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38 Cards in this Set

  • Front
  • Back


a. Investment decision


b. Financial asset


c. Public corporation


d. Corporation


e.Treasurer


f. The cost resulting from conflicts of interest betweenmanagers and shareholders



Financial Decisions. What is the difference between capital budgeting decisions and capital structure decisions?

Both capital budgeting decisions and capital structuredecisions are long-term financial decisions. However, capital budgeting decisions are long-term investment decisions,while capital structure decisions are long-term financing decisions. Capital structure decisions essentiallyinvolve selecting between equity financing and long-term debt financing.

Real versus Financial Assets. Which of the following are real assets, and which are financial?


a. A share of stock


b. A personal IOU


c. A trademark


d. A truck


e. Undeveloped land


f. The balance in the firm’s checking account


g. An experienced and hardworking sales force


h. A bank loan agreement


“Companies usually buy real assets.These include both tangible assets such as executive airplanes andintangible assets such as brand names. To pay for these assets, theysell financial assetssuch as bonds. The decision about which assets to buyis usually termed the capital budgeting or investment decision. The decision about how to raise the money isusually termed the financing decision.”


a. Private corporation


b. Partnership


c. Public corporation


d. Public corporation

Corporations. What do we mean when we say that corporate income is subject to double taxation?

Double taxation means that a corporation’s income is taxedfirst at the corporate tax rate, and then, when the income is distributed toshareholders as dividends, the income is taxed again at each shareholder’spersonal tax rate

Corporations. Which of the following statements always apply to corporations?


a. Unlimited liability


b. Limited life


c. Ownership can be transferred without affecting operations


d. Managers can be fired with no effect on ownership

Ownershipcan be transferred without affecting operations and D. Managers can be firedwith no effect on ownership

Corporations. What is limited liability, and who benefits from it?

The individual stockholders of a corporation (i.e., theowners) are legally distinct from the corporation itself, which is a separatelegal entity. Consequently, thestockholders are not personally liable for the debts of the corporation; thestockholders’ liability for the debts of the corporation is limited to theinvestment each stockholder has made in the shares of the corporation.


B. The corporation survives even if managers aredismissed and C. Shareholders can sell their holdings without disrupting thebusiness.

Corporations. Is limited liability always an advantage for a corporation and its shareholders? Hint: Could limited liability reduce a corporation’s access to financing?

Limited liability is generally advantageous to largecorporations. Large corporations wouldnot be able to obtain financing from thousands or even millions of shareholdersif those shareholders were not protected by the fact that the corporation is adistinct legal entity, conferring the benefit of limited liability on itsshareholders. On the other hand, lendersdo not view limited liability as advantageous to them. In some situations, lenders are not willingto lend to a corporation without personal guarantees from shareholders,promising repayment of a loan in the event that the corporation does not havethe financial resources to repay the loan. Typically, these situations involve small corporations, with only a fewshareholders; often these corporations can obtain debt financing only if theshareholders provide these personal guarantees.

Financial Managers. Which of the following statements more accurately describes the treasurer than the controller?


a. Monitors capital expenditures to make sure that they are not misappropriated


b. Responsible for investing the firm’s spare cash


c. Responsible for arranging any issue of common stock


d. Responsible for the company’s tax affairs

B. Responsible for investing thefirm’s spare cash and C. Responsible for arranging any issue of commonstock.

Financial Managers. Explain the differences between the CFO’s responsibilities and the treasurer’s and controller’s responsibilities.

The responsibilities of the treasurer include thefollowing: supervising cash management, raising capital, and bankingrelationships. The controller’s responsibilities include supervision ofaccounting, preparation of financial statements, and tax matters. The CFO of alarge corporation supervises both the treasurer and the controller. The CFO is responsible for large-scalecorporate planning and financial policy.

Goals of the Firm. Give an example of an action that might increase short-run profits but at the same time reduce stock price and the market value of the firm.

A corporation might cut its labor force dramatically,which could reduce immediate expenses and increase profits in the shortterm. Over the long term, however, thefirm might not be able to serve its customers properly, or it might alienate itsremaining workers; if so, future profits will decrease, and the stock price,and the market value of the firm, will decrease in anticipation of theseproblems.


Similarly,a corporation can boost profits over the short term by using less costlymaterials even if this reduces the quality of the product. Once customers catch on, sales will decreaseand profits will fall in the future. Thestock price will fall.


The moral of these examples is that,because stock prices reflect present andfuture profitability, the corporation should not necessarily sacrificefuture prospects for short-term gains.

Cost of Capital. Why do financial managers refer to the opportunity cost of capital? How would you find the opportunity cost of capital for a safe investment?

Financialmanagers refer to the opportunity cost of capital because corporations increasevalue for their shareholders only by accepting all investment projects thatearn more than this rate. If the company earns below this rate, the marketvalue of the company’s stock falls and stockholders look for other places toinvest. To find the opportunity cost of capitalfor a safe investment, managers and investors look at current interest rates onsafe debt securities, such as U.S. Treasury debt.

Goals of the Firm. You may have heard big business criticized for focusing on short-term performance at the expense of long-term results. Explain why a firm that strives to maximize stock price should be less subject to an overemphasis on short-term results than one that simply maximizes profits.

The stock price reflects the value of bothcurrent and future dividends that the shareholders expect to receive. In contrast, profits reflect performance inthe current year only. Profit maximizersmay try to improve this year’s profits at the expense of future profits. But stock-price maximizers will take accountof the entire stream of cash flows that the firm can generate. They are more apt to be forward-looking.

Goals of the Firm. Fritz is risk-averse and is content with a relatively low but safe return on his investments. Frieda is risk-tolerant and seeks a very high rate of return on her invested savings. Yet both shareholders will applaud a high-risk capital investment that nevertheless offers a superior rate of return. Why? What is meant by “superior”?

Inthis situation, a “superior” rate of return is a rate greater than the rate ofreturn investors could earn elsewhere in the financial markets from alternativeinvestments with risk equal to that of the “high-risk capital investment”described in the problem. Fritz (who isrisk-averse) will likely sell the investment since he is risk averse. Frieda(who is risk-tolerant) will likely keep her shares since it matches her risktolerance

Goals of the Firm. We claim that the goal of the firm is to maximize current market value. Could the following actions be consistent with that goal?


a. The firm adds a cost-of-living adjustment to the pensions of its retired employees.


b. The firm reduces its dividend payment, choosing to reinvest more earnings in the business.


c. The firm buys a corporate jet for its executives.


d. The firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5.


Shareholders want managers to maximize the market value of their investments. The firm faces a trade-off. It can either invest its cash in real assets or it can give the cash back to shareholders in the form of a dividend and they can invest it in financial assets. Shareholders want the company to invest in real assets only if the expected return is higher than they could earn for themselves. The return that shareholders could earn for themselves is therefore the opportunity cost of capital for the firm.

Goals of the Firm. Explain why each of the following may not be appropriate corporate goals.


a. Increase market share


b. Minimize costs


c. Underprice any competitors d. Expand profits


A. Make shareholders as wealthy as possible by investing in real assets.

Cost of Capital. British Quince comes across an average-risk investment project that offers a rate of return of 9.5%. This is less than the company’s normal rate of return, but one of Quince’s directors notes that the company can easily borrow the required investment at 7%. “It’s simple,” he says. “If the bank lends us money at 7%, then our cost of capital must be 7%. The project’s return is higher than the cost of capital, so let’s move ahead.” How would you respond?

The director is mistaken. The risk of the project isnot determined by the borrowing rate from the bank. The opportunity cost ofcapital is the rate of return available from investments in the financialmarkets at the same level of risk as Quince’s average-risk investments. Therefore, the opportunity cost of capital isalso the minimum acceptable rate of return for a firm’s capital investments. The rate of return on the average-riskinvestment project must be compared to the firm’s cost of capital in order todetermine whether to move ahead with the project.

Cost of Capital. In a stroke of good luck, your company has uncovered an opportunity to invest for 10 years at a guaranteed 6% rate of return. How would you determine the opportunity cost of capital for this investment?

The opportunity cost of capital for this investment isthe rate of return that investors can earn in the financial markets from safeinvestments, such as U.S. Treasury securities. The best estimate of theopportunity cost of capital would rely on interest rates on U.S. Treasurieswith the same maturity as that of the proposed investment, i.e., 1-year Treasurybills.


a. Sincethe government guarantees the payoff for the investment, the opportunity costof capital is the rate of return on U.S. Treasuries with 1 year to maturity(i.e., 1-year Treasury bills).


b. Sincethe average rate of return from an investment in carbon is expected to be about20%, this is the opportunity cost of capital for the investment underconsideration by Pollution Busters, Inc. Purchase of the additional sequesters is not a worthwhile capital investmentbecause the expected rate of return is 15% (i.e., a $15,000 gain on a $100,000investment), less than the opportunity cost of capital.

Ethics. Look at some of the practices described in the box on page 20. What, if any, do you believe are the ethical issues involved?

Thereare not necessarily right or wrong answers to these issues. It is important,however, to keep in mind that short selling, acquisitions, and tax avoidanceare all the by-product of an attempt to maximize shareholder value. In theabsence of laws banning companies from producing wealth for their owners,someone will use these techniques to create value for owners

Agency Issues. Many firms have devised defenses that make it much more costly or difficult for other firms to take them over. How might such takeover defenses affect the firm’s agency problems? Are managers of firms with formidable takeover defenses more or less likely to act in the firm’s interest rather than their own?

Takeoverdefenses increase the target firm’s agency problems. One of the mechanisms that stockholders relyon to mitigate agency problems is the threat that an underperforming company(with an underperforming management) will be taken over by anothercompany. If management is protectedagainst takeovers by takeover defenses, it is more likely that managers willact in their own best interest, rather than in the interests of the firm andits stockholders.

Agency Issues. Sometimes lawyers work on a contingency basis. They collect a percentage of their clients’ settlements instead of receiving fixed fees. Why might clients prefer this arrangement? Would the arrangement mitigate an agency problem? Explain.

The contingency arrangement aligns the interests of thelawyer with those of the client. Neithermakes any money unless the case is won. If a client is unsure about the skill or integrity of the lawyer, thisarrangement can make sense. First, thelawyer has an incentive to work hard. Second, if the lawyer turns out to be incompetent and loses the case,the client will not have to pay a bill. Third, the lawyer will not be tempted to accept a very weak case simplyto generate bills. Fourth, there is noincentive for the lawyer to charge for hours not really worked. Once a client is more comfortable with thelawyer, and is less concerned with potential agency problems, a fee-for-servicearrangement might make more sense.

Agency Issues. One of the “Finance through the Ages” episodes that we cited is the 1993 collapse of Barings Bank, when one of its traders lost $1.3 billion. Traders are compensated in large part according to their trading profits. How might this practice have contributed to an agency problem?

Traderscan earn huge bonuses when their trades are very profitable, but if the tradeslose large sums, as in the case of Barings Bank, the trader’s exposure islimited. This asymmetry can create anincentive to take big risks with the firm’s (i.e., the shareholders’)money. This is an agency problem

Agency Issues. When a company’s stock is widely held, it may not pay an individual shareholder to spend time monitoring managers’ performance and trying to replace poor performers. Explain why. Do you think that a bank that has made a large loan to the company is in a different position?

Even if a shareholder could monitor and improvemanagers’ performance, and thereby increase the value of the firm, the payoffwould be small, since the ownership share in a large corporation is verysmall. For example, if you own $10,000of Ford Motor stock and can increase the value of the firm by 5%, a veryambitious goal, you benefit by only: 0.05 ´$10,000 = $500.




In contrast, a bank that has amultimillion-dollar loan outstanding to the firm has a large stake in makingsure that the loan can be repaid. It isclearly worthwhile for the bank to spend considerable resources on monitoringthe firm.

Agency Issues. Company A pays its managers a fixed salary. Company B ties compensation to the performance of the stock.


a. Which company’s compensation would most help to mitigate conflicts of interest between managers and shareholders?


b. Other things equal, which company would experience the greatest variation in earnings?

a. Payingmanagers according to the performance of the firm’s stock aligns their interestwith those of the owners. Since managers are likely to seek to maximize theirown income, linking their compensation to share price is likely to cause themto focus on increasing firm value.


b. Payingmanagers according to the performance of the firm’s stock will cause managersto focus on short- term results, since that will create higher income tomanagers sooner. Long- term decisions may not produce short- term profits, thusmanagers may shy away from making good long- term decisions. Salary compensation plans may induce betterlong- term decisions.

Corporate Governance. How do clear and comprehensive financial reports promote effective corporate governance?

Clearand comprehensive financial reports provide essential information to thenumerous shareholders of large corporations, allowing the shareholders tomonitor the performance of the corporation and its board of directors andmanagement. The debacles at WorldCom andEnron were directly related to a lack of clear and comprehensive financialreports

Corporate Governance. Some commentators have claimed that the U.S. system of corporate governance is “broken” and needs thorough reform. What do you think? Do you see systematic failures in corporate governance or just a few “bad apples”?

While the answer to this question is largely a matterof opinion, and there are significant numbers of “commentators” on each side ofthe issue, the perspective of the authors is that failures of corporategovernance are a matter of a few “bad apples” rather than a symptom ofsystematic failure. The mechanismsdiscussed in the text (such as takeovers, compensation plans, and legal andregulatory requirements) for ameliorating agency problems generally contributeto effective corporate governance. Onthe other hand, commentators on both sides of the issue would likely welcomeimprovements in these mechanisms.

Agency Issues. Which of the following forms of compensation is most likely to align the interests of managers and shareholders?


a. A fixed salary


b. A salary linked to company profits


c. A salary that is paid partly in the form of the company’s shares


Agency Costs. What are agency costs? List some ways by which agency costs are mitigated.

Agencycosts are caused by conflicts of interest between managers and shareholders,who are the owners of the firm. In mostlarge corporations, the principals (i.e., the stockholders) hire the agents(i.e., managers) to act on behalf of the principals in making many of the majordecisions affecting the corporation and its owners. However, it is unrealistic to believe thatthe agents’ actions will always be consistent with the objectives that thestockholders would like to achieve. Managers may choose not to work hard enough, to overcompensatethemselves, to engage in empire building, to overconsume perquisites, and soon.


Corporations use numerous arrangements in anattempt to ensure that managers’ actions are consistent with stockholders’objectives. Agency costs can bemitigated by “carrots,” linking the manager’s compensation to the success ofthe firm, or by “sticks,” creating an environment in which poorly performingmanagers can be removed.

Reputation. As you drive down a deserted highway, you are overcome with a sudden desire for a hamburger. Fortunately, just ahead are two hamburger outlets; one is owned by a national brand, and the other appears to be owned by “Joe.” Which outlet has the greater incentive to serve you cat meat? Why?

The national chain has a great incentive to imposequality control on all of its outlets. If one store serves its customers poorly, that can result in lost futuresales. The reputation of each restaurantin the chain depends on the quality in all the other stores. In contrast, if Joe’s serves mostly passingtravelers who are unlikely to show up again, unsatisfied customers pose a farlower cost. They are unlikely to be seenagain anyway, so reputation is not a valuable asset.




The important distinction is not that Joe has one outlet while thenational chain has many. Instead, it isthe likelihood of repeat relations with customers and the value ofreputation. If Joe’s were located in thecenter of town instead of on the highway, one would expect his clientele to berepeat customers from town. He wouldthen have the same incentive to establish a good reputation as the chain has.

Ethics. In some countries, such as Japan and Germany, corporations develop close long-term relationships with one bank and rely on that bank for a large part of their financing needs. In the United States, companies are more likely to shop around for the best deal. Do you think that this practice is more or less likely to encourage ethical behavior on the part of the corporation?

Long-termrelationships can encourage ethical behavior. If you know that you will engage in business with another party on arepeated basis, you will be less likely to take advantage of your businesspartner if an opportunity to do so arises. When people say "What goes around comes around," theyrecognize that the way they deal with their associates will influence the waytheir associates treat them. Whenrelationships are short-lived, however, the temptation to be unfair is greatersince they provide less reason to fear reprisal and less opportunity for fairdealing to be reciprocated

Ethics. Is there a conflict between “doing well” and “doing good”? In other words, are policies that increase the value of the firm (doing well) necessarily at odds with socially responsible policies (doing good)? When there are conflicts, how might government regulations or laws tilt the firm toward doing good? For example, how do taxes or fees charged on pollutants affect the firm’s decision to pollute? Can you cite other examples of “incentives” used by governments to align private interests with public ones?

As the text notes, the first step in doing well isdoing good by your customers. Businessescannot prosper for long if they do not provide to their customers the productsand services they desire. In addition,reputation effects often make it in the firm’s own interest to act ethicallytoward its business partners and employees since the firm’s ability to makedeals and to hire skilled labor depends on its reputation for dealing fairly. In some circumstances, when firms haveincentives to act in a manner inconsistent with the public interest, taxes orfees can align private and public interests. For example, taxes or fees charged on pollution make it more costly forfirms to pollute, thereby affecting the firm’s decisions regarding activitiesthat cause pollution. Other “incentives”used by governments to align private interests with public interests includelegislation providing for worker safety and product, or consumer, safety;building code requirements enforced by local governments; and pollution andgasoline mileage requirements imposed on automobile manufacturers.

Goals of the Firm. It is sometimes suggested that instead of seeking to maximize shareholder value and, in the process, pursuing profit, the firm should seek to maximize the welfare of all its stakeholders, such as its employees, its customers, and the community in which it operates. How far would this objective conflict with one of maximizing shareholder value? Do you think such an objective is feasible or desirable?

There need not be a conflict between maximizingshareholder value and maximizing the value of stakeholders. A good reputationwith customers, employees, and other stakeholders is important for the firm’slong-run profitability and value. Mangers who view satisfied stakeholders asdetracting from value instead of enhancing value ignore the long- term valuecreated by an enhanced reputation. Short- term value may be enhanced byneglecting stakeholders, but such behavior is shortsighted and will destroytotal value.