FIN 605 - Chapter 1 - Role and Objective of Financial Management

Which type of corporation is more likely to be a shareholder wealth maximizer - one with wide ownership and no owners directly involved in the firm's management or one that is closely held?

A closely-held firm is more likely to be a wealth maximizer than a corporation with wide ownership. In the closely-held firm, the owners and the managers will share the same objectives because the owners are the managers. In a widely-held corporation, where the ownership and management functions are separate, it is likely that managers may pursue objectives that are more self-serving than owner-serving. Examples of alternative objectives that might be pursued in this situation are extreme risk-averse behavior, size maximization, satisficing, or personal utility function maximization.

Explain what is meant by agency relationships and agency costs.

An agency relationship occurs when one or more individuals (the principals) hire another individual (the agent) to perform a service on behalf of the principals. Two of the most important agency relationships in finance are between the stockholders (principals) and management (agent), and between the owners (agents) and creditors (principals). Agency costs are incurred when attempting to control agency problems. Agency problems arise when the agent makes decisions consistent with the maximization of his or her own utility rather than the maximization of the utility of the principals.

In 2001, Polaroid Corp. declared bankruptcy. How can you reconcile a bankruptcy declaration with management pledged to maximize shareholder wealth?

By declaring bankruptcy, Polaroid hoped to protect itself from the claims of creditors while it sought a way to either sell or restructure its assets. Presumably, the management at Polaroid thought that the bankruptcy declaration would provide it with an opportunity to restructure itself, while it was protected from the pressures of making burdensome interest and other payments to creditors.

What is the source of potential agency conflicts between owners and bondholders? Who is the agent and who is the principal in this relationship?

Creditors (the principal) have a fixed financial claim on the resources of the firm whereas owners (agents) have a residual claim on the firm's resources. As a consequence, owners may attempt to increase the riskiness of the firm's investments in hopes of earning higher returns. Creditors suffer from this type of behavior because they do not have an opportunity to share in these higher potential returns, yet they suffer from the increased risk.

Why is earnings per share not a consistently good measure of a firm's performance?

Earnings per share figures can be misleading because factors such as (1) reductions in the number of shares; (2) a decline in the return being earned on the company's equity; and (3) an increase in the risk of the firm, all could lead to increased earnings per share, but not necessarily to an increase in the value of the firm's shares in the marketplace.

Explain why social responsibility activities are not necessarily inconsistent with shareholder wealth maximization.

Engaging in social responsibility activities can be justified on the basis that these activities help to create an environment in which the goal of shareholder wealth maximization more easily can be pursued.

Give some examples of agency costs incurred by shareholders in the agency relationship between the shareholders (owners) and management of a firm.

Examples of agency costs incurred by shareholders include • Expenditures to structure the organization in a way that will minimize the incentives for management to take actions contrary to shareholder interests, such as providing a portion of compensation in the form of the stock in the company . • Expenditures to monitor management's performance, such as internal and external audits. • Bonding expenditures to protect against managerial dishonesty. • Lost profits (opportunity costs) of complex organizational structures.

How can adherence to high standards of ethical business practice contribute to the goal of shareholder wealth maximization?

Firms that expect their employees to act according to a high standard of ethical behavior can expect to experience lower litigation costs. Customers, suppliers, and investors can be expected to value a firm committed to maintaining high ethical standards in the conduct of its business, and thereby build long-term loyalties and business relationships.

What are the differences between shareholder wealth maximization and profit maximization? If a firm chooses to pursue the objective of shareholder wealth maximization, does this prevent the use of profit maximization decision-making rules?

Profit maximization typically is defined as a more static concept than shareholder wealth maximization. The profit maximization objective from economic theory does not normally consider the time dimension or the risk dimension in the measurement of profits. In contrast, the shareholder wealth maximization objective provides a convenient framework for evaluating both the timing and the risks associated with various investment and financing strategies. The marginal decision rules derived from economic theory are extremely useful to a wealth maximizing firm. Any decision, either in the short run or the long run, that results in marginal revenues exceeding the marginal costs of the decision will be consistent with wealth maximization. When a decision has consequences extending beyond a year in time, the marginal benefits and marginal costs of that decision must be evaluated in a present value framework.

Define shareholder wealth. Explain how it is measured.

Shareholder wealth is defined as the present value of the expected future returns to the owners (that is, shareholders) of the firm. These returns can take the form of periodic dividend payments and/or proceeds from the sale of the stock. Shareholder wealth is measured by the market value (that is, the price that the stock trades in the marketplace) of the firm's common stock.

Compare the potential for agency problems in sole proprietorships, partnerships, and corporations. In light of your analysis, why is the corporate form of organization so popular?

Sole proprietorships are characterized by the virtual non-existence of agency problems between owners and managers, because the owner and manager are usually one and the same. Of course, there still is the potential agency conflict between creditors and owners. However, even in this case the risk to creditors is reduced because the owner has unlimited personal liability for the debts of the firm. The major shortcoming of the proprietorship form of organization is the limited ability of the owner to raise capital, because the owner is the sole source of equity and the owner is personally liable for all of the firm's debts. Partnerships provide a greater potential for raising capital because there is more than one owner-manager. The capital raising potential of partnerships is limited to the number of partners of the firm. Owner-manager agency problems assume increased importance in a partnership because each partner only bears a fractional portion of the cost of his/her actions. Hence, if a partner consumes excessive perquisites, the partner will only pay a fractional share of the cost of this wasteful behavior. The larger the partnership, the greater is this potential problem. Corporations have the greatest potential for owner-manager agency problems because of the separation of ownership from control. Offsetting this corporate disadvantage is the nearly unlimited ability of corporations to raise capital, both debt and equity. The capital raising ability of corporations can be attributed largely to the limited liability feature of common stock ownership. This limited liability feature gives rise to increased agency cost problems between owners and creditors.

MetLife Insurance Co., Swiss Bank Corp., and several other holders of RJR Nabisco bonds filed suit against the company to prevent it from completing the leveraged buyout acquisition from Kohlberg Kravis Roberts. Why do you think the bond-holders wanted to block this transaction? What arguments can you make for and against the bondholders' case?

The bondholders in the RJR Nabisco takeover case wanted to block the transaction because the takeover was to be financed with substantial increases in the amount of debt, and therefore increases in the risk of default. The case of the bondholders was rejected in the courts because, it was argued, these knowledgeable investors knew they were exposed to this type of event risk when they purchased the bonds, and presumably were compensated for the expected risk in the form of the risk premium earned on the bonds.

Explain the differences in the responsibilities of the treasurer and the controller in a large corporation.

The controller usually has responsibility for all accounting related functions, such as financial accounting, cost accounting, and accounting information systems. The treasurer normally has responsibility for the acquisition, custody, and expenditure of funds, including cash and marketable securities management, capital budgeting analysis, financial, and pension fund management, and financial planning. Because not all companies divide the responsibilities in this manner, the actual functions performed by the controller and treasurer will vary from company to company.

Is the shareholder wealth maximization goal a short- or long-term goal? Explain.

The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is a function of all the future returns to the shareholders. Hence, in making decisions that maximize shareholder wealth, management must consider the long-run impact on the firm and not just focus on short-run (i.e., current period) effects. For example, a firm could increase short-run earnings and dividends by eliminating all research and development expenditures. However, this decision would reduce long-run earnings and dividends, and hence shareholder wealth, because the firm would be unable to develop new products to produce and sell.

Why do you think the action by USX (announcing a plan to split its stock into separate steel and energy issues that increased the stock by $2.37 to close at $31.25) was so well received by the stock market?

The market's reaction may have reflected (1) an expectation that there would ultimately be a splitting up and spinoff of the natural resources business from the steel business, thereby assuring that cash flows generated by Marathon Oil would not be wasted on reinvestment in the low return steel business; or (2) the potential that this separation would make it more difficult for the steel segment of USX to tap the cash flows of Marathon Oil.

Explain why management may tend to pursue goals other than shareholder wealth maximization.

The separation of ownership and control in corporations may result in management pursuing goals other than shareholder wealth maximization, such as maximization of their own personal welfare (utility). Concern for their own self-interests may lead management to make decisions that promote their long-run survival (job security), such as minimizing (or limiting) the amount of risk incurred by the firm.

What are the major factors that determine the value of a firm's stock?

The three major factors that determine the market value of a firm's stock are (1) the amount of the cash flows expected to be generated for the benefit of stockholders; (2) the timing of these cash flows; and (3) the risk of the cash flows.

Explain the relationship between financial management and (a) microeconomics and (b) macroeconomics.

a. Financial management employs the marginal revenue -- marginal cost relationships of microeconomics in making long-term investment (capital budgeting) decisions and short-term investment (working capital) decisions. b. Financial management requires an understanding of macroeconomic concepts dealing with monetary and fiscal policy. Knowledge of these concepts is necessary in making company sales forecasts and in raising funds in the money and capital markets.