Chapter 1: An overview of managerial finance
1-1 The value of a company can be measured by the market value of its share. Thus,
the company maximises value and wealth by maximising the value of it share.
1-2 Value is measured as the present value of the cash flows that an investment is
expected to generate during its life. The three factors that determine value are:
(1) the amount of future cash flows; (2) the timing of future cash flows; and (3)
investors’ required rate of return. If cash flows increase or are received sooner,
investors’ required rate of return decreases, or any combination of these events
occur, the value of an investment will increase.
1-3 Shareholder wealth maximisation is a long-run goal. Companies, and
consequently their shareholders, prosper by management making decisions that
will produce long-term increases in earnings and, thus, wealth. Actions that are
continually short-sighted often ‘catch up’ with a business, and as a result, the
business might find itself unable to compete effectively against its competitors.
There has been much criticism in recent years that some Australian companies
are too short-run profit oriented. An example is the Australian resource industry,
which has been accused of developing mining sites without regard for the
environmental consequences associated with mining activities.
1-4 Profit maximisation abstracts from the timing of profits and the riskiness of
different operating plans. However, both of these factors are reflected in share
price maximisation. Thus, profit maximisation does not necessarily lead to share
price maximisation.
1-5 Factors such as a compensation system based on management performance (i.e.
bonuses tied to profits or share-option plans) and the possibility of being
removed from office (e.g. voted out of office or an unfriendly tender offer by
another company) serve to keep management’s focus on shareholders’ interests.
1-6 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 productive work force. Corporate philanthropy, however, may be
negatively perceived by shareholders (and possibly stakeholders) who do not
live in the company’s headquarters city because they do not see any direct
benefits. Shareholders are interested in actions that maximise share price,
and if competing companies are not making similar contributions, the ‘cost’ of
this philanthropy has to be borne by someone – the shareholders. Thus, share
price could decrease.
b. Provided that the rate of return on assets exceeds the interest rate on debt,
greater use of debt will raise the expected rate of return on shareholders’
equity. Also, the interest on debt is tax deductible, which provides a further
Copyright © 2013 Cengage Learning Australia Pty Limited
, Corporate Finance 1e – Instructor’s Manual
advantage. However, greater use of debt will have a negative impact on the
shareholders if the company’s return on assets falls below the cost of debt,
and increased use of debt increases the chances of going bankrupt. The
effects of the use of debt, called financial leverage, are spelled out in detail in
Chapter 14.
c. The company will retain more earnings, so its growth rate should go up, which
should increase its share price. However, the decline in dividends will pull the
share price down. It is unclear whether the net effect on its share will increase
or decrease its price; the change will depend on whether shareholders prefer
dividends or increased growth.
1-7 Taking into account factors such as differential labour costs abroad,
transportation and tax advantages, Australian companies can maximise long-run
profits. There are also non-profit behavioural and strategic considerations, such
as maximising market share and enhancing the prestige of corporate officers.
1-8 Factors that make financial decision making more complicated for businesses that
operate in foreign countries include differences in currency, language, culture,
governmental relations, political risk, legal structure and economy. The general
techniques and concepts applied by purely domestic businesses are valid for
multinational companies. These factors, however, increase the risks that
multinational companies face when making financial decisions.
Copyright © 2013 Cengage Learning Australia Pty Limited
1-1 The value of a company can be measured by the market value of its share. Thus,
the company maximises value and wealth by maximising the value of it share.
1-2 Value is measured as the present value of the cash flows that an investment is
expected to generate during its life. The three factors that determine value are:
(1) the amount of future cash flows; (2) the timing of future cash flows; and (3)
investors’ required rate of return. If cash flows increase or are received sooner,
investors’ required rate of return decreases, or any combination of these events
occur, the value of an investment will increase.
1-3 Shareholder wealth maximisation is a long-run goal. Companies, and
consequently their shareholders, prosper by management making decisions that
will produce long-term increases in earnings and, thus, wealth. Actions that are
continually short-sighted often ‘catch up’ with a business, and as a result, the
business might find itself unable to compete effectively against its competitors.
There has been much criticism in recent years that some Australian companies
are too short-run profit oriented. An example is the Australian resource industry,
which has been accused of developing mining sites without regard for the
environmental consequences associated with mining activities.
1-4 Profit maximisation abstracts from the timing of profits and the riskiness of
different operating plans. However, both of these factors are reflected in share
price maximisation. Thus, profit maximisation does not necessarily lead to share
price maximisation.
1-5 Factors such as a compensation system based on management performance (i.e.
bonuses tied to profits or share-option plans) and the possibility of being
removed from office (e.g. voted out of office or an unfriendly tender offer by
another company) serve to keep management’s focus on shareholders’ interests.
1-6 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 productive work force. Corporate philanthropy, however, may be
negatively perceived by shareholders (and possibly stakeholders) who do not
live in the company’s headquarters city because they do not see any direct
benefits. Shareholders are interested in actions that maximise share price,
and if competing companies are not making similar contributions, the ‘cost’ of
this philanthropy has to be borne by someone – the shareholders. Thus, share
price could decrease.
b. Provided that the rate of return on assets exceeds the interest rate on debt,
greater use of debt will raise the expected rate of return on shareholders’
equity. Also, the interest on debt is tax deductible, which provides a further
Copyright © 2013 Cengage Learning Australia Pty Limited
, Corporate Finance 1e – Instructor’s Manual
advantage. However, greater use of debt will have a negative impact on the
shareholders if the company’s return on assets falls below the cost of debt,
and increased use of debt increases the chances of going bankrupt. The
effects of the use of debt, called financial leverage, are spelled out in detail in
Chapter 14.
c. The company will retain more earnings, so its growth rate should go up, which
should increase its share price. However, the decline in dividends will pull the
share price down. It is unclear whether the net effect on its share will increase
or decrease its price; the change will depend on whether shareholders prefer
dividends or increased growth.
1-7 Taking into account factors such as differential labour costs abroad,
transportation and tax advantages, Australian companies can maximise long-run
profits. There are also non-profit behavioural and strategic considerations, such
as maximising market share and enhancing the prestige of corporate officers.
1-8 Factors that make financial decision making more complicated for businesses that
operate in foreign countries include differences in currency, language, culture,
governmental relations, political risk, legal structure and economy. The general
techniques and concepts applied by purely domestic businesses are valid for
multinational companies. These factors, however, increase the risks that
multinational companies face when making financial decisions.
Copyright © 2013 Cengage Learning Australia Pty Limited
