Answers to Concepts Review and Critical Thinking Questions
1. Capital budgeting (deciding whether to expand a manufacturing
plant), capital structure (deciding whether to issue new equity and use the
proceeds to retire outstanding debt), and working capital management (modifying
the firm’s credit collection policy with its customers).
2. Disadvantages: unlimited liability, limited life, difficulty in
transferring ownership, hard to raise capital funds. Some advantages: simpler,
less regulation, the owners are also the managers, sometimes personal tax rates
are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double
taxation to shareholders of distributed earnings and dividends. Some advantages
include: limited liability, ease of transferability, ability to raise capital, and
unlimited life.
4. In response to
Sarbanes-Oxley, small firms have elected to go dark because of the costs of
compliance. The costs to comply with Sarbox can be several million dollars,
which can be a large percentage of a small firms profits. A major cost of going
dark is less access to capital. Since the firm is no longer publicly traded, it
can no longer raise money in the public market. Although the company will still
have access to bank loans and the private equity market, the costs associated
with raising funds in these markets are usually higher than the costs of
raising funds in the public market.
5. The treasurer’s office and the controller’s office are the two
primary organizational groups that report directly to the chief financial
officer. The controller’s office handles cost and financial accounting, tax
management, and management information systems, while the treasurer’s office is
responsible for cash and credit management, capital budgeting, and financial
planning. Therefore, the study of corporate finance is concentrated within the
treasury group’s functions.
6. To maximize the current market value (share price) of the equity
of the firm (whether it’s publicly-traded or not).
7. In the corporate form of ownership, the shareholders are the owners
of the firm. The shareholders elect the directors of the corporation, who in
turn appoint the firm’s management. This separation of ownership from control
in the corporate form of organization is what causes agency problems to exist.
Management may act in its own or someone else’s best interests, rather than
those of the shareholders. If such events occur, they may contradict the goal
of maximizing the share price of the equity of the firm.
8. A primary market transaction.
9. In auction markets like the NYSE, brokers and agents meet at a
physical location (the exchange) to match buyers and sellers of assets. Dealer
markets like NASDAQ consist of dealers operating at dispersed locales who buy
and sell assets themselves, communicating with other dealers either electronically
or literally over-the-counter.
10. Such organizations frequently pursue social or political missions,
so many different goals are conceivable. One goal that is often cited is
revenue minimization; i.e., provide whatever goods and services are offered at
the lowest possible cost to society. A better approach might be to observe that
even a not-for-profit business has equity. Thus, one answer is that the
appropriate goal is to maximize the value of the equity.
11. Presumably, the current stock value reflects the risk, timing, and
magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.
12. An argument can be made either way. At the one extreme, we could
argue that in a market economy, all of these things are priced. There is thus
an optimal level of, for example, ethical and/or illegal behavior, and the
framework of stock valuation explicitly includes these. At the other extreme,
we could argue that these are non-economic phenomena and are best handled
through the political process. A classic (and highly relevant) thought question
that illustrates this debate goes something like this: “A firm has estimated
that the cost of improving the safety of one of its products is $30 million.
However, the firm believes that improving the safety of the product will only
save $20 million in product liability claims. What should the firm do?”
13. The
goal will be the same, but the best course of action toward that goal may be
different because of differing social, political, and economic institutions.
14. The
goal of management should be to maximize the share price for the current
shareholders. If management believes that it can improve the profitability of
the firm so that the share price will exceed $35, then they should fight the
offer from the outside company. If management believes that this bidder or
other unidentified bidders will actually pay more than $35 per share to acquire
the company, then they should still fight the offer. However, if the current
management cannot increase the value of the firm beyond the bid price, and no
other higher bids come in, then management is not acting in the interests of
the shareholders by fighting the offer. Since current managers often lose their
jobs when the corporation is acquired, poorly monitored managers have an
incentive to fight corporate takeovers in situations such as this.
15. We
would expect agency problems to be less severe in countries with a relatively
small percentage of individual ownership. Fewer individual owners should reduce
the number of diverse opinions concerning corporate goals. The high percentage
of institutional ownership might lead to a higher degree of agreement between
owners and managers on decisions concerning risky projects. In addition,
institutions may be better able to implement effective monitoring mechanisms on
managers than can individual owners, based on the institutions’ deeper
resources and experiences with their own management. The increase in
institutional ownership of stock in the United
States and the growing activism of these large
shareholder groups may lead to a reduction in agency problems for U.S.
corporations and a more efficient market for corporate control.
16. How much is too much? Who is worth more, Ray Irani or Tiger Woods?
The simplest answer is that there is a market for executives just as there is
for all types of labor. Executive compensation is the price that clears the
market. The same is true for athletes and performers. Having said that, one
aspect of executive compensation deserves comment. A primary reason executive
compensation has grown so dramatically is that companies have increasingly
moved to stock-based compensation. Such movement is obviously consistent with
the attempt to better align stockholder and management interests. In recent
years, stock prices have soared, so management has cleaned up. It is sometimes
argued that much of this reward is simply due to rising stock prices in
general, not managerial performance. Perhaps in the future, executive
compensation will be designed to reward only differential performance, i.e.,
stock price increases in excess of general market increases.
