Chapter One: Introducing the Firm and its goals

Questions
1.4 Would a manager confronted with given circumstances necessarily make
the same decision when pursuing either profit- or wealth-maximising
objectives? Explain with an example.

Profit maximisation must have a time period attached — in the short-term or in the
long-term. Different behaviours will be indicated, depending on which it is.
Maximisation of shareholder (or owner) wealth implies that the timing of returns has
been taken into account. Thus, $1 earned in one year’s time will be worth less now than
$1 in the hand now. The time value of money is taken into account.
Risk must be taken into account. Business operations almost all have some risk
attached. If $100 000 is spent on a new machine, will all of its one million items of
output sell every year, or will only 700 000 sell? More mundanely, if we buy in
20 copies of a new paperback book, will we sell all 20 copies within a reasonable time
or will we sell only 10 copies?

1.7 Internal auditors normally report to the chief financial officer.

(a) What do you think are the roles of the internal auditor?
(b) Is there likely to be an adversarial or collegial relationship between the
internal auditor and the chief financial officer?
(c) Which type of relationship is likely to be most beneficial to the firm?

(a) Check the application and efficiency of the firm’s management processes, check
the accounting, reporting and cash control systems, check taxation management
and reporting systems.
(b) Either, depending on the persons involved. Collegial is probably better than
adversarial, so long as professional standards are maintained.
(c) Collegial. Adversarial, if seriously so, could be detrimental to optimal outcomes.

1.8 Why would a firm not want to keep more working capital than necessary
in a cheque account?

Cheque accounts earn little interest. Therefore, there is an opportunity cost in keeping
balances in cheque accounts. On the other hand, sufficient liquidity must be maintained
to be able to honour payments.

1.10 What are some of the reasons that might motivate a corporate chief
executive officer (CEO) not to try to maximise his shareholders’ wealth in
relation to the firm’s activities?

HIH is a good example: arrogance, greed, incompetence, lack of control by directors,

wrong signals being sent by remuneration conditions.

© John Wiley and Sons Australia, Ltd 2008 1.1

 Chapter One: Introducing the firm and its goals

1.13 Genuine Used Cars is a second-hand car dealer with a landscaped yard on
a busy highway serving Sydney. The plants used to ‘decorate’ the yard are
all high water users. Drought is setting in and the local council has asked
businesses to conserve as much water as possible. Town water is still
available, bore water may be accessed in fairly shallow bores and the
council is encouraging businesses to install underground tanks to conserve
rain water. Which source of water should be used to gain the most brownie-
points ethically? Should the firm change the plants for more efficient water
users?

Rain water, as the other two sources are limited. Changing the plants over time to local
natives which are more efficient water users and drought-hardy is the best solution long-
term.

1.15 An investment firm supports the coal-mining industry with infrastructure

funds and also invests in tree plantations for paper-pulp production. Are
the environmental ‘goods’ attached to the plantations cancelled out by the
environmental ‘bads’ of the coal mining?

This is a value judgement where the values of the beholder decide the issue.

Financial problems
1.3 Toowoomba Computer Works (TCW) has employed a programmer to write
business programs for their clients. She writes a program which will be ideal
to use to teach first-year accounting students the rudiments of electronic
financial record-keeping. It sells for $200 per copy. TCW decides to give 100
copies free to the local university to be distributed to students in whatever
way the course lecturer decides. The firm also gives the university a free site
licence.
(a) Would this action tend to work against TCW’s avowed objective of
wealth maximisation?
(b) Is there an ethical problem here for any of the parties?

(a) Profit maximisation involves juggling both revenue and costs, short- or long-term.
Does giving the product away decrease revenue? Probably not. Product is not in
short-supply. Any required number can be produced on CD and packed for
possibly less than $2 per copy. Giving away probably will not decrease full-price
sales.
Does giving the product away increase revenue? Probably yes. If the university
adopts this program as its teaching aid, many thousands of copies will be sold
over the next few years, so there is an excellent chance revenue will increase
substantially.
Does giving the product away decrease costs? Possibly yes. This gift may be used
to promote the firm instead of spending funds on print, radio or TV advertising.

© John Wiley and Sons Australia, Ltd 2008 1.2

 Chapter One: Introducing the firm and its goals

Does giving the product away increase costs? Marginally yes, by the marginal
production costs per copy — possibly less than $2 per copy. Cost of the site
licence is zero.
So, on balance, there is a good chance this action will work towards profit
maximisation if it results in increased sales.

(b) For TCW — probably not. Action is seen as distributing free samples for potential
customers to try, a well-known business practice. Also could be seen as a donation
to local education.
For the university — probably not. Action is seen as distributing free samples for
potential customers to try, a well-known business practice. Also could be seen as
a donation to local education.
For course leader — could be. Course leader would have to be careful to distribute
the 100 copies in a transparent and fair way, fair and seen to be fair. Must not in
any way benefit personally by the gift.

1.4 Dan Levy is in partnership with three others in their business, Outdoor
Camping World. (Outdoor World had been Dan’s business and Camping
World had been run by the other three until they merged the businesses last
year. They merged the names too, so they might keep all their old customers,
even though it doesn’t make much sense.) Dan argues that the firm should
maximise gross profit margins [(selling price – buying price)/ selling price]
on each item of stock.
(a) Do you think this is a valid financial objective?
(b) Is this objective consistent with maximisation of partners’ wealth?
(c) What problems do you see in operationalising this objective?

(a) If the firm’s goal was to maximise short-term profits, this could be a valid
financial operational goal. However, maximising gross profit margin puts
emphasis on maximising selling price and minimising buying price to the
exclusion of other variables. This could lead a firm to increase prices and reduce
the number of units sold. It could also lead to a reduction in quality to reduce the
cost price.

(b) Probably not. Actions to maximise gross profit margin may do just that and not
even maximise short-term profit. Even if it resulted in maximal short-term profit,
almost surely long-term profit and partners’ wealth would not be maximised.

(c) Setting sales price, deciding on quality and buying costs, need information about
market demand to trade off prices and numbers to be sold if any form of profit
maximisation objective is to be pursued.

1.9 On what bases could you argue the collapse of HIH was an example of the
principal-agent problem?

The CEO ran the firm for his own glory and the executives generally were either acting
in their own best interests or incompetent.

© John Wiley and Sons Australia, Ltd 2008 1.3

 Chapter One: Introducing the firm and its goals

1.11 The incorporation of ethics into business practices has been characterised as
‘doing well by doing good’.
(a) Why would firms want to ‘do good’?
(b) Give some examples of ‘doing good’ by employees, the general
community and the natural environment.

(a) To adhere to the social contract; general ethical principles; gain sales advantage
by being seen to be doing good.
(b) Good employment conditions; extraordinary care about safety issues — noise
reduction; smell reduction; proper treatment and disposal of water-based waste
(e.g. not into the river); smoke reduction.

1.13 Tinsel Tin Company, an Australian company, mines tin using cheap,
resource-wasteful techniques in a tropical country. The effects of the mining
include pollution of freshwater streams from almost their sources to the sea.
The local people used to fish, hunt near, get drinking water from and swim
in these streams, but now none of these things are possible. Local people now
buy canned meat for protein. It is relatively cheap and tends to be very poor
quality with a very high fat content. As a result, the local people are much
fatter than they used to be and their health is poorer. Tinsel has supplied a
fully equipped medical clinic but expects the local people to supply the staff.
Discuss each of the following questions.
(a) Has Tinsel contravened, in your view, its ethical responsibilities?
(b) Is it possible to trade off an ethical ‘bad’ with an ethical ‘good’?
(c) Has Tinsel done enough to compensate for the change they have
brought about in the local people’s lives?

(a) Yes. It would not be allowed by law or public opinion to act this way in Australia.
It has affected the lives of the local people and local other species with little or no
compensation. The medical centre is not real or effective compensation.
(b) It depends on how bad the ‘bad’ and how well balanced the volume of each.
Probably seldom achieved, because greed gets in the way of effecting just
compensation.
(c) No. They should clean up the technology. If this is not possible or not economical,
they should stop mining. Then they should try to effect restitution. As well, they
should pay compensation in a useful form such as education, effective medical
assistance, etc.

© John Wiley and Sons Australia, Ltd 2008 1.4