Chapter1

TheRoleandObjectiveofFinancialManagement

CHAPTER1
THEROLEANDOBJECTIVE
OFFINANCIALMANAGEMENT
ANSWERSTOQUESTIONS:
1.Shareholderwealthisdefinedasthepresentvalueoftheexpectedfuturereturnstothe
owners(thatis,shareholders)ofthefirm.Thesereturnscantaketheformofperiodicdividend
paymentsand/orproceedsfromthesaleofthestock.Shareholderwealthismeasuredbythe
marketvalue(thatis,thepricethatthestocktradesinthemarketplace)ofthefirm'scommon
stock.
2.Profitmaximizationtypicallyisdefinedasamorestaticconceptthanshareholderwealth
maximization.Theprofitmaximizationobjectivefromeconomictheorydoesnotnormally
considerthetimedimensionortheriskdimensioninthemeasurementofprofits.Incontrast,
theshareholderwealthmaximizationobjectiveprovidesaconvenientframeworkforevaluating
boththetimingandtherisksassociatedwithvariousinvestmentandfinancingstrategies.
Themarginaldecisionrulesderivedfromeconomictheoryareextremelyusefultoawealth
maximizingfirm.Anydecision,eitherintheshortrunorthelongrun,thatresultsinmarginal
revenuesexceedingthemarginalcostsofthedecisionwillbeconsistentwithwealth
maximization.Whenadecisionhasconsequencesextendingbeyondayearintime,the
marginalbenefitsandmarginalcostsofthatdecisionmustbeevaluatedinapresentvalue
framework.
3.Acloselyheldfirmismorelikelytobeawealthmaximizerthanacorporationwithwide
ownership.Inthecloselyheldfirm,theownersandthemanagerswillsharethesame
objectivesbecausetheownersarethemanagers.Inawidelyheldcorporation,wherethe
ownershipandmanagementfunctionsareseparate,itislikelythatmanagersmaypursue
objectivesthataremoreselfservingthanownerserving.Examplesofalternativeobjectives
thatmightbepursuedinthissituationareextremeriskaversebehavior,sizemaximization,
satisficing,orpersonalutilityfunctionmaximization.Amorecompletediscussionof
alternativeobjectivesmaybefoundinMcGuigan,Moyer,andHarris,ManagerialEconomics,
10thedition(SouthWestern,20059),Chapterl.
4.Thegoalofshareholderwealthmaximizationisalongtermgoal.Shareholderwealthisa
functionofallthefuturereturnstotheshareholders.Hence,inmakingdecisionsthatmaximize
shareholderwealth,managementmustconsiderthelongrunimpactonthefirmandnotjust
focusonshortrun(i.e.,currentperiod)effects.Forexample,afirmcouldincreaseshortrun

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Chapter1
TheRoleandObjectiveofFinancialManagement
earningsanddividendsbyeliminatingallresearchanddevelopmentexpenditures.However,
thisdecisionwouldreducelongrunearningsanddividends,andhenceshareholderwealth,
becausethefirmwouldbeunabletodevelopnewproductstoproduceandsell.
5.Engaginginsocialresponsibilityactivitiescanbejustifiedonthebasisthattheseactivities
helptocreateanenvironmentinwhichthegoalofshareholderwealthmaximizationmore
easilycanbepursued.
6.Theseparationofownershipandcontrolincorporationsmayresultinmanagement
pursuinggoalsotherthanshareholderwealthmaximization,suchasmaximizationoftheirown
personalwelfare(utility).Concernfortheirownselfinterestsmayleadmanagementtomake
decisionsthatpromotetheirlongrunsurvival(jobsecurity),suchasminimizing(orlimiting)
theamountofriskincurredbythefirm.
7.Anagencyrelationshipoccurswhenoneormoreindividuals(theprincipals)hireanother
individual(theagent)toperformaserviceonbehalfoftheprincipals.Twoofthemost
importantagencyrelationshipsinfinancearebetweenthestockholders(principals)and
management(agent),andbetweentheowners(agents)andcreditors(principals).Agencycosts
areincurredwhenattemptingtocontrolagencyproblems.Agencyproblemsarisewhenthe
agentmakesdecisionsconsistentwiththemaximizationofhisorherownutilityratherthanthe
maximizationoftheutilityoftheprincipals.
8.Examplesofagencycostsincurredbyshareholdersinclude

Expenditurestostructuretheorganizationinawaythatwillminimizetheincentivesfor
managementtotakeactionscontrarytoshareholderinterests,suchasprovidingaportion
ofcompensationintheformofthestockinthecompany.
Expenditurestomonitormanagement'sperformance,suchasinternalandexternalaudits.
Bondingexpenditurestoprotectagainstmanagerialdishonesty.
Lostprofits(opportunitycosts)ofcomplexorganizationalstructures.
9.Creditors(theprincipal)haveafixedfinancialclaimontheresourcesofthefirmwhereas
owners(agents)havearesidualclaimonthefirm'sresources.Asaconsequence,ownersmay
attempttoincreasetheriskinessofthefirm'sinvestmentsinhopesofearninghigherreturns.
Creditorssufferfromthistypeofbehaviorbecausetheydonothaveanopportunitytosharein
thesehigherpotentialreturns,yettheysufferfromtheincreasedrisk.
10.Thecontrollerusuallyhasresponsibilityforallaccountingrelatedfunctions,suchas
financialaccounting,costaccounting,andaccountinginformationsystems.Thetreasurer
normallyhasresponsibilityfortheacquisition,custody,andexpenditureoffunds,including

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Chapter1
TheRoleandObjectiveofFinancialManagement
cashandmarketablesecuritiesmanagement,capitalbudgetinganalysis,financial,andpension
fundmanagement,andfinancialplanning.Becausenotallcompaniesdividethe
responsibilitiesinthismanner,theactualfunctionsperformedbythecontrollerandtreasurer
willvaryfromcompanytocompany.
11.a.Financialmanagementemploysthemarginalrevenuemarginalcostrelationshipsof
microeconomicsinmakinglongterminvestment(capitalbudgeting)decisionsandshortterm
investment(workingcapital)decisions.
b.Financialmanagementrequiresanunderstandingofmacroeconomicconceptsdealingwith
monetaryandfiscalpolicy.Knowledgeoftheseconceptsisnecessaryinmakingcompany
salesforecastsandinraisingfundsinthemoneyandcapitalmarkets.
12.Earningspersharefigurescanbemisleadingbecausefactorssuchas(1)reductionsinthe
numberofshares;(2)adeclineinthereturnbeingearnedonthecompany'sequity;and(3)an
increaseintheriskofthefirm,allcouldleadtoincreasedearningspershare,butnot
necessarilytoanincreaseinthevalueofthefirm'ssharesinthemarketplace.
13.ThebondholdersintheRJRNabiscotakeovercasewantedtoblockthetransactionbecause
thetakeoverwastobefinancedwithasubstantialincreaseintheamountofdebt,andtherefore
anincreaseintheriskofdefault.Thecaseofthebondholderswasrejectedinthecourts
because,itwasargued,theseknowledgeableinvestorsknewtheywereexposedtothistypeof
eventriskwhentheypurchasedthebonds,andpresumablywerecompensatedfortheexpected
riskintheformoftheriskpremiumearnedonthebonds.
14.Thethreemajorfactorsthatdeterminethemarketvalueofafirm'sstockare(1)theamount
ofthecashflowsexpectedtobegeneratedforthebenefitofstockholders;(2)thetimingof
thesecashflows;and(3)theriskofthecashflows.
15.Themarketsreactionmayhavereflected(1)anexpectationthattherewouldultimatelybe
asplittingupandspinoffofthenaturalresourcesbusinessfromthesteelbusiness,thereby
assuringthatcashflowsgeneratedbyMarathonOilwouldnotbewastedonreinvestmentinthe
lowreturnsteelbusiness;or(2)thepotentialthatthisseparationwouldmakeitmoredifficult
forthesteelsegmentofUSXtotapthecashflowsofMarathonOil.
16.Bydeclaringbankruptcy,GeneralMotors(GM)hopedtoprotectitselffromtheclaimsof
creditorswhileitsoughtawaytoeithersellorrestructureitsassets.Presumably,the
managementatGMthoughtthatthebankruptcydeclarationwouldprovideitwithan
opportunitytorestructureitself,whileitwasprotectedfromthepressuresofmaking
burdensomeinterestandotherpaymentstocreditors.
17.Firmsthatexpecttheiremployeestoactaccordingtoahighstandardofethicalbehavior
canexpecttoexperiencelowerlitigationcosts.Customers,suppliers,andinvestorscanbe
expectedtovalueafirmcommittedtomaintaininghighethicalstandardsintheconductofits

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TheRoleandObjectiveofFinancialManagement
business,andtherebybuildlongtermloyaltiesandbusinessrelationships.
18.Soleproprietorshipsarecharacterizedbythevirtualnonexistenceofagencyproblems
betweenownersandmanagers,becausetheownerandmanagerareusuallyoneandthesame.
Ofcourse,therestillisthepotentialagencyconflictbetweencreditorsandowners.However,
eveninthiscasetherisktocreditorsisreducedbecausetheownerhasunlimitedpersonal
liabilityforthedebtsofthefirm.Themajorshortcomingoftheproprietorshipformof
organizationisthelimitedabilityoftheownertoraisecapital,becausetheowneristhesole
sourceofequityandtheownerispersonallyliableforallofthefirm'sdebts.
Partnershipsprovideagreaterpotentialforraisingcapitalbecausethereismorethanone
ownermanager.Thecapitalraisingpotentialofpartnershipsislimitedtothenumberof
partnersofthefirm.Ownermanageragencyproblemsassumeincreasedimportanceina
partnershipbecauseeachpartneronlybearsafractionalportionofthecostofhis/heractions.
Hence,ifapartnerconsumesexcessiveperquisites,thepartnerwillonlypayafractionalshare
ofthecostofthiswastefulbehavior.Thelargerthepartnership,thegreateristhispotential
problem.
Corporationshavethegreatestpotentialforownermanageragencyproblemsbecauseofthe
separationofownershipfromcontrol.Offsettingthiscorporatedisadvantageisthenearly
unlimitedabilityofcorporationstoraisecapital,bothdebtandequity.Thecapitalraising
abilityofcorporationscanbeattributedlargelytothelimitedliabilityfeatureofcommonstock
ownership.
Thislimitedliabilityfeaturegivesrisetoincreasedagencycostproblemsbetweenownersand
creditors.

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