EoCB_chap1

Question 1

Section 1.1
1. What are the three most basic types of financial decisions managers must make?

Answer 1

The three most basic decisions each business must make are the capital budgeting decision, the financing decision, and the working capital management decision. These decisions determine which productive assets to buy, how to pay for or finance these purchases, and how to manage the day-to-day financial matters so the company can pay its bills.

Question 2

Section 1.1
2. Explain why you would make an investment if the value of the expected cash flows exceeds the cost of the project.

Answer 2

You would accept an investment project whose cash flows exceed the cost of the project because such projects will increase the value of the firm, making the owners wealthier. Most people start a business to increase their wealth. Remember that the cost of capital (time value of money) will affect the decision about whether to invest.

Question 3

Section 1.1
3. Why are capital budgeting decisions among the most important decisions in the life of a firm?

Answer 3

The capital budgeting decisions are considered the most important in the life of the firm because these decisions determine which productive assets the firm purchases and these assets generate most of the firm’s cash flows. Furthermore, capital budgeting decisions are long-term decisions and if you make a mistake in selecting a productive asset, you are stuck with the decision for a long time.

Question 4

Section 1.2
1. What are the major responsibilities of the CFO?

Answer 4

The major responsibilities of a CFO are recommendation and financial analysis of financial decisions. Although all top managers in a firm participate in these decisions, the final report and analysis is ultimately the responsibility of the CFO.

Question 5

Section 1.2
2. Identify three financial officers who typically report to the CFO and describe their duties.

Answer 5

The financial officers discussed in the chapter who report to the CFO are the controller, the treasurer, and the internal auditor. The controller is the firm’s chief accounting officer, and thus prepares the financial statements and taxes. This position also requires close cooperation with the external auditors. The treasurer’s responsibility is the collection and disbursement of cash, investing excess cash, raising new capital, handling foreign exchange, and overseeing the company’s pension fund management. (S)he also assists the CFO in handling important Wall Street relationships. Finally, the internal auditor is responsible for conducting risk assessment and for performing audits of high-risk areas.

Question 6

Section 1.2
3. Why does the internal auditor report to both the CFO and the board of directors?

Answer 6

The internal auditor reports to the CFO on a day-to-day basis but is ultimately accountable for reporting any accounting irregularities to the board of directors. The dual reporting system serves as a check to ensure that there are no discrepancies in the company’s financial statements.

Question 7

Section 1.4
1. Why is profit maximization an unsatisfactory goal for managing a firm?

Answer 7

Profit maximization is not a satisfactory goal when managing a firm because it is rather difficult to define profits since accountants can apply and interpret the same accounting principles differently. Also, profit maximization does not define the size, the uncertainty, and the timing of cash flows; it ignores the time value of money concept.

Question 8

Section 1.4
2. Explain why maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s management.

Answer 8

Maximizing the current market price of a firm’s stock is an appropriate goal for the firm’s management because it is an unambiguous objective and it is easy to measure. One can simply look at the value of the company’s stock on any given day to determine whether it went up or down.

Question 9

Section 1.4
3. What is the fundamental determinant of an asset’s value?

Answer 9

The fundamental determinant of an asset’s value is the future cash flow the asset is expected to generate. Other factors that may help determine the price of an asset are internal decisions, such as the company’s expansion strategy, as well as external stimulants, such as the state of the economy.

Question 10

Section 1.5
1. What are agency conflicts?

Answer 10

An agency conflict occurs when the goals of the principals are not aligned with the goals of the agents. Management is often more concerned with pursuing its own self-interest, and so the maximization of shareholder value is pushed to the side.

Question 11

Section 1.5
2. What are corporate raiders?

Answer 11

Corporate raiders can make the economy more efficient by keeping the top managers on their toes. Top managers know that if the company’s performance declines and its stock slips, it makes itself vulnerable to takeovers by corporate raiders who are just waiting to temporarily acquire a company, turn it around, and sell it for profit. Therefore, the role of the corporate raiders in the economy is twofold: first, the fear of takeovers pushes managers to do a better job, and second, if the managers are not performing up to expectations, the company can be rescued and restructured into a contributor again. However, the threat of a corporate raider could result in an incentive conflict for managers, inducing them to focus on short-term profitability over long-term value creation.

Question 12

Section 1.5
3. List the three main objectives of the Sarbanes-Oxley Act.

Answer 12

The three main goals of the Sarbanes-Oxley Act are to reduce agency costs in corporations, to restore ethical conduct in the business sector, and to improve the integrity of accounting reporting systems within firms.

Question 13

Section 1.6
1. What is a conflict of interest in a business setting?

Answer 13

Conflict of interest in the business setting refers to a conflict between a person’s personal or institutional gain and the obligation to serve the interest of another party. For example, the chapter discussed the problem that arises when the real estate agent helping you buy a house is also the listing agent.

Question 14

2. How would you define an ethical business culture?

Answer 14

An ethical business culture means that people have a set of principles, or moral values, that helps them identify moral issues and then make ethical judgments without being told what to do.

Question 15

1.1 Give an example of a capital budgeting decision and a financing decision.

Answer 15

Capital budgeting involves deciding which productive assets the firm invests in, such as buying a new plant or investing in the renovation of an existing facility. Financing decisions determine how a firm will raise capital. Examples of financing decisions include the decision to borrow from a bank or issue debt in the public capital markets.

Question 16

What is the appropriate decision criterion for financial managers to use when selecting a capital project?

Answer 16

Financial managers should select a capital project only if the value of the project’s expected future cash flows exceeds the cost of the project. In other words, managers should only make investments that will increase firm value, and thus increase the stockholders’ wealth.

Question 17

1.3 What are some of the things that managers do to manage a firm’s working capital?

Answer 17

Working capital management is the day-to-day management of a firm’s short- term assets and liabilities. Working capital can be managed by maintaining the optimal level of inventory, managing receivables and payables, deciding to whom the firm should extend credit, and making appropriate investments with excess cash.

Question 18

1.4 Which one of the following characteristics does not pertain to corporations?
a. Can enter into contracts
b. Can borrow money
c. Are the easiest type of business to form
d. Can be sued
e. Can own stock in other companies

Answer 18

The answer that does not pertain to corporations is: c. Are the easiest type of
business to form.

Question 19

1.5 What are typically the main components of an executive compensation package?

Answer 19

The three main components of a typical executive compensation package are: base salary, bonus based on accounting performance, and compensation tied to
the firm’s stock price.

Question 20

Describe the cash flows between a firm and its stakeholders.

Answer 20

Cash flows are generated by a firm’s productive assets that were purchased through either issuing debt or raising equity. These assets generate revenues through the sale of goods and services. A portion of this revenue is then used to pay wages and salaries to employees, pay suppliers, pay taxes, and pay interest on the borrowed money. The leftover money, residual cash, is then either reinvested back in the business or is paid out to stockholders in the form of dividends.

Question 21

1.2 What are the three fundamental decisions the financial manager is concerned with, and how do they affect the firm’s balance sheet?

Answer 21

The primary financial management decisions every company faces are capital budgeting decisions, financing decisions, and working capital management decisions. Capital budgeting addresses the question of which productive assets to buy; thus, it affects the asset side of the balance sheet. Financing decisions focus on raising the money the firm needs to buy productive assets. This is typically accomplished by selling long-term debt and equity. Finally, working capital decisions involve how firms manage their current assets and liabilities. The focus here is seeing that a firm has enough money to pay its bills and that any spare money is invested to earn a return.

Question 22

1.3 What is the difference between stockholders and stakeholders?

Answer 22

Stockholders, also referred to as shareholders, are the owners of the company. A stakeholder, on the other hand, is anyone with a claim on the assets of the firm, including, but not limited to, shareholders. Stakeholders include the firm’s employees, suppliers, creditors, and the government.

Question 23

1.4 Suppose that a group of accountants wants to start an accounting business. What organizational form would they most likely choose, and why?

Answer 23

Most lawyers, accountants, and doctors form what are known as limited liability partnerships. This formation combines the tax advantages of partnerships with the limited liability of corporations.

Question 24

1.5 Why would the owners of a business choose to form a corporation even though they will face double taxation?

Answer 24

Because the benefits, such as limited liability and access to large amounts of capital at relatively low cost in the public markets, outweigh the cost of double taxation (as well as the higher costs associated with forming a corporation).

Question 25

1.6 Explain why profit maximization is not the best goal for a company. What is a better goal?

Answer 25

Although profit maximization appears to be the logical goal for any company, it has many drawbacks. First, profit can be defined in a number of different ways, and variations in net income for similar firms can vary widely. Second, accounting profits do not exactly equal cash flows. Third, profit maximization does not account for timing and ignores risk associated with cash flows. An appropriate goal for financial managers who do not have these objections is to maximize the value of the firm’s current stock price. In order to achieve this goal, management must make financial decisions so that the total value of cash inflows exceeds the total value of cash outflows.

Question 26

1.7 What are some of the major external and internal factors that affect a firm’s stock price? What is the difference between the two general types of factors?

Answer 26

External factors that affect the firm’s stock price are: (1) economic shocks, such as natural disasters or wars, (2) the state of the economy, such as the level of interest rates, and (3) the business environment, such as taxes or regulations. On one hand, external factors are variables over which the management has no control. On the other hand, internal factors that affect the stock price can be controlled by management to some degree, because they are firm specific, such as financial management decisions, product quality and cost, and the line of business, the management has selected to enter. Finally, perhaps the most important internal variable that determines the stock price is the expected cash flow stream: its magnitude, timing, and riskiness.

Question 27

1.8 Identify the sources of agency costs. What are some ways these costs can be controlled in a company?

Answer 27

gency costs are the costs that result from conflicts of interest between the agent and the principal. They can either be direct, such as lavish dinners or trips, or indirect, which are usually missed investment opportunities. A company can control these costs by tying management compensation to company’s performance and by establishing an independent board of directors. Outside factors that contribute to the minimization of agency costs are the threat of corporate raiders that can take over a company not performing up to expectations and the competitive nature of the managerial labor market.

Question 28

1.9 What is the Sarbanes-Oxley Act, and what does it focus on? Why does it focus in these areas?

Answer 28

The Sarbanes-Oxley Act is an act of Congress that was passed in 2002. This act was passed in the aftermath of several corporate scandals that occurred at the turn of the century. The act focuses on (1) reducing agency costs in corporations, (2) restoring ethical conduct within the business sector, and (3) improving the integrity of accounting reporting system within firms. Failures in these areas led to the corporate scandals that
preceded passage of Sarbanes-Oxley.

Question 29

1.10 Give an example of a conflict of interest in a business setting, other than the one involving the real estate agent discussed in the chapter text.

Answer 29

For example, imagine a situation in which you are a financial officer at a growing software company and your firm has decided to hire outside consultants to formulate a global expansion strategy. Coincidentally, your wife works for one of the major consulting firms that your company is considering hiring. In this scenario, you have a conflict of interest, because instinctively, you might be inclined to give the business to your wife’s firm, because it will benefit your family’s financial situation if she lands the contract, regardless of whether or not it makes the best sense for your firm.