IFM10 Ch01 Solutions Manual.docx
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IFM10 Ch01 Solutions Manual.docx
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IFM10Ch01SolutionsManual
Chapter1
AnOverviewofFinancialManagement
ANSWERSTOBEGINNING-OF-CHAPTERQUESTIONS
1-1Theprimarygoalisassumedtobeshareholderwealthmaximization,whichtranslatestostockpricemaximization.That,inturn,meansmaximizingthePVoffuturefreecashflows.
Maximizingshareholderwealthrequiresthatthefirmproducethingsthatcustomerswant,andatthelowestcostconsistentwithhighquality.Italsomeansholdingriskdown,whichwillresultinarelativelylowcostofcapital,whichisnecessarytomaximizethePVofagivencashflowstream.
Thisalsogetsintotheissueofcapitalstructure—howmuchdebtshouldweuse?
Themoredebtthefirmuses,theloweritstaxes,andthefewersharesoutstanding,hencelessdilutionofearnings.However,moredebtmeansmorerisk.So,it’snecessarytoconsidercapitalstructurewhenattemptingtomaximizeshareprices.
Dividendpolicyisalsoanissue—howmuchofitsearningsshouldthefirmpayoutasdividends?
Theanswertothatquestiondependsonanumberoffactors,includingthefirm’sinvestmentopportunities,itsaccesstocapitalmarkets,itsstockholders’desires(andtheirtaxrates),andthekindofsignalsstockholdersgetfromdividendactions.
Shareholderwealthmaximizationispartiallyconsistentandpartiallyinconsistentwithgenerallyacceptedsocietalgoals.Itisconsistentbecausewell-runfirmsproducegoodproductsatlowcosts,sellthematcompetitiveprices,employpeople,paytaxes,andgenerallyimprovesociety.However,withoutconstraints,firmswouldtendtoformmonopoliesandendupchargingpricesthataretoohighandnotproducingenoughoutput.Theymightalsopollutetheairandwater,engageinunfairlaborpractices,andsoon.So,constraints(antitrust,labor,environmental,etc.laws)shouldbeandareimposedonbusinesses.Thatsaid,stockpricemaximizationisconsistentwithastrongeconomy,economicprogress,and“thegoodlife”formostcitizens.
Instandardintroductorymicroeconomicscourses,weassumethatfirmsattempttomaximizeprofits.Inmoreadvancedeconcourses,thegoalisbroadenedtovaluemaximizing,sofinanceandeconomicsareindeedconsistent.
AsWorldCom,Enron,andothercorporatescandalsdemonstratedveryclearly,managersdonotalwayshavestockholders’interestsasaprimarygoal—somemanagershavetheirowninterests.Thispointisdiscussedfurtherbelow.
1-2Seethemodelforquantitativeanswerstothisquestion.Allofthesevaluationsinvolveapplicationsofthebasicvaluationmodel:
.
ValuesforCFt,r,andNarespecified.Forbonds,theCFsareinterestpaymentsandthematurityvalue,andNisthebond’slife.Otherthingsheldconstant,thehigherthegoinginterestrate,r,thelowerthevalueofthebond.Also,ifthecouponrateishigh,thenCFsarealsohigh,andthatincreasesthevalueofthebond.Forastock,theCFsaredividends,andforacapitalbudgetingproject,theyareoperatingcashflows.
Themainpointtogetacrosswiththisquestionisthatallassetsarevaluedinessentiallythesameway.TheExcelmodelgoesintoalittlemoredetailonsensitivityanalysis.Muchmorecomeslaterinthebook.
1-3Anagencyrelationshipexistswhenoneparty(theprincipal)delegatesauthoritytosomeotherparty(theagent).Stockholdersdelegateauthoritytomanagers,anddebtholdersdelegateauthoritytostockholders(whoactthroughmanagers).Anyconflictbetweenprincipalsandagentsiscalledanagencyproblem,oragencyconflict.Agoodexampleofanagencyconflictbetweenstockholdersandmanagersisrelatedtoexecutivesalaries.Tosomeextent,topexecutivesestablishtheirowncompensation,andifthatcompensationis“toohigh,”itadverselyaffectsstockholders.
Theprimaryconflictsbetweenstockholdersandmanagersrelateto
(2)managerialcompensation,
(2)managerialperks,and(3)managerialeffort.Thecompensationissueisobvious.Perksarelessobvious,buttheyhavethesameeffectasexcessivesalaries—theydrainthefirm’sfundstothebenefitofmanagersbutnotstockholders.Theeffortissuerelatestomanagerstakingtoomuchtimeoffforleisureactivities,andalsotoserve(withcompensation)onothercorporateboardsandthelike.
Agencyconflictsarereallyquitepervasive.Theyexistbetweenmanyemployeesandtheirsupervisors,andtheycertainlyexistamonggovernmentworkersandperhapsbetweenelectedofficialsandthepeoplewhoelectedthem.
1-4Agencyconflictsbetweenstockholdersandmanagerscanobviouslysiphonofffundsthroughexcessivesalaries,perks,andinsufficientmanagerialeffort.Todealwiththis,companiestrytostructureexecutivecompensationsothatmanagersdowellifandwhenstockholdersdowell.Thismeansthatcompensationisbasedinlargepartonoperatingperformanceandstockprices.Inaddition,“good”boardsofdirectorsconsistlargelyofstrong,independent,outsidedirectors,whoarenotbeholdentomanagement,andwhoarewillingandabletoreplaceamanagerialteamthathasnotperformedwell.
Agencyconflictsbetweenstockholders(managers)anddebtholderscanalsohavebadconsequences.Bondholdersinvestexpectingthefirmtoinvestinassetswithagivendegreeofrisk,andtofinancewithagivencapitalstructure.If,afterraisingdebtcapitalwhenthefirmhadlowriskassetsandamodestamountofdebt,thefirmthenstartedsellinglowriskassetsandredeployingcapitalintoriskyventures,andborrowingextensively,thentheriskoftheoutstandingdebtwouldrise,andthatwouldleadtoadeclineinitsvalue.Thatmightbenefitthestockholders,becauseiftheriskynewventuressucceededthestockholderswouldgetmostofthebenefits,butiftheyfailed,thebondholderswouldsharefullyinthelosses—headsIwin,tailsyoulose.
Ifafirmdevelopsareputationfortreatingcreditorsshabbily,thenitwillfinditsaccesstocapitalmarketslimited,andthecostofanymoneyitcanborrowexpensive.Also,creditorswill(andshould)buildcovenantsintodebtagreementsthatconstraintheactionsfirmscantakeifthoseactionswouldadverselyaffectthecreditors.
1-5Sarbanes-Oxley(SOX)isanactpassedbyCongressin2002andcreatedtoaddressagencyproblemsbetweenmanagementandshareholders,andbetweenexternalevaluatorslikeanalystsandauditingfirms,andshareholders.SOXputinplaceregulationsthatmadeitmoredifficultformanagerstolietoshareholdersaboutafirm’sperformance,andtosetupaccountingschemestostealfromthefirm.SOXalsoputinplaceregulationsthatmadeitlesslikelythatauditorswouldhaveconflictsofinterestthatwouldinducethemtocollaboratewithmanagementintheseschemes.Finally,SOXputinplaceregulationsthatweredesignedtolimittheincentivesforinvestmentanalyststomisrepresenttheiranalysisinreturnforsalary,bonus,orotherreasons.
1-6Thecostofmoneyisaffectedby
(1)productionopportunities,
(2)thetimepreferenceforconsumption,(3)risk,and(4)inflation.Whenproductionopportunitiesaregood,andassetsareearninghighratesofreturn,theninterestratestendtobehigherbecausethereisalargerdemandforborrowingtofinancetheseprojects.Also,investorswhoareconsideringlendingmoneyrecognizethattheiralternativeinvestmentshaveahighreturn,andsodemandahighreturnontheirinvestments.Wheninvestorshaveastrongpreferenceforcurrentconsumption,thentheydemandahigherreturnontheirinvestmentstocompensatethemforhavingtodefercurrentpurchases,andsothecostofmoneyishigher.Investorsdemandahigherrateofreturnonriskierinvestmentsinordertocompensatethemforthehavingtobeexposedtomorerisk,andwheninvestorsexpectfutureinflation,thenthecostofmoneyincreasessothatinvestmentreturnsbettercoverthisfuturepriceincrease.
Ifanyofthesefactorschange,thenthecostofmoneywillchange,andhencetheyieldandthepriceofasecuritywillchangeaswell.Forexample,ifoverallthetimepreferenceforconsumptionincreases,thenoverallinterestrateswilltendtoincreaseandtheyieldondebtinstrumentswilltendtoincrease,andtheirpriceswillfall.Iftheunderlyinglevelofinflationdeclines,asitdidthroughthe1990s,theninterestratesondebtinstrumentswilldecline,drivinguptheirprices.Ontheotherhand,ifacompanyexperiencesfinancialproblems,increasingthelikelihoodofdefaultandbankruptcyandbecomingmorerisky,thentheyieldonitsbondswillincreaseandtheirpriceswillfall.
ANSWERSTOEND-OF-CHAPTERQUESTIONS
1-1a.Stockholderwealthmaximizationistheappropriategoalformanagementdecisions.Theriskandtimingassociatedwithexpectedearningspershareandcashflowsareconsideredinordertomaximizethepriceofthefirm’scommonstock.
b.Productionopportunitiesarethereturnsavailablewithinaneconomyfrominvestmentinproductiveassets.Thehighertheproductionopportunities,themoreproducerswouldbewillingtopayforrequiredcapital.Consumptiontimepreferencesrefertothepreferredpatternofconsumption.Consumer’stimepreferencesforconsumptionestablishhowmuchconsumptiontheyarewillingtodefer,andhencesave,atdifferentlevelsofinterest.
c.AforeigntradedeficitoccurswhenbusinessesandindividualsintheU.S.importmoregoodsfromforeigncountriesthanareexported.Tradedeficitsmustbefinanced,andthemainsourceoffinancingisdebt.Therefore,asthetradedeficitincreases,thedebtfinancingincreases,drivingupinterestrates.U.S.interestratesmustbecompetitivewithforeigninterestrates;iftheFederalReserveattemptstosetinterestrateslowerthanforeignrates,foreignerswillsel
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