Terricina Jackson

August 31, 2009

Written Assignment

Questions {1-2, 1-3, 1-7, 1-8, 1-10, 2-2, 2-3, 2-9, 2-10 and 2-12}
 FINC510 Foundations of Financial Management

Questions

1.2 If most investors expect the same cash flows from Companies A and B but are more
confident that A’s cash flows will be closer to their expected value, which company should have
the higher stock price? Explain

The primary goal of a corporation should be to maximize its owner’s value. If a manager is to
maximize shareholder wealth, he or she must know how that wealth is determined. Essentially,
shareholder wealth is the number of shares outstanding at times the market price per share. A
stock’s price at any given time depends on the cash flows a “marginal” investor expects to
receive after buying the stock. That being said Company A’s cash flow would increase the stock
price and the risk would be minimal. Management’s goal should be to make decisions designed
to maximize the stock’s price.

1.3 What is the firm’s intrinsic value? Its current stock price? Is the stock’s “true long run
value” more closely related to its intrinsic value or to its current price?

Intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. The
intrinsic value can be estimated but not measured precisely and a market price, which is the
actual market price based on perceived but possibly incorrect information as seen by the
marginal investor. A manager’s estimates of intrinsic values are generally better than those of
outside investors which makes “true long run value” more closely related to intrinsic value.
Intrinsic value is a long run concept. It reflects both improper actions and proper actions.
Management’s goal should be to take actions designed to maximize the firm’s intrinsic value, not
its current market price.

1.7 If a company’s board of directors wants management to maximize shareholder wealth,

should the CEO’s compensation be set as a fixed dollar amount, or should the compensations
depend on how well the firm performs? If it is to be based on performance, how should
performance is measured? Would it be easier to measure performance by the growth rate in
reported profits or the growth rate in the stock’s intrinsic value? Which would be the better
performance measure? Why?
Good executive compensation plans can motivate managers to act in their shareholder’s best
interest. Useful motivation tools include (1) reasonable compensation packages, (2) firing of
managers who don’t perform well, and (3) the threat of hostile takeovers. Compensation
packages should be sufficient to attract and retain able managers, but they should not go beyond
what is needed. Also, compensation should be structured so that managers are rewarded on the
basis of the stock’s performance over the long run, not the stock’s price on an option exercise
date. This means that options should be phased in over a number of years so that managers have
an incentive to keep the stock price high over time. When the intrinsic value can be measured in
an objective and verifiable manner, performance pay can be based on changes in intrinsic value.
However, because intrinsic value is not observable, compensation must be based on the stock’s
market price but the price used should be an average over time rather than on a specific date.

Give managers an incentive to focus on stock prices, stock holders can award executives stock
options that could be exercised on a specified future date. An executive could exercise the option
on that date, receive stock, immediately sell it and earn a profit. The profit is based on the stock
price on the option exercise date, which may lead managers to try to maximize the stock price on
that specified date, not over the long run.

1.8 What are the four forms of business organization? What are the advantages and
disadvantages of each?

Proprietorship: An unincorporated business owned by one individual.

Partnership: An unincorporated business owned by two or more persons.

Corporation: A legal entity created by a state, separate and distinct from its owners and
managers, having unlimited life, easy transferability of ownership, and limited liability.

Limited Liability Company: A relatively new type of organization that is a hybrid

between a partnership and a corporation.

Proprietorship has three important advantages: They are easily and inexpensively formed, they
are subject to few government regulations, and they are subject to lower income taxes than are
corporations. Proprietorships also have three important limitations: they have unlimited personal
liability for the business’s debts, so they can lose more than the amount of money they invested
in the company. The life of the business is limited to the life of the individual who created it; and
to bring in new equity, investors require a change in the structure of the business. Because of the
first two points, proprietorships have difficulty obtaining large sums of capital; hence,
proprietorships are used primarily for small businesses.
Partnerships can be established relatively easily and inexpensively. The firm’s income is
allocated on a pro rata basis to the partners and is taxed on an individual basis. This allows the
firm to avoid the corporate income tax. Partners are generally subject to unlimited personal
liability, which means that if a partnership goes bankrupt and any partner is unable to meet their
pro rata share of the firm’s liabilities, the remaining partners will be responsible for making good
on the unsatisfied claims.

Corporations have a legal entity that limits stockholders’ losses to the amount they invested in
the firm. The corporation can lose all of its money, but its owners can lose only the funds that
they invested in the company. Corporations also have unlimited lives, and it is easier to transfer
shares of stock in corporation than one’s interest in an unincorporated business. It is easier to
raise the capital necessary to operate large businesses. A major drawback to corporations is taxes
most are subject to double taxation.

Limited Liability Company has limited liability like corporations but is taxed like partnerships.
The investors in an LLC have votes in proportion to their ownership interest.

1.10 What are some actions that stockholders can take to ensure that management’s and
stockholder’s interest aligned?

Four primary mechanisms are used to motivate managers to act in stockholders’ best interests:

• Managerial compensation
• Direct intervention by stockholders
• Threat of firing
• Threat of takeovers
Managerial Compensation
Managerial compensation should be constructed not only to retain competent managers, but
to align managers’ interests with those of stockholders as much as possible.
Direct Intervention by Stockholders
Today, the majority of a company’s stock is owned by large institutional investors, such as
mutual funds and pensions. As such, these large institutional stockholders have the ability to
exert influence on mangers and, as a result, the firm’s operations.

Threat of Firing
If stockholders are unhappy with current management, they can encourage the existing board
of directors to change the existing management, or stockholders may even re-elect a new
board of directors that will accomplish the task.

Threat of Takeovers
If a stock price deteriorates because of management’s inability to run the company
effectively, competitors or stockholders may take a controlling interest in the company and
bring in their own managers.
2.2 Describe the different ways in which capital can be transferred from suppliers of
capital to those who are demanding capital.
Direct transfers of money and securities, when a business sells its stocks or bonds directly to
savers, without going through any type of financial institution. The business delivers its
securities to savers, who, in turn, give the firm the money it needs.
Transfers may also go through an investment bank, which underwrites the issue. An
underwriter serves as a middle man and facilitates the issuance of securities. The company
sells its stocks or bonds to the investment bank, which then sells these same securities to
savers.
Transfers can also be made through a financial intermediary such as a bank, an insurance
company, or a mutual fund. Here the intermediary obtains funds from savers in exchange for
its securities. The intermediary uses this money to buy and hold businesses’ securities, while
the savers hold the intermediary’s securities.
2.3 Is an initial public offering an example of a primary or a secondary market transaction?
An IPO is a market for stocks of companies that are in the process of going public. Whenever
a stock in a closely held corporation is offered to the public for the first time, the company is
said to be going public. Primary markets are the markets in which corporations raise new
capital by issuing new securities. It is important to recognize that firms can go public without
raising any additional capital thus far making an IPO a primary market transaction.
2.9 Describe the three different forms of market efficiency.
 Market efficiency
 Efficient capital market
 Efficient market hypothesis (EMH)
 EMH misconception
Market efficiency/Capital market efficiency
The degree to which the present asset price accurately reflects current information in the
market place.

Efficient capital market

A market in which new information is very quickly reflected accurately in share prices.

Efficient Market Hypothesis

States that all relevant information is fully and immediately reflected in a security's market
price, thereby assuming that an investor will obtain an equilibrium rate of return. In other
words, an investor should not expect to earn an abnormal return (above the market return)
through either technical analysis or fundamental analysis.
The efficient market hypothesis (EMH) implies that if new information is revealed about a
firm it will be incorporated into the share price rapidly and rationally, with respect to the
direction of the share price movement and the size of that movement.
In an efficient market no trader will be presented with an opportunity for making a return on
a share (or other security) that is greater than a fair return for the riskiness associated with
that share (or any other security). The absence of abnormal profit possibilities arises because
current and past information is immediately reflected in current prices. It is only new
information, which causes prices to change.
Note: Stock market efficiency does not mean that investors have perfect powers of
prediction; all it means is that the current level is an unbiased estimate of its true economic
value based on the information revealed.
In the major stock markets of the world prices are set by forces of supply and demand. There
are hundreds of analysts and thousands of traders, each receiving new information on a
company through electronic and paper media. The moment an unexpected, positive piece of
information leaks out investors will act and prices will rise rapidly to a level that gives no
opportunity to make further profit.
Reference: http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page4.htm

2.10 Investors expect a company to announce a 10% increase in earnings; instead, the
company announces a 1% increase. If the market is semi-strong form efficient, which of the
following would you expect to happen?

Semi-strong form, which contends that all publicly available information is immediately
incorporated into stock prices (i.e., that one cannot analyze published reports and then beat
the market). The stock’s price will stay the same because earnings announcements have no
effect if the market is semi-strong form efficient.

2.12 Explain whether the following statements are true or false.

A. False B. True C. False D. True E. True F. True