Intermediate Financial Management Ch 1 Solutions Essay

Chapter 1 An Overview of Financial Management ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 1-1The primary goal is assumed to be shareholder wealth maximization, which translates to stock price maximization. That, in turn, means maximizing the PV of future free cash flows. Maximizing shareholder wealth requires that the firm produce things that customers want, and at the lowest cost consistent with high quality. It also means holding risk down, which will result in a relatively low cost of capital, which is necessary to maximize the PV of a given cash flow stream. This also gets into the issue of capital structure—how much debt should we use?

The more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less dilution of earnings. However, more debt means more risk. So, it’s necessary to consider capital structure when attempting to maximize share prices. Dividend policy is also an issue—how much of its earnings should the firm pay out as dividends? The answer to that question depends on a number of factors, including the firm’s investment opportunities, its access to capital markets, its stockholders’ desires (and their tax rates), and the kind of signals stockholders get from dividend actions.

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Shareholder wealth maximization is partially consistent and partially inconsistent with generally accepted societal goals. It is consistent because well-run firms produce good products at low costs, sell them at competitive prices, employ people, pay taxes, and generally improve society. However, without constraints, firms would tend to form monopolies and end up charging prices that are too high and not producing enough output. They might also pollute the air and water, engage in unfair labor practices, and so on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed on businesses.

That said, stock price maximization is consistent with a strong economy, economic progress, and “the good life” for most citizens. In standard introductory microeconomics courses, we assume that firms attempt to maximize profits. In more advanced econ courses, the goal is broadened to value maximizing, so finance and economics are indeed consistent. As WorldCom, Enron, and other corporate scandals demonstrated very clearly, managers do not always have stockholders’ interests as a primary goal—some managers have their own interests. This point is discussed further below. 1-2See the model for quantitative answers to this question.

All of these valuations involve applications of the basic valuation model: [pic]. Values for CFt , r, and N are specified. For bonds, the CFs are interest payments and the maturity value, and N is the bond’s life. Other things held constant, the higher the going interest rate, r, the lower the value of the bond. Also, if the coupon rate is high, then CFs are also high, and that increases the value of the bond. For a stock, the CFs are dividends, and for a capital budgeting project, they are operating cash flows. The main point to get across with this question is that all assets are valued in essentially the same way.

The Excel model goes into a little more detail on sensitivity analysis. Much more comes later in the book. 1-3An agency relationship exists when one party (the principal) delegates authority to some other party (the agent). Stockholders delegate authority to managers, and debtholders delegate authority to stockholders (who act through managers). Any conflict between principals and agents is called an agency problem, or agency conflict. A good example of an agency conflict between stockholders and managers is related to executive salaries.

To some extent, top executives establish their own compensation, and if that compensation is “too high,” it adversely affects stockholders. The primary conflicts between stockholders and managers relate to (2) managerial compensation, (2) managerial perks, and (3) managerial effort. The compensation issue is obvious. Perks are less obvious, but they have the same effect as excessive salaries—they drain the firm’s funds to the benefit of managers but not stockholders. The effort issue relates to managers taking too much time off for leisure activities, and also to serve (with compensation) on other corporate boards and the like.

Agency conflicts are really quite pervasive. They exist between many employees and their supervisors, and they certainly exist among government workers and perhaps between elected officials and the people who elected them. 1-4Agency conflicts between stockholders and managers can obviously siphon off funds through excessive salaries, perks, and insufficient managerial effort. To deal with this, companies try to structure executive compensation so that managers do well if and when stockholders do well.

This means that compensation is based in large part on operating performance and stock prices. In addition, “good” boards of directors consist largely of strong, independent, outside directors, who are not beholden to management, and who are willing and able to replace a managerial team that has not performed well. Agency conflicts between stockholders (managers) and debtholders can also have bad consequences. Bondholders invest expecting the firm to invest in assets with a given degree of risk, and to finance with a given capital structure.

If, after raising debt capital when the firm had low risk assets and a modest amount of debt, the firm then started selling low risk assets and redeploying capital into risky ventures, and borrowing extensively, then the risk of the outstanding debt would rise, and that would lead to a decline in its value. That might benefit the stockholders, because if the risky new ventures succeeded the stockholders would get most of the benefits, but if they failed, the bondholders would share fully in the losses—heads I win, tails you lose.

If a firm develops a reputation for treating creditors shabbily, then it will find its access to capital markets limited, and the cost of any money it can borrow expensive. Also, creditors will (and should) build covenants into debt agreements that constrain the actions firms can take if those actions would adversely affect the creditors. 5. Sarbanes-Oxley (SOX) is an act passed by Congress in 2002 and created to address agency problems between management and shareholders, and between external evaluators like analysts and auditing firms, and shareholders.

SOX put in place regulations that made it more difficult for managers to lie to shareholders about a firm’s performance, and to set up accounting schemes to steal from the firm. SOX also put in place regulations that made it less likely that auditors would have conflicts of interest that would induce them to collaborate with management in these schemes. Finally, SOX put in place regulations that were designed to limit the incentives for investment analysts to misrepresent their analysis in return for salary, bonus, or other reasons. -6The cost of money is affected by (1) production opportunities, (2) the time preference for consumption, (3) risk, and (4) inflation. When production opportunities are good, and assets are earning high rates of return, then interest rates tend to be higher because there is a larger demand for borrowing to finance these projects. Also, investors who are considering lending money recognize that their alternative investments have a high return, and so demand a high return on their investments.

When investors have a strong preference for current consumption, then they demand a higher return on their investments to compensate them for having to defer current purchases, and so the cost of money is higher. Investors demand a higher rate of return on riskier investments in order to compensate them for the having to be exposed to more risk, and when investors expect future inflation, then the cost of money increases so that investment returns better cover this future price increase. If any of these factors change, then the cost of money will change, and hence the yield and the price of a security will change as well.

For example, if overall the time preference for consumption increases, then overall interest rates will tend to increase and the yield on debt instruments will tend to increase, and their prices will fall. If the underlying level of inflation declines, as it did through the 1990s, then interest rates on debt instruments will decline, driving up their prices. On the other hand, if a company experiences financial problems, increasing the likelihood of default and bankruptcy and becoming more risky, then the yield on its bonds will increase and their prices will fall. pic]ANSWERS TO END-OF-CHAPTER QUESTIONS 1-1a. Stockholder wealth maximization is the appropriate goal for management decisions. The risk and timing associated with expected earnings per share and cash flows are considered in order to maximize the price of the firm’s common stock. b. Production opportunities are the returns available within an economy from investment in productive assets. The higher the production opportunities, the more producers would be willing to pay for required capital. Consumption time preferences refer to the preferred pattern of consumption.

Consumer’s time preferences for consumption establish how much consumption they are willing to defer, and hence save, at different levels of interest. c. A foreign trade deficit occurs when businesses and individuals in the U. S. import more goods from foreign countries than are exported. Trade deficits must be financed, and the main source of financing is debt. Therefore, as the trade deficit increases, the debt financing increases, driving up interest rates. U. S. interest rates must be competitive with foreign interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates, foreigners will sell U.

S. bonds, decreasing bond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relative to the size of the overall economy, it may hinder the Fed’s ability to combat a recession by lowering interest rates. d. An agency relationship arises whenever one or more individuals, the principals, hire another individual, the agent, to perform some service and then delegate decision-making authority to that agent. Primary agency relationships exist between (1) stockholders and managers, and (2) between debtholders and stockholders. e.

Agency costs include all costs borne by shareholders to encourage managers to maximize a firm’s stock price rather than act in their own self-interests. The three major categories of agency costs are (1) expenditures to monitor managerial actions, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside investors to the board of directors; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for stockholder votes n certain issues, limit the ability of managers to take timely actions that would enhance shareholder wealth. f. An agency problem arises whenever a manager of a firm owns less than 100 percent of the firm’s common stock, creating a potential conflict of interest called an agency conflict. The fact that the manager will neither gain all the benefits of the wealth created by his or her efforts nor bear all of the costs of perquisite consumption will increase the incentive to take actions that are not in the best interests of the nonmanager shareholders.

In addition to conflicts between stockholders and managers, there can also be conflicts between stockholders (through managers) and creditors. Creditors have a claim on part of the firm’s earnings stream for payment of interest and principal on debt, and they have a claim on the firm’s assets in the event of bankruptcy. However, stockholders have control (through managers) of decisions that affect the riskiness of the firm. g.

A typical executive compensation program is structured in three parts: (1) a specified annual salary; (2) a bonus paid at the end of the year, which depends on the company’s profitability during the year; and (3) options to buy stock, or actual shares of stock, which reward the executive for long-term performance. Economic Value Added (EVA) is a method used to measure a firm’s true profitability. EVA is found by taking the firm’s after-tax operating profit and subtracting the annual cost of all the capital a firm uses.

If the firm generates a positive EVA, its management has created value for its shareholders. If the EVA is negative, management has destroyed shareholder value. h. Executive stock options are performance-based incentive plans popular in the 1950s and 1960s which allowed managers to purchase stock at some time in the future at a given price. This type of plan lost favor in the 1970s; they generally did not pay in the 1970s because the stock market declined. i. A market is said to be transparent when reliable and accurate nformation is available to all market participants. j. A conflict of interests arises for an accounting firm when it provides both consulting services and auditing services to the same client. The accounting firm may be reluctant to do a good job in auditing if it fears that in doing so it might lose consulting business. k. The Sarbanes-Oxley Act of 2002 established increased requirements for corporate accountability, and increased penalties for corporate fraud. It was enacted in response to the widespread accounting scandals of the early 2000s. -2Such factors as a compensation system that is based on management performance (bonuses tied to profits, stock option plans) as well as the possibility of being removed from office (voted out of office, an unfriendly tender offer by another firm) serve to keep management’s focus on stockholders’ interests. 1-3A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when discounted at the weighted average cost of capital. If the market price reflects all relevant information, then the observed price is also the intrinsic price. 1-4a.

Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more attractive community that will make it easier to hire a productive work force. This corporate philanthropy could be received by stockholders negatively, especially those stockholders not living in its headquarters city. Stockholders are interested in actions that maximize share price, and if competing firms are not making similar contributions, the “cost” of this philanthropy has to be borne by someone–the stockholders. Thus, stock price could decrease. . Companies must make investments in the current period in order to generate future cash flows. Stockholders should be aware of this, and assuming a correct analysis has been performed, they should react positively to the decision. The Chinese plant is in this category. Assuming that the correct capital budgeting analysis has been made, the stock price should increase in the future. 1-5Earnings per share in the current year will decline due to the cost of the investment made in the current year and no significant performance impact in the short run.

However, the company’s stock price should increase due to the significant cost savings expected in the future. 1-6The executive wants to demonstrate strong performance in a short period of time. Strong performance can be demonstrated either through improved earnings and/or a higher stock price. The current board of directors is well served if the manager works to increase the stock price; however, the board is not well served if the manager takes short-run actions which bump up short-run earnings, at the expense of long-run profitability and the company’s stock price.

Consequently, the board may want to rely more on stock options and less on performance shares which are tied to accounting performance. 1-7As the stock market becomes more volatile, the link between the stock price and the ability of senior management is weakened. Therefore, in this environment, companies may choose to de-emphasize the awarding of stock and stock options, and rely more on bonuses and performance shares which are tied to other performance measures besides the company’s stock price.

Moreover, in this environment, it may be harder to attract or retain top talent if the compensation were tied too much to the company’s stock price. 1-8a. No, the TIAA-CREF is not an ordinary shareholder. Because it is the largest institutional shareholder in the United States and it controls over $400 billion in pension funds, its voice carries a lot of weight. This “shareholder” in effect consists of many individual shareholders whose pensions are invested with this group. b. The owners of TIAA-CREF are the individual teachers whose pensions are invested with this group. . For the TIAA-CREF to be effective in yielding its weight, it must act as a coordinated unit. In order to do this, the fund’s managers should solicit from the individual shareholders their “votes” on the fund’s practices, and from those “votes” act on the majority’s wishes. In so doing, the individual teachers whose pensions are invested in the fund have in effect determined the fund’s voting practices. MINI CASE Suppose you decided (like Michael Dell) to start a computer company.

You know from experience that many students, who are now required to own and operate a personal computer, are having difficulty setting up their computers, accessing various materials from the local college network and from the Internet, and installing new programs when they become available. Your immediate plan is to provide a service under which representatives of your company will help students set up their computers, show them how to access various databases, and offer an e-mail “help desk” for various problems that will undoubtedly arise. You will also provide a gateway web page to the campus computer center and the campus Intranet.

If things go well—and you think they will—you plan to purchase computers and offer them, with all required software fully installed, to students. Moreover, you plan to develop your web site with links to various destinations students will like, and as traffic to your site builds, to offer advertising services (and to charge for links) to local businesses. For example, someone could go through your web site to order pizza while studying for a finance exam. Once you have established your company and set up procedures for operating it, you plan to expand to other colleges in the area, and eventually to go nationwide.

At some point, probably sooner rather than later, you plan to go public with an IPO, then to buy a yacht and take off for the South Pacific. With these issues in mind, you need to answer for yourself, and potential investors, the following questions. a. Why is corporate finance important to all managers? Answer:Corporate finance provides the skills managers need to: (1) identify and select the corporate strategies and individual projects that add value to their firm; and (2) forecast the funding requirements of their company, and devise strategies for acquiring those funds. b.

What should be the primary objective of managers? Answer:The corporation’s primary goal is stockholder wealth maximization, which translates to maximizing the price of the firm’s common stock. b. 1. Do firms have any responsibilities to society at large? Answer:Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, the most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses. . 2. Is stock price maximization good or bad for society? Answer:The same actions that maximize stock prices also benefit society. Stock price maximization requires efficient, low-cost operations that produce high-quality goods and services at the lowest possible cost. Stock price maximization requires the development of products and services that consumers want and need, so the profit motive leads to new technology, to new products, and to new jobs.

Also, stock price maximization necessitates efficient and courteous service, adequate stocks of merchandise, and well-located business establishments–factors that are all necessary to make sales, which are necessary for profits. b. 3. Should firms behave ethically? Answer:Yes. Results of a recent study indicate that the executives of most major firms in the United States believe that firms do try to maintain high ethical standards in all of their business dealings. Furthermore, most executives believe that there is a positive correlation between ethics and long-run profitability.

Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy. There is no room for unethical behavior in the business world. c. What three aspects of cash flows affect the value of any investment? Answer: (1) amount of expected cash flows; (2) timing of the cash flow stream; and (3) riskiness of the cash flows. d. What are free cash flows? What are the three determinants of free cash flows?

Answer:Free cash flows are the cash flows available for distribution to all investors (stockholders and creditors) after paying expenses (including taxes) and making the necessary investments to support growth. Three factors determine cash flows: (1) current level and growth rates of sales; (2) operating costs and taxes; and (3) investment in operating capital. FCF=sales revenues – operating costs – operating taxes – required investments in operating capital. e. What is the weighted average cost of capital? What affects it?

Answer:The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors). It is affected by the firm’s capital structure, interest rates, the firm’s risk, and the market’s overall attitude toward risk. f. What are some economic conditions that affect the cost of money? Answer:The cost of money will be influenced by such things as fed policy, fiscal deficits, business activity, and foreign trade deficits. The cost of money for an international investment is also affected by ountry risk, which refers to the risk that arises from investing or doing business in a particular country. This risk depends on the country’s economic, political, and social environment. Country risk also includes the risk that property will be expropriated without adequate compensation, as well as new host country stipulations about local production, sourcing or hiring practices, and damage or destruction of facilities due to internal strife. The cost of money for an international investment is also affected by exchange rate risk.

When investing overseas the security usually will be denominated in a currency other than the dollar, which means that the value of the investment will depend on what happens to exchange rates. Changes in relative inflation or interest rates will lead to changes in exchange rates. International trade deficits/surpluses affect exchange rates. Also, an increase in country risk will also cause the country’s currency to fall. g. How do free cash flows and the weighted average cost of capital interact to determine a firm’s value?

Answer:A firm’s value is the sum of all future expected free cash flows, converted into today’s dollars. [pic] h. When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency problems exist? Explain. Answer:No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. Since you are the only employee and only your money is invested in the business, you own 100 percent of the firm.

As a single proprietor presumably you will operate the business so as to maximize your own welfare, with welfare measured in the form of increased personal wealth, more leisure, or perquisites. i. If you expanded, and hired additional people to help you, might that give rise to agency problems? Answer:By expanding the business and hiring additional employees, this might give rise to agency problems. An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them. . If you needed capital to buy an inventory of computers to sell to students, or to develop software to help run the business, might that lead to agency problems? Would it matter if the new capital came in the form of an unsecured bank loan, a bank loan secured by your inventory of computers, or from new stockholders (assuming you incorporate)? Answer:Acquiring outside capital could lead to agency problems. Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors.

There are three potential agency conflicts: conflicts between stockholders and managers, conflicts between stockholders and creditors, and conflicts among stockholders, managers, and creditors. k. Would potential agency problems increase or decrease if you expanded operations to other campuses? Would agency problems be affected by whether you expanded by licensing franchisees or by direct expansion, where your company actually owned the businesses on other campuses and operated them as divisions of your original company?

Answer:Potential agency problems would increase if operations were expanded to other campuses. You could not physically be at all locations at the same time. Consequently, you would have to delegate decision-making authority to others. This is, by definition, an agency relationship and potential conflicts could arise. Potential agency problems could arise by either expansion method: licensing franchisees or direct expansion. l. If you were a bank lending officer looking at the situation, can you think of any action or actions that might make a loan to the company feasible?

Answer:Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk. m. As the founder-owner-president of the company, what action or actions can you think of that might mitigate agency problems if you expanded beyond your home campus? Would going public in an IPO increase or decrease agency problems? Answer:You could mitigate agency problems from expansion by structuring compensation packages to attract and retain able managers whose interests are aligned with yours.

In addition, the threat of firing is always a possibility. Finally, you could mitigate agency problems by increasing “monitoring” costs by making frequent visits to “off campus” locations to ensure that your agents were acting in accordance with the appropriate goals. By going public through an IPO, your firm would bring in new shareholders. This would increase agency problems. n. If you had an IPO and became a public company, would agency problems be more likely if you (1) bought the yacht and took off or (2) stayed on as CEO and ran the company?

Answer:If an IPO is undertaken, more agency problems are likely if you buy the yacht than if you stay on as the CEO and run the company. With an IPO new stockholders have been brought in and a potential conflict of interests immediately arises. In essence, the fact that the owner-manager will neither gain all the benefits of the wealth created by his or her efforts nor bear all of the costs of perquisites will increase the incentive to take actions that are not in the best interests of other shareholders.

You could minimize potential agency problems by staying on as CEO and running the company. o. Why might you want to inflate your reported earnings to make your financial position look stronger? What are the potential consequences of doing this? Answer:A manager might want to make a firm’s earnings look better than they really are or make its debt appear lower than it really is in order to make the company (temporarily) look better to the market. If the manager can do this, at least temporarily, the stock price may be higher.

This would make the manager better off if he or she were just about to cash in some executive stock options or executive stock grants. However the market will certainly discover this manipulation and the stock price will eventually fall to what it should be. In some cases firms have failed entirely when such fraud has been revealed. p. If the company were successful, what kind of compensation program might you use to minimize agency problems? Answer:You want to structure the compensation package to attract and retain able managers whose interests are aligned with yours.

Compensation could be divided into three parts: (1) a “reasonable” annual salary, which is necessary to meet living expenses; (2) a cash bonus (or a stock bonus if the firm goes through with the IPO) paid at the end of the year; and (3) if the firm has gone through with the IPO, options to buy stock, or actual shares of stock, which are rewards for long-term performance. The bonus and options should be tied to a measure of managerial performance, EVA. By doing this, managerial compensation would be tied to stockholder wealth maximization.