SOLUTION MANUAL & TEST BANK
FINANCIAL MANAGEMENT
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Chapter 1
An Overview Of Financial Management
Learning Objectives
After Reading This Chapter, Students Should Be Able To Do The Following:
Explain The Role Of Finance And The Different Types Of Jobs In Finance.
Identify The Advantages And Disadvantages Of Different Forms Of Business Organization.
Explain The Links Between Stock Price, Intrinsic Value, And Executive Compensation.
Identify The Potential Conflicts That Arise Within The Firm Between Stockholders And Managers And
Between Stockholders And Bondholders, And Discuss The Techniques That Firms Can Use To Mitigate
These Potential Conflicts.
Discuss The Importance Of Business Ethics And The Consequences Of Unethical Behavior.
Chapter 1: An Overview Of Financial Management Learning Objectives 1
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Lecture Suggestions
Chapter 1 Covers Some Important Concepts And Discussing Them In Class Can Be Interesting. However,
Students Can Read The Chapter On Their Own, So It Can Be Assigned But Not Covered In Class.
We Spend The First Day Going Over The Syllabus And Discussing Grading And Other Mechanics
Relating To The Course. To The Extent That Time Permits, We Talk About The Topics That Will Be
Covered In The Course And The Structure Of The Book. We Also Briefly Discuss The Fact That It Is
Assumed That Managers Try To Maximize Stock Prices, But That They May Have Other Goals, Hence
That It Is Useful To Tie Executive Compensation To Stockholder-Oriented Performance Measures. If Time
Permits, We Think It’s Worthwhile To Spend At Least A Full Day On The Chapter. If Not, We Ask Students
To Read It On Their Own, And To Keep Them Honest, We Ask One Or Two Questions About The Material
On The First Exam.
One Point We Emphasize In The First Class Is That Students Should Print A Copy Of The
Powerpoint Slides For Each Chapter Covered And Purchase A Financial Calculator Immediately And Bring
Both To Class Regularly. We Also Put Copies Of The Various Versions Of Our ―Brief Calculator Manual,‖
Which In About 12 Pages Explains How To Use The Most Popular Calculators, In The Copy Center.
Students Will Need To Learn How To Use Their Calculators Before Time Value Of Money Concepts Are
Covered In Chapter 5. It Is Important For Students To Grasp These Concepts Early As Many Of The
Remaining Chapters Build On The TVM Concepts.
We Are Often Asked What Calculator Students Should Buy. If They Already Have A Financial
Calculator That Can Find Irrs, We Tell Them That It Will Do, But If They Do Not Have One, We
Recommend Either The
HP-10BII+ Or 17BII+. Please See The ―Lecture Suggestions‖ For Chapter 5 For More On Calculators.
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
,2 Lecture Suggestions Chapter 1: An Overview Of Financial Management
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Answers To End-Of-Chapter Questions
1-1 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 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, Leads To Deviations Between The Actual
Prices And Intrinsic Values.
1-3 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 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 That 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 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.
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
,1-6 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
Chapter 1: An Overview Of Financial Management Answers And Solutions 3
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, 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 Difficulty In Raising Capital And The Complexity Of
Setting Them Up.
1-7 Stockholder Wealth Maximization Is A Long-Run Goal. Companies, And Consequently The
Stockholders, Prosper By Management Making Decisions That Will Produce Long-Term Earnings
Increases. Actions That Are Continually Shortsighted Often ―Catch Up‖ With A Firm And, As A
Result, It May Find Itself Unable To Compete Effectively Against Its Competitors. There Has Been
Much Criticism In Recent Years That U.S. Firms Are Too Short-Run Profit-Oriented. A Prime
Example Is The U.S. Auto Industry, Which Has Been Accused Of Continuing To Build Large ―Gas
Guzzler‖ Automobiles Because They Had Higher Profit Margins Rather Than Retooling For
Smaller, More Fuel-Efficient Models.
1-8 Useful Motivational Tools That Will Aid In Aligning Stockholders’ And Management’s Interests Include:
(1) Reasonable Compensation Packages, (2) Direct Intervention By Shareholders, Including Firing
Managers Who Don’t Perform Well, And (3) The Threat Of Takeover.
The Compensation Package Should Be Sufficient To Attract And Retain Able Managers But Not
Go Beyond What Is Needed. Also, Compensation Packages Should Be Structured So That
Managers Are 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 Managers Will Have An Incentive To Keep The Stock Price High
Over Time. 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.
Stockholders Can Intervene Directly With Managers. Today, The Majority Of Stock Is Owned
By Institutional Investors And These Institutional Money Managers Have The Clout To Exercise
Considerable Influence Over Firms’ Operations. First, They Can Talk With Managers And Make
Suggestions About How The Business Should Be Run. In Effect, These Institutional Investors Act
As Lobbyists For The Body Of Stockholders. Second, Any Shareholder Who Has Owned $2,000
Of A Company’s Stock For One Year Can Sponsor A Proposal That Must Be Voted On At The
Annual Stockholders’ Meeting, Even If Management Opposes The Proposal. Although
Shareholder- Sponsored Proposals Are Non-Binding, The Results Of Such Votes Are Clearly
Heard By Top Management. Shareholder Activism Has Increasingly Played An Important Part
Ensuring That Managers Act In Shareholders’ Interests. Indeed, In 2014, Activists Established A
Record Level Of Influence When They Were Granted A Board Seat In 73% Of The Proxy Fights
That Occurred That Year. GE Is One Of A Small Group Of Companies That Has Voluntarily Made
It Easier For Shareholders To Secure A Board Seat. The Firm’s New Plan Allows Shareholder
Groups Holding At Least 3% Of The Company’s Stock To Directly Nominate Candidates For Its
Board.
If A Firm’s Stock Is Undervalued, Then Corporate Raiders Will See It To Be A Bargain And
Will Attempt To Capture The Firm In A Hostile Takeover. If The Raid Is Successful, The Target’s
Executives Will Almost Certainly Be Fired. This Situation Gives Managers A Strong Incentive To
Take Actions To Maximize Their Stock’s Price.
1-9 A. Corporate Philanthropy Is Always A Sticky Issue, But It Can Be Justified In Terms Of
Helping To Create A More Attractive Community That Will Make It Easier To Hire A
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Productive Work Force. This Corporate Philanthropy Could Be Received By Stockholders
Negatively, Especially Those Stockholders Not Living In Its Headquarters City.
Stockholders Are Interested In Actions That
4 Answers And Solutions Chapter 1: An Overview Of Financial Management
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Maximize Share Price, And If Competing Firms Are Not Making Similar Contributions, The ―Cost‖
Of This Philanthropy Must Be Borne By Someone—The Stockholders. Thus, Stock Price Could
Decrease.
b. Companies Must Make Investments In The Current Period To Generate Future Cash Flows.
Stockholders Should Be Aware Of This, And Assuming A Correct Analysis Has Been
Performed, They Should React Positively To The Decision. The International Plant Is In This
Category. Capital Budgeting Is Covered In Depth In Part 4 Of The Text. Assuming That The
Correct Capital Budgeting Analysis Has Been Made, The Stock Price Should Increase In The
Future.
c. U.S. Treasury Bonds Are Considered Safe Investments, While Common Stocks Are Far
Riskier. If The Company Were To Switch The Emergency Funds From Treasury Bonds To
Stocks, Stockholders Should See This As Increasing The Firm’s Risk Because Stock Returns
Are Not Guaranteed— Sometimes They Increase And Sometimes They Decline. The Firm
Might Need The Funds When The Prices Of Their Investments Were Low And Not Have The
Needed Emergency Funds. Consequently, The Firm’s Stock Price Would Probably Fall.
1-10 A. No, TIAA-CREF Is Not An Ordinary Shareholder. Because It Is One Of The Largest
Institutional Shareholders In The United States And It Controls More Than 900 Billion In
Pension Funds, Its Voice Carries A Lot Of Weight. This ―Shareholder‖ In Effect Consists
Of Many Individual Shareholders Whose Pensions Are Invested With This Group.
B. For TIAA-CREF To Be Effective In Wielding Its Weight, It Must Act As A Coordinated Unit. To
Do This, The Fund’s Managers Should Solicit From The Individual Shareholders Their ―Votes‖
On The Fund’s Practices, And From Those ―Votes‖ Act On The Majority’s Wishes. In So
Doing, The Individual Teachers Whose Pensions Are Invested In The Fund Have, In Effect,
Determined The Fund’s Voting Practices.
1-11 Earnings Per Share In The Current Year Will Decline Due To The Cost Of The Investment Made
In The Current Year And No Significant Performance Impact In The Short Run. However, The
Company’s Stock Price Should Increase Due To The Significant Cost Savings Expected In The
Future.
1-12 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. 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. The Board Should Probably Set
The CEO’s Compensation As A Mix Between A Fixed Salary And Stock Options.
The Actions Of The Vice President Of Company X Would Be Different Than If He Were CEO Of
Some Other Company.
1-13 Setting The Compensation Policy For Three Division Managers Would Be Different Than Setting
The Compensation Policy For A CEO Because Performance Of Each Of These Managers Could Be
More Easily Observed. For A CEO, An Award Based On Stock Price Performance Makes Sense,
While Basing The Compensation For Division Managers On Stock Price Performance Doesn’t Make
Sense. Each Of The Managers Could Still Be Given Stock Awards; However, Rather Than The
Award Being Based On Stock Price It Could Be Determined From Some Observable Measure Like
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Increased Gas Output, Oil Output, Etc.
Chapter 1: An Overview Of Financial Management Answers And Solutions 5
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
FINANCIAL MANAGEMENT
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Chapter 1
An Overview Of Financial Management
Learning Objectives
After Reading This Chapter, Students Should Be Able To Do The Following:
Explain The Role Of Finance And The Different Types Of Jobs In Finance.
Identify The Advantages And Disadvantages Of Different Forms Of Business Organization.
Explain The Links Between Stock Price, Intrinsic Value, And Executive Compensation.
Identify The Potential Conflicts That Arise Within The Firm Between Stockholders And Managers And
Between Stockholders And Bondholders, And Discuss The Techniques That Firms Can Use To Mitigate
These Potential Conflicts.
Discuss The Importance Of Business Ethics And The Consequences Of Unethical Behavior.
Chapter 1: An Overview Of Financial Management Learning Objectives 1
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Lecture Suggestions
Chapter 1 Covers Some Important Concepts And Discussing Them In Class Can Be Interesting. However,
Students Can Read The Chapter On Their Own, So It Can Be Assigned But Not Covered In Class.
We Spend The First Day Going Over The Syllabus And Discussing Grading And Other Mechanics
Relating To The Course. To The Extent That Time Permits, We Talk About The Topics That Will Be
Covered In The Course And The Structure Of The Book. We Also Briefly Discuss The Fact That It Is
Assumed That Managers Try To Maximize Stock Prices, But That They May Have Other Goals, Hence
That It Is Useful To Tie Executive Compensation To Stockholder-Oriented Performance Measures. If Time
Permits, We Think It’s Worthwhile To Spend At Least A Full Day On The Chapter. If Not, We Ask Students
To Read It On Their Own, And To Keep Them Honest, We Ask One Or Two Questions About The Material
On The First Exam.
One Point We Emphasize In The First Class Is That Students Should Print A Copy Of The
Powerpoint Slides For Each Chapter Covered And Purchase A Financial Calculator Immediately And Bring
Both To Class Regularly. We Also Put Copies Of The Various Versions Of Our ―Brief Calculator Manual,‖
Which In About 12 Pages Explains How To Use The Most Popular Calculators, In The Copy Center.
Students Will Need To Learn How To Use Their Calculators Before Time Value Of Money Concepts Are
Covered In Chapter 5. It Is Important For Students To Grasp These Concepts Early As Many Of The
Remaining Chapters Build On The TVM Concepts.
We Are Often Asked What Calculator Students Should Buy. If They Already Have A Financial
Calculator That Can Find Irrs, We Tell Them That It Will Do, But If They Do Not Have One, We
Recommend Either The
HP-10BII+ Or 17BII+. Please See The ―Lecture Suggestions‖ For Chapter 5 For More On Calculators.
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
,2 Lecture Suggestions Chapter 1: An Overview Of Financial Management
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Answers To End-Of-Chapter Questions
1-1 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 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, Leads To Deviations Between The Actual
Prices And Intrinsic Values.
1-3 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 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 That 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 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.
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
,1-6 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
Chapter 1: An Overview Of Financial Management Answers And Solutions 3
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, 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 Difficulty In Raising Capital And The Complexity Of
Setting Them Up.
1-7 Stockholder Wealth Maximization Is A Long-Run Goal. Companies, And Consequently The
Stockholders, Prosper By Management Making Decisions That Will Produce Long-Term Earnings
Increases. Actions That Are Continually Shortsighted Often ―Catch Up‖ With A Firm And, As A
Result, It May Find Itself Unable To Compete Effectively Against Its Competitors. There Has Been
Much Criticism In Recent Years That U.S. Firms Are Too Short-Run Profit-Oriented. A Prime
Example Is The U.S. Auto Industry, Which Has Been Accused Of Continuing To Build Large ―Gas
Guzzler‖ Automobiles Because They Had Higher Profit Margins Rather Than Retooling For
Smaller, More Fuel-Efficient Models.
1-8 Useful Motivational Tools That Will Aid In Aligning Stockholders’ And Management’s Interests Include:
(1) Reasonable Compensation Packages, (2) Direct Intervention By Shareholders, Including Firing
Managers Who Don’t Perform Well, And (3) The Threat Of Takeover.
The Compensation Package Should Be Sufficient To Attract And Retain Able Managers But Not
Go Beyond What Is Needed. Also, Compensation Packages Should Be Structured So That
Managers Are 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 Managers Will Have An Incentive To Keep The Stock Price High
Over Time. 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.
Stockholders Can Intervene Directly With Managers. Today, The Majority Of Stock Is Owned
By Institutional Investors And These Institutional Money Managers Have The Clout To Exercise
Considerable Influence Over Firms’ Operations. First, They Can Talk With Managers And Make
Suggestions About How The Business Should Be Run. In Effect, These Institutional Investors Act
As Lobbyists For The Body Of Stockholders. Second, Any Shareholder Who Has Owned $2,000
Of A Company’s Stock For One Year Can Sponsor A Proposal That Must Be Voted On At The
Annual Stockholders’ Meeting, Even If Management Opposes The Proposal. Although
Shareholder- Sponsored Proposals Are Non-Binding, The Results Of Such Votes Are Clearly
Heard By Top Management. Shareholder Activism Has Increasingly Played An Important Part
Ensuring That Managers Act In Shareholders’ Interests. Indeed, In 2014, Activists Established A
Record Level Of Influence When They Were Granted A Board Seat In 73% Of The Proxy Fights
That Occurred That Year. GE Is One Of A Small Group Of Companies That Has Voluntarily Made
It Easier For Shareholders To Secure A Board Seat. The Firm’s New Plan Allows Shareholder
Groups Holding At Least 3% Of The Company’s Stock To Directly Nominate Candidates For Its
Board.
If A Firm’s Stock Is Undervalued, Then Corporate Raiders Will See It To Be A Bargain And
Will Attempt To Capture The Firm In A Hostile Takeover. If The Raid Is Successful, The Target’s
Executives Will Almost Certainly Be Fired. This Situation Gives Managers A Strong Incentive To
Take Actions To Maximize Their Stock’s Price.
1-9 A. Corporate Philanthropy Is Always A Sticky Issue, But It Can Be Justified In Terms Of
Helping To Create A More Attractive Community That Will Make It Easier To Hire A
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Productive Work Force. This Corporate Philanthropy Could Be Received By Stockholders
Negatively, Especially Those Stockholders Not Living In Its Headquarters City.
Stockholders Are Interested In Actions That
4 Answers And Solutions Chapter 1: An Overview Of Financial Management
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
, Maximize Share Price, And If Competing Firms Are Not Making Similar Contributions, The ―Cost‖
Of This Philanthropy Must Be Borne By Someone—The Stockholders. Thus, Stock Price Could
Decrease.
b. Companies Must Make Investments In The Current Period To Generate Future Cash Flows.
Stockholders Should Be Aware Of This, And Assuming A Correct Analysis Has Been
Performed, They Should React Positively To The Decision. The International Plant Is In This
Category. Capital Budgeting Is Covered In Depth In Part 4 Of The Text. Assuming That The
Correct Capital Budgeting Analysis Has Been Made, The Stock Price Should Increase In The
Future.
c. U.S. Treasury Bonds Are Considered Safe Investments, While Common Stocks Are Far
Riskier. If The Company Were To Switch The Emergency Funds From Treasury Bonds To
Stocks, Stockholders Should See This As Increasing The Firm’s Risk Because Stock Returns
Are Not Guaranteed— Sometimes They Increase And Sometimes They Decline. The Firm
Might Need The Funds When The Prices Of Their Investments Were Low And Not Have The
Needed Emergency Funds. Consequently, The Firm’s Stock Price Would Probably Fall.
1-10 A. No, TIAA-CREF Is Not An Ordinary Shareholder. Because It Is One Of The Largest
Institutional Shareholders In The United States And It Controls More Than 900 Billion In
Pension Funds, Its Voice Carries A Lot Of Weight. This ―Shareholder‖ In Effect Consists
Of Many Individual Shareholders Whose Pensions Are Invested With This Group.
B. For TIAA-CREF To Be Effective In Wielding Its Weight, It Must Act As A Coordinated Unit. To
Do This, The Fund’s Managers Should Solicit From The Individual Shareholders Their ―Votes‖
On The Fund’s Practices, And From Those ―Votes‖ Act On The Majority’s Wishes. In So
Doing, The Individual Teachers Whose Pensions Are Invested In The Fund Have, In Effect,
Determined The Fund’s Voting Practices.
1-11 Earnings Per Share In The Current Year Will Decline Due To The Cost Of The Investment Made
In The Current Year And No Significant Performance Impact In The Short Run. However, The
Company’s Stock Price Should Increase Due To The Significant Cost Savings Expected In The
Future.
1-12 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. 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. The Board Should Probably Set
The CEO’s Compensation As A Mix Between A Fixed Salary And Stock Options.
The Actions Of The Vice President Of Company X Would Be Different Than If He Were CEO Of
Some Other Company.
1-13 Setting The Compensation Policy For Three Division Managers Would Be Different Than Setting
The Compensation Policy For A CEO Because Performance Of Each Of These Managers Could Be
More Easily Observed. For A CEO, An Award Based On Stock Price Performance Makes Sense,
While Basing The Compensation For Division Managers On Stock Price Performance Doesn’t Make
Sense. Each Of The Managers Could Still Be Given Stock Awards; However, Rather Than The
Award Being Based On Stock Price It Could Be Determined From Some Observable Measure Like
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, Increased Gas Output, Oil Output, Etc.
Chapter 1: An Overview Of Financial Management Answers And Solutions 5
© 2022 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
