Chapter 1

Questions
1. Finance is a discipline concerned with determining value and making decisions. The finance function allocates
resources, which includes acquiring, investing, and managing the resources.
Financial management is an area of finance that applies financial principles within an organization to create
and maintain value through decision making and proper resource management.
The first major question that financial managers deal with is investment decisions. These decisions are
primarily concerned with the asset (left) side of the balance sheet. They answer such questions as should we buy
new computers or a new warehouse? The second major question deals with financial decisions. These decisions are
primarily concerned with the liabilities and stockholders= equity (right) side of the balance sheet. They answer such
questions as how much debt should we have and should the debt be short- or long-term, or should we borrow in
foreign currency? The third major question deals with managerial decisions. These decisions are primarily
concerned with the firm=s policies and day-to-day operating and financial decisions. They answer such questions as
how large should the firm be, and how fast should it grow?

2. The two basic types of financial securities that firms issue are equity and debt.
Equity is the firm=s ownership and is typically represented by shares of common stock. Common stock is
a proportional form of equity. Debt is a legal obligation to make contractually agreed upon future payments,
identified as interest and repayment of the principal (original debt amount). Debtholders loan the firm money but
have no claim of ownership as long as the firm meets its payment obligations. The firm controls the use of the funds.

3. The three problems associated with using profit maximization as the goal of the firm are the following: First, profit
maximization is vague. Profit has many different definitions such as accounting profit based on book value or
economic profit based on market value. Second, profit maximization ignores differences in when we get the money.
It does not distinguish between getting a dollar today and getting a dollar one year from today. The time value of
money plays an important role in valuing an asset or liability. Third, profit maximization ignores risk differences
among alternative courses of action. When given a choice between two alternatives that have the same return but
different risk, most people will take the less risky one. This makes the less risky one more valuable. Profit
maximization ignores such differences in value.
Shareholder wealth maximization is maximizing the value of the firm to its owners. The ownership value of
the firm is the market value of the shares owned.
Shareholder wealth maximization deals with these three problems by focusing profit motives squarely on
the owners. First, shareholder wealth is unambiguous. It is based on the present value of the future cash flows that
are expected to come to the shareholders, rather than an ambiguous notion of profit or other revenues. Second,
shareholder wealth depends explicitly on the timing of future cash flows. Finally, our process for measuring
shareholder wealth accounts for risk differences.

4. The advantages of the corporate form of organization over the sole proprietorship and partnership forms are:
Limited liability - Shareholder liability for corporate obligations is limited to the loss of the shares.
Permanency - A corporation=s legal existence is not affected when a shareholder dies or sells his/her shares.
Transferability of ownership - Selling shares in a corporation is normally easier then selling a proprietorship or a
general-partnership interest.
Better access to external sources of capital - Because if its permanency and its ability to borrow money or to sell
additional shares, a corporation has greater financing flexibility.
The primary disadvantage of the corporate form is because of the tax laws. Operating income paid to
shareholders through cash dividends is taxed twice, first to the corporation and then to the shareholder.

5. Investment decisions are primarily concerned with the asset or left side of the balance sheet. Such decisions include
whether to introduce a new product. Financial decisions are primarily concerned with the liabilities and
stockholders= equity or right side of the balance sheet. Such decisions include whether to issue new stock in the
firm.

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6. Examples of a firm=s stakeholders in the set-of-contracts view of the firm include banks, customers, governments,
preferred stockholders, communities, short-term creditors, managers, suppliers, society at large, common
stockholders, the environment, employees, and bondholders. An explicit contract is a specific agreement among two
or more parties. An example is a contract with a debtholder that specifies the repayment schedule. An implicit
contract is a generally accepted agreement among two or more parties. An example is a manager=s obligation to act
honestly and in the best interest of the shareholders. Sometimes a court of law is necessary to define the components
and obligations of an implicit contract.

7. A contingent claim is contingent on the value of some other asset or a particular occurrence. An example of a
contingent claim is a manager receiving a bonus after reaching a certain objective. The bonus is contingent on a
certain event, that is, the objective being reached.

8. The four types of common stockholder rights are:

Dividend right - Shareholders get an identical per-share amount of any dividends.
Voting rights - Shareholders have the right to vote on certain matters, such as the election of directors.
Liquidation rights - Shareholders have the right to a proportional share of the firm=s residual value in the event of
liquidation. The residual value is what remains after all of the corporation=s other obligations have been settled.
Preemptive rights - In some corporations, shareholders have the right to subscribe proportionately to any new issue
of the corporation=s shares. Such offerings are called rights offerings.

Preemptive rights are often left out of modern corporate charters.

Challenging Questions
9. a. corporate finance
b. capital markets and financial intermediaries
c. investments
d. corporate finance
e. investments
f. capital markets and financial intermediaries
g. corporate finance

10. Note that many conflicts of interest are not unique to particular stakeholders.
a) If Henry makes late or less than full payments, it will be costly to the bank, and yet it may not be worth it to sue
Henry for the loss. If Henry runs off with the money the bank may not ever get repaid. If Henry borrows a
great deal of additional money from a different bank, it may be difficult to repay the first bank. If Henry invests
in an entirely different line of business that is much riskier than making cars, the bank=s risk will be increased,
which will decrease the value of its claim.
b) If Henry uses an expense account to pay personal expenses (such as meals and dry cleaning clothes), the cost
decreases the value of the other shareholders= claim. If Henry takes unnecessary trips at firm expense, the cost
decreases the value of the other shareholders= claim. If Henry doesn=t put in much effort running the
business, the value of the other shareholders= claim will be decreased.
c) If the managers pay themselves an excessive salary, the other shareholders bear the cost. If managers travel in
excessively expensive Astyle@ (such as staying in more expensive than reasonable hotels), the other
shareholders bear the cost. If the managers have excessively fancy offices, the other shareholders bear part of
the cost.

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