Chapter 1: The Role of Financial Management © Pearson Education Limited 2005

ANSWERS TO QUESTIONS

1. With an objective of maximizing shareholder wealth, capital will

tend to be allocated to the most productive investment

opportunities on a risk-adjusted return basis. Other decisions

will also be made to maximize efficiency. If all firms do this,

productivity will be heightened and the economy will realize higher

real growth. There will be a greater level of overall economic

want satisfaction. Presumably people overall will benefit, but

this depends in part on the redistribution of income and wealth via

taxation and social programs. In other words, the economic pie

will grow larger and everybody should be better off if there is no

reslicing. With reslicing, it is possible some people will be

worse off, but that is the result of a governmental change in

redistribution. It is not due to the objective function of

corporations.

2. Maximizing earnings is a nonfunctional objective for the following

reasons:

a. Earnings is a time vector. Unless one time vector of earnings

clearly dominates all other time vectors, it is impossible to

select the vector that will maximize earnings.

b. Each time vector of earning possesses a risk characteristic.

Maximizing expected earnings ignores the risk parameter.

c. Earnings can be increased by selling stock and buying treasury

bills. Earnings will continue to increase since stock does

not require out-of-pocket costs.

d. The impact of dividend policies is ignored. If all earnings

are retained, future earnings are increased. However, stock

prices may decrease as a result of adverse reaction to the

absence of dividends.

Maximizing wealth takes into account earnings, the timing and risk

of these earnings, and the dividend policy of the firm.

3. Financial management is concerned with the acquisition, financing,

and management of assets with some overall goal in mind. Thus, the

function of financial management can be broken down into three

major decision areas: the investment, financing, and asset

management decisions.

4. Yes, zero accounting profit while the firm establishes market

position is consistent with the maximization of wealth objective.

Other investments where short-run profits are sacrificed for the

long run also are possible.

5. The goal of the firm gives the financial manager an objective

function to maximize. He/she can judge the value (efficiency) of

any financial decision by its impact on that goal. Without such a

goal, the manager would be "at sea" in that he/she would have no

objective criterion to guide his/her actions.

6. The financial manager is involved in the acquisition, financing,

and management of assets. These three functional areas are all

interrelated (e.g., a decision to acquire an asset necessitates the

financing and management of that asset, whereas financing and

management costs affect the decision to invest).

7. If managers have sizable stock positions in the company, they will

have a greater understanding for the valuation of the company.

Moreover, they may have a greater incentive to maximize shareholder

wealth than they would in the absence of stock holdings. However,

to the extent persons have not only human capital but also most of

their financial capital tied up in the company, they may be more

risk averse than is desirable. If the company deteriorates because

a risky decision proves bad, they stand to lose not only their jobs

but have a drop in the value of their assets. Excessive risk

aversion can work to the detriment of maximizing shareholder wealth

as can excessive risk seeking if the manager is particularly risk

prone.

8. Regulations imposed by the government constitute constraints

against which shareholder wealth can still be maximized. It is

important that wealth maximization remain the principal goal of

firms if economic efficiency is to be achieved in society and

people are to have increasing real standards of living. The

benefits of regulations to society must be evaluated relative to

the costs imposed on economic efficiency. Where benefits are small

relative to the costs, businesses need to make this known through

the political process so that the regulations can be modified.

Presently there is considerable attention being given in Washington

to deregulation. Some things have been done to make regulations

less onerous and to allow competitive markets to work.

9. As in other things, there is a competitive market for good

managers. A company must pay them their opportunity cost, and

indeed this is in the interest of stockholders. To the extent

managers are paid in excess of their economic contribution, the

returns available to investors will be less. However, stockholders

can sell their stock and invest elsewhere. Therefore, there is a

balancing factor that works in the direction of equilibrating

managers' pay across business firms for a given level of economic

contribution.

10. In competitive and efficient markets, greater rewards can be

obtained only with greater risk. The financial manager is

constantly involved in decisions involving a trade-off between the

two. For the company, it is important that it do well what it

knows best. There is little reason to believe that if it gets into

a new area in which it has no expertise that the rewards will be

commensurate with the risk that is involved. The risk-reward

trade-off will become increasingly apparent to the student as this

book unfolds.

Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 10

11. Corporate governance refers to the system by which corporations are

managed and controlled. It encompasses the relationships among a

company’s shareholders, board of directors, and senior management.

These relationships provide the framework within which corporate

objectives are set and performance is monitored.

The board of directors sets company-wide policy and advises the CEO

and other senior executives, who manage the company’s day-to-day

activities. Boards review and approve strategy, significant

investments, and acquisitions. The board also oversees operating

plans, capital budgets, and the company’s financial reports to

common shareholders.

12. The controller's responsibilities are primarily accounting in

nature. Cost accounting, as well as budgets and forecasts, would

be for internal consumption. External financial reporting would be

provided to the IRS, the SEC, and the stockholders.

The treasurer's responsibilities fall into the decision areas most

commonly associated with financial management: investment (capital

budgeting, pension management), financing (commercial banking and

investment banking relationships, investor relations, dividend

disbursement), and asset management (cash management, credit

management).

Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 10