FIN 507 Solution ANSWERS TO QUESTIONS 1. With an objective of maximizing shareholder wealth, capital wll tend to be allocated to the ‘most productive investment opportunities on a risk-adjusted retum basis. Other decisions will also be made to maximize efficiency. If all firms do this, productivity will be heightened and the economy will ealize higher real growth. There will be a greater level of overall economic want satisfaction, Presumably people overall will benefit, but this depends in part on the redistribution of income and wealth via taxation and social programs. In other words, the economic pie will grow larger and everybody should be better off if there is no reslicing. With reslcing, itis possible some people will be worse off, but that isthe result of a governmental change in redistribution. It is not due to the objective function of corporations, 2. Maximizing earnings is a nonfunctional objective for the following reasons: 1, Earnings is a time vector. Unless one time vector of earnings elearly dominates all other lime vectors, itis impossible to select the vector that will maximize earnings. b. Each time vector of eaming possesses a risk characteristic. Maximizing expected ‘earnings ignores the risk parameter, c. Earnings can be inereased by selling stock and buying treasury bills. Earnings will ‘continue to increase since stock does not require out-of-pocket costs 4. The impact of dividend policies is ignored. If all earnings are retained, future earnings are increased. However, stock prices may deerease as a tesult of adverse reaction to the absence of dividends, Maximizing wealth takes into account camings, the timing and risk of these earnings, and the dividend policy of the firm, 3. Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind. Thus, the funetion of Financial management can be broken down into three major decision areas: the investment, financing, and asset ‘management decisions, 4. Yes, zero accounting profit while the firm establishes market position is consistent with the maximization of wealth objective. Other investments where short-run profits are sacrificed for the long-run also are possible 5. The goal of the firm gives the financial manager an objective function to maximize. He/she can judge the value (efficiency) of any financial decision by its impact on that goal. Without such a goal, the manager would be "at sea” in that he/she would have no objective criterion to guide his/her actions, 6, The financial manager is involved in the acquisition, financing, and management of assets, These three functional areas are all interrelated (e.g., 4 decision to acquire an asset necessitates the financing and management of that asset, whereas financing and ‘management costs affect the decision to invest) 7. If managers have sizable stock positions in the company, they will have a greater understanding for the valuation of the company. Moreover, they may have a greater incentive to maximize sharcholder wealth than they would in the absence of stock holdings. However, to the extent persons have not only human capital but also most of their financialFIN 507 10. In comp Solution \Van Horne and Wachowicz, Fundamentals of Financial Management, 13" edition, Instructor's Manual capital tied up in the company, they may be more risk averse than is desirable. If the company deteriorates because a risky decision proves bad, they stand to Jose uot only their Jobs but have a drop in the value of their assets. Excessive risk aversion can work to the detriment of maximizing shareholder wealth as can excessive risk seeking, if the manager is particularly risk prone. Regulations imposed by the government constitute constraints agsinst which shareholder ‘wealth can still be maximized, Is important that wealth maximization remain the principal goal of firms if economic efficiency is to be achieved in society and people are to have increasing real standards of living, The benefits of regulations to society must be evaluated relative to the costs imposed on economic efficiency. Where benefits ate small relative to the costs, businesses need to make this known through the political process so that the regulations can be modified. Presently there is considerable attention being given in ‘Washington to deregulation, Some thinus have been done to make regulations less onerous and to allow competitive markets to work. A in other things, there is a competitive market for good managers, A company must pay them their opportunity cost, and indeed this is in the interest of stockholders. To the extent managers are paid in excess of their economic contribution, the returns available to investors will be less. However, stockholders can sell their stock and invest elsewhere. Therefore, there is balameing factor that works in the direction of equilibrating, managers’ pay across business firms for a given level of economic contribution tive and efficient markets, greater rewards can be obtained only with greater risk. The financial manager is constantly involved in decision involving a trade-off between the two. For the company, it is important that it do well what it knows best. There is Tittle reason to believe that if it gets into a new area in whieh it has no expertise that the rewards will be commensurate with the risk that is involved, The sisk-rewatd trade-off will become increasingly apparent tothe student as this book unfolds, Corporate governance refers to the system by which corporations are managed and controlled. It encompasses the relationships among a company’s shareholders, board of directors, and senior management. These relationships provide the framework within which corporate objectives are set and performance is monitored. The board of directors sets company-wide policy and advises the CEO and other senior executives, who manage the company’s day-to-day activities. The Board reviews and approves strategy, significant investments, and acquisitions. The board also oversees operating plans, eapital budgets, and the company’s financial reports to common shareholders ‘The controller's responsibilities are primarily accounting in nature. Cost accounting, as well as budgets and forecasts, would be for intemal consumption. External financial reporting ‘would be provided to the IRS, the SEC, and the stockholders. The treasurer's responsibilities fall into the decision areas most commonly associated with financial management: investment (capital budgeting, pension management), financing (commercial banking and investment banking relationships, investor relations, dividend. disbursement), and asset management (cash management, ctedit management)