-off. It can either invest its cash in real assets or it can give the cash back to shareholders in the form of a dividend and they can invest it in financial assets. Shareholders want the company to invest in real assets only if the expected return is higher than they could earn for themselves. The return that shareholders could earn for themselves is therefore the opportunity cost of capital for the firm.

Question 20

20. Goals of the Firm. Explain why each of the following may not be appropriate corporate goals.
    a. Increase market share
    b. Minimize costs
    c. Underprice any competitors
    d. Expand profits

Answer 20

a. Increased market share can be an inappropriate goal if it requires reducing prices to such an extent that the firm is harmed financially. Increasing market share can be part of a well-reasoned strategy, but one should always remember that market share is not a goal in itself. The owners of the firm want managers to maximize the value of their investment in the firm.

b. Minimizing costs can also conflict with the goal of value maximization. For example, suppose a firm receives a large order for a product. The firm should be willing to pay overtime wages and to incur other costs in order to fulfill the order, as long as it can sell the additional product at a price greater than those costs. Even though costs per unit of output increase, the firm still comes out ahead if it agrees to fill the order.

c. A policy of underpricing any competitor can lead the firm to sell goods at a price lower than the price that would maximize market value. Again, in some situations, this strategy might make sense, but it should not be the ultimate goal of the firm. It should be evaluated with respect to its effect on firm value.

d. Expanding profits is a poorly defined goal of the firm. The text gives three reasons:
(i) There may be a trade-off between accounting profits in one year and accounting profits in another year. For example, writing off a bad investment may reduce this year’s profits but increase profits in future years. Which year’s profits should be maximized?
(ii) Investing more in the firm can increase profits, even if the increase in profits is insufficient to justify the additional investment. In this case the increased investment increases profits but can reduce shareholder wealth.
(iii) Profits can be affected by accounting rules, so a decision that increases profits using one set of rules may reduce profits using another.

Question 21

21. Goals of the Firm. We can imagine the financial manager doing several things on behalf of the firm’s stockholders. For example, the manager might do the following:
    a. Make shareholders as wealthy as possible by investing in real assets.
    b. Modify the firm’s investment plan to help shareholders achieve a particular time pattern of consumption.
    c. Choose high- or low-risk assets to match shareholders’ risk preferences.
    d. Help balance shareholders’ checkbooks.
    However, in well-functioning capital markets, shareholders will vote for only one of these goals. Which one will they choose?

Answer 21

A. Make shareholders as wealthy as possible by investing in real assets.