Chapter 1

An Overview of Financial Management

ANSWERS TO END-OF-CHAPTER QUESTIONS

1-1 a. A proprietorship, or sole proprietorship, is a business owned by one

individual. A partnership exists when two or more persons associate
to conduct a business. In contrast, a corporation is a legal entity
created by a state. The corporation is separate and distinct from
its owners and managers.

b. In a limited partnership, limited partners’ liabilities, investment

returns and control are limited, while general partners have
unlimited liability and control. A limited liability partnership
(LLP), sometimes called a limited liability company (LLC), combines
the limited liability advantage of a corporation with the tax
advantages of a partnership. A professional corporation (PC), known
in some states as a professional association (PA), has most of the
benefits of incorporation but the participants are not relieved of
professional (malpractice) liability.

c. Stockholder wealth maximization is the appropriate goal for

management decisions. The risk and timing associated with expected
earnings per share and cash flows are considered in order to maximize
the price of the firm’s common stock.

d. Social responsibility is the concept that businesses should be partly

responsible for, and thus bear the costs of, the welfare of society
at large. Business ethics can be thought of as a company’s attitude
and conduct toward its employees, customers, community, and
stockholders. A firm’s commitment to business ethics can be measured
by the tendency of the firm and its employees to adhere to laws and
regulations relating to such factors as product safety and quality,
fair employment practices, and the like.

e. Normal profits are those profits close to the average for all firms
within an industry. Similarly, a normal rate of return is a return
on investment that is close to the return earned by an average firm
in the industry. Firms with normal profits cannot easily increase
their social responsibility costs unless the entire industry does so.

f. An agency problem arises whenever a manager of a firm owns less than

100 percent of the firm’s common stock, creating a potential conflict
of interest called an agency conflict. The fact that the manager
will neither gain all the benefits of the wealth created by his or
her efforts nor bear all of the costs of perquisite consumption will

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 increase the incentive to take actions that are not in the best
interests of the nonmanager shareholders.

g. Economic Value Added (EVA) is a method used to measure a firm’s true

profitability. EVA is found by taking the firm’s after-tax operating
profit and subtracting the annual cost of all the capital a firm
uses. If the firm generates a positive EVA, its management has
created value for its shareholders. If the EVA is negative,
management has destroyed shareholder value.

h. Performance shares are shares of the firm’s stock given to executives

on the basis of performance as measured by earnings per share, return
on assets, return on equity, and so on. Executive stock options are
performance-based incentive plans popular in the 1950s and 1960s
which allowed managers to purchase stock at some time in the future
at a given price. This type of plan lost favor in the 1970s; they
generally did not pay in the 1970s because the stock market declined.

i. A hostile takeover, when management does not want the firm to be

taken over, is most likely to occur when a firm’s stock is
undervalued relative to its potential because of poor management.
The managers of the acquired firm are generally fired, or lose the
autonomy they had prior to the acquisition.

j. Profit maximization is merely maximizing the net income (earnings) of

the firm. Because of factors such as risk, timing of earnings,
number of shares outstanding, and so on, profit maximization does not
necessarily lead to stockholder wealth maximization.

k. Earnings per share (EPS) is the net income of the firm divided by the
number of shares of common stock outstanding (generally the average
number of shares outstanding over some period, say a quarter or
year).

l. Dividend policy is, basically, the decision regarding how much of

current earnings should be paid to stockholders as dividends rather
than retained and reinvested in the firm.

1-2 Sole proprietorship, partnership, and corporation are the three

principal forms of business organization. The advantages of the first
two include the ease and low cost of formation. The advantages of the
corporation include limited liability, indefinite life, ease of
ownership transfer, and access to capital markets.
The disadvantages of a sole proprietorship are (1) difficulty in
obtaining large sums of capital; (2) unlimited personal liability for
business debts; and (3) limited life. The disadvantages of a
partnership are (1) unlimited liability, (2) limited life, (3)
difficulty of transferring ownership, and (4) difficulty of raising
large amounts of capital. The disadvantages of a corporation are (1)
double taxation of earnings and (2) requirements to file state and
federal reports for registration, which are expensive, complex and time-

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 consuming.

1-3 No. The normal rate of return on investment would vary among
industries, principally due to varying risk. The normal rate of return
would be expected to change over time due to (1) underlying changes in
the industry and (2) business cycles.

1-4 An increase in the rate of inflation would most likely increase the
relative importance of the financial manager. Virtually all of the
manager’s functions, from obtaining funds for the firm to internal cost
accounting, become more demanding in periods of high inflation.
Usually, uncertainty is also increased by inflation, hence, the effects
of a poor decision are magnified.

1-5 Stockholder wealth maximization is a long-run goal. Companies, and

consequently the stockholders, prosper by management making decisions
which will produce long-term increases in earnings. Actions that are
continually short-sighted often "catch up" with a firm and, as a result,
it may find itself unable to compete effectively against its competi-
tors. There has been much criticism in recent years that U.S. firms are
too short-run profit-oriented. A prime example is the U.S. auto
industry in the 1970s and 1980s which was accused of continuing to build
large "gas guzzler" automobiles because they had higher profit margins
rather than retooling for smaller, more fuel-efficient models.

1-6 Even though firms follow generally accepted accounting principles, there
is still sufficient margin for firms to use different procedures.
Leasing and inventory (LIFO versus FIFO) accounting are two of the many
areas where procedural differences could complicate relative performance
measures.

1-7 The management of an oligopolistic firm would be more likely to engage

voluntarily in "socially conscious" practices, since they usually
generate above-normal profits. Competitive firms would be less able to
engage in such practices unless they were cost-justified. Investors
would be more likely to invest in firms not contributing large sums of
money to charity; thus, the socially-oriented firm is put at a
disadvantage in the capital markets. For this reason, even highly
profitable, publicly-owned firms are generally constrained against
taking unilateral cost-increasing social actions.

1-8 Profit maximization does not reflect (1) the timing of profits and (2)
the riskiness of different operating plans. However, both of these
factors are reflected in stock price maximization. Thus, profit
maximization would not necessarily lead to stock price maximization.

1-9 Such factors as a compensation system that is based on management

performance (bonuses tied to profits, stock option plans) as well as the
possibility of being removed from office (voted out of office, an
unfriendly tender offer by another firm) serve to keep management’s
focus on stockholders’ interests.

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1-10 a. Corporate philanthropy is always a sticky issue, but it can be
justified in terms of helping to create a more attractive community
which will make it easier to hire a productive work force. This
corporate philanthropy could be received by stockholders negatively,
especially those stockholders not living in its headquarters city.
Stockholders are interested in actions that maximize share price, and
if competing firms are not making similar contributions, the "cost"
of this philanthropy has to be borne by someone--the stockholders.
Thus, stock price could decrease.

b. Companies must make investments in the current period in order to

generate future cash flows. Stockholders should be aware of this,
and assuming a correct analysis had been done, they should react
positively to the decision. The foreign plant is in this category.
This is covered in depth in Part IV of the text. Assuming that the
correct capital budgeting analysis had been made, the stock price
would increase in the future.

c. Provided that the rate of return on assets exceeds the interest rate
on debt, greater use of debt will raise the expected rate of return
on stockholders’ equity. Also, the interest on debt is tax
deductible, which provides a further advantage. However, (1) greater
use of debt will have a negative impact on the stockholders if the
company’s return on assets falls below the cost of debt, and (2)
increased use of debt increases the chances of going bankrupt. The
effects of the use of debt, called "financial leverage," are spelled
out in detail in Chapters 15 and 16.

d. Today (2001), nuclear generation of electricity is regarded as being

quite risky. Therefore, if the company has a heavy investment in
nuclear generators, its risk will be high, and its stock price will
be adversely affected. However, this negative impact could be offset
by higher profits if the nuclear generators provided significantly
lower costs.

e. The company will be retaining more earnings, so its growth rate

should go up, which should increase its stock price. The decline in
dividends, however, will pull the stock price down. It is unclear
whether the net effect on its stock will be an increase or a decrease
in its price, but the change will depend on whether stockholders
prefer dividends or increased growth.

1-11 The executive wants to demonstrate strong performance in a short period

of time. Strong performance can be demonstrated either through improved
earnings and/or a higher stock price. The current board of directors is
well served if the manager works to increase the stock price; however,
the board is not well served if the manager takes short-run actions
which bump up short-run earnings, at the expense of long-run
profitability and the company’s stock price. Consequently, the board
may want to rely more on stock options and less on performance shares
which are tied to accounting performance.

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1-12 As the stock market becomes more volatile, the link between the stock
price and the ability of senior management is weakened. Therefore, in
this environment, companies may choose to de-emphasize the awarding of
stock and stock options, and rely more on bonuses and performance shares
which are tied to other performance measures besides the company’s stock
price. Moreover, in this environment, it may be harder to attract or
retain top talent if the compensation were tied too much to the
company’s stock price.

1-13 a. No, the TIAA-CREF is not an ordinary shareholder. Because it is the

largest institutional shareholder in the United States and it
controls $125 billion in pension funds, its voice carries a lot of
weight. This "shareholder" in effect consists of many individual
shareholders whose pensions are invested with this group.

b. The owners of TIAA-CREF are the individual teachers whose pensions

are invested with this group.

c. For the TIAA-CREF to be effective in yielding its weight, it must act

as a coordinated unit. In order to do this, the fund’s managers
should solicit from the individual shareholders their "votes" on the
fund’s practices, and from those "votes" act on the majority’s
wishes. In so doing, the individual teachers whose pensions are
invested in the fund have in effect determined the fund’s voting
practices.

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 CYBERPROBLEM

1-14 The detailed solution for the cyberproblem is available on the

instructor’s side of the Harcourt College Publishers’ web site:
http://www.harcourtcollege.com/finance/theory10e.

Solution to Cyberproblem: 1- 6 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc.
 MINI CASE

Take a Walk on the Wild Side

JOE BIRDSONG OPENED TAKE A WALK ON THE WILD SIDE 17 YEARS AGO; THE STORE IS
LOCATED IN NANTAHALA, NC, AND SELLS HIKING, RAFTING, AND KAYAKING EQUIPMENT.
TODAY, TAKE A WALK ON THE WILD SIDE HAS 50 EMPLOYEES INCLUDING HIS DAUGHTER
ANNE, WHO WORKS PART TIME IN THE STORE TO HELP PAY FOR HER COLLEGE EDUCATION.
JOE’S BUSINESS HAS BOOMED IN RECENT YEARS, AND HE IS LOOKING FOR NEW
WAYS TO TAKE ADVANTAGE OF HIS INCREASING BUSINESS OPPORTUNITIES. ALTHOUGH
JOE’S FORMAL BUSINESS TRAINING IS LIMITED, ANNE WILL SOON GRADUATE WITH A
DEGREE AN MBA. JOE HAS OFFERED HER THE OPPORTUNITY TO JOIN THE BUSINESS AS A
FULL-FLEDGED PARTNER. ANNE IS INTERESTED, BUT SHE IS ALSO CONSIDERING OTHER
CAREER OPPORTUNITIES IN FINANCE.
RIGHT NOW, ANNE IS LEANING TOWARDS STAYING WITH THE FAMILY BUSINESS,
PARTLY BECAUSE SHE THINKS IT FACES A NUMBER OF INTERESTING CHALLENGES AND
OPPORTUNITIES. ANNE IS PARTICULARLY INTERESTED IN FURTHER EXPANDING THE
BUSINESS AND THEN INCORPORATING IT. JOE IS INTRIGUED BY HER IDEAS, BUT HE IS
ALSO CONCERNED THAT HER PLANS MIGHT CHANGE THE WAY IN WHICH HE DOES BUSINESS.
IN PARTICULAR, JOE HAS A STRONG COMMITMENT TO SOCIAL ACTIVISM, AND HE HAS
ALWAYS TRIED TO STRIKE A BALANCE BETWEEN WORK AND PLEASURE. HE IS WORRIED
THAT THESE GOALS WILL BE COMPROMISED IF THE COMPANY INCORPORATES AND BRINGS IN
OUTSIDE SHAREHOLDERS.
ANNE AND JOE PLAN TO TAKE A LONG WEEKEND OFF TO SIT DOWN AND THINK ABOUT
ALL OF THESE ISSUES. ANNE, WHO IS HIGHLY ORGANIZED, HAS OUTLINED A SERIES OF
QUESTIONS FOR THEM TO ADDRESS:

A. WHAT THREE QUESTIONS DOES FINANCIAL MANAGEMENT SEEK TO ANSWER?

ANSWER: (1) WHAT CAUSES A COMPANY TO HAVE A PARTICULAR STOCK VALUE? (2) HOW
CAN MANGERS MAKE CHOICES THAT ADD VALUE TO THEIR COMPANIES? (3) HOW
CAN MANAGERS ENSURE THAT THEIR COMPANIS DON’T RUN OUT OF CASH WHILE
EXECUTIG THEIR PLANS?

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B. WHAT KINDS OF CAREER OPPORTUNITIES ARE OPEN TO FINANCE MAJORS?
ANSWER: CAREER OPPORTUNITIES FOR FINANCE MAJORS EXIST IN THREE INTERRELATED
AREAS: (1) INSTITUTIONS AND CAPITAL MARKETS, WHICH DEALS WITH
SECURITIES MARKETS AND FINANCIAL INSTITUTIONS; (2) INVESTMENTS, WHICH
FOCUSES ON THE DECISIONS OF BOTH INDIVIDUAL AND INSTITUTIONAL
INVESTORS AS THEY CHOOSE SECURITIES FOR THEIR INVESTMENT PORTFOLIOS;
AND (3) FINANCIAL MANAGEMENT, OR “BUSINESS FINANCE,” WHICH INVOLVES
THE ACTUAL MANAGEMENT OF FIRMS.
IN THE INSTITUTIONS AND CAPITAL MARKETS AREA, MANY FINANCE MAJORS
GO TO WORK FOR FINANCIAL INSTITUTIONS, INCLUDING BANKS, INSURANCE
COMPANIES, MUTUAL FUNDS, AND INVESTMENT BANKING FIRMS. FINANCE
GRADUATES WHO GO INTO INVESTMENTS OFTEN WORK FOR A BROKERAGE HOUSE
EITHER IN SALES OR AS A SECURITY ANALYST. OTHERS WORK FOR BANKS,
MUTUAL FUNDS, OR INSURANCE COMPANIES IN THE MANAGEMENT OF THEIR
INVESTMENT PORTFOLIOS; FOR FINANCIAL CONSULTING FIRMS WHICH ADVISE
INDIVIDUAL INVESTORS OR PENSION FUNDS ON HOW TO INVEST THEIR FUNDS;
OR FOR AN INVESTMENT BANKER WHOSE PRIMARY FUNCTION IS TO HELP
BUSINESSES RAISE NEW CAPITAL. THE JOB OPPORTUNITIES IN FINANCIAL
MANAGEMENT RANGE FROM MAKING DECISIONS REGARDING PLANT EXPANSIONS TO
CHOOSING WHAT TYPES OF SECURITIES TO ISSUE TO FINANCE EXPANSION.
FINANCIAL MANAGERS ALSO HAVE THE RESPONSIBILITY FOR DECIDING THE
CREDIT TERMS UNDER WHICH CUSTOMERS MAY BUY, HOW MUCH INVENTORY THE
FIRM SHOULD CARRY, HOW MUCH CASH TO KEEP ON HAND, WHETHER TO ACQUIRE
OTHER FIRMS, AND HOW MUCH OF THE FIRM’S EARNINGS TO PLOW BACK INTO
THE BUSINESS VERSUS PAY OUT AS DIVIDENDS.

C. 1. WHAT ARE THE ALTERNATIVE FORMS OF BUSINESS ORGANIZATION?

ANSWER: THE THREE MAIN FORMS OF BUSINESS ORGANIZATION ARE (1) SOLE
PROPRIETORSHIPS, (2) PARTNERSHIPS, AND (3) CORPORATIONS. IN
ADDITION, SEVERAL HYBRID FORMS ARE GAINING POPULARITY. THESE HYBRID
FORMS ARE THE LIMITED PARTNERSHIP, THE LIMITED LIABILITY PARTNERSHIP,
THE PROFESSIONAL CORPORATION, AND THE S CORPORATION.

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C. 2. WHAT ARE THEIR ADVANTAGES AND DISADVANTAGES?

ANSWER: THE PROPRIETORSHIP HAS THREE IMPORTANT ADVANTAGES: (1) IT IS EASILY

AND INEXPENSIVELY FORMED, (2) IT IS SUBJECT TO FEW GOVERNMENT
REGULATIONS, AND (3) THE BUSINESS PAYS NO CORPORATE INCOME TAXES.
THE PROPRIETORSHIP ALSO HAS THREE IMPORTANT LIMITATIONS: (1) IT IS
DIFFICULT FOR A PROPRIETORSHIP TO OBTAIN LARGE SUMS OF CAPITAL; (2)
THE PROPRIETOR HAS UNLIMITED PERSONAL LIABILITY FOR THE BUSINESS’S
DEBTS, AND (3) THE LIFE OF A BUSINESS ORGANIZED AS A PROPRIETORSHIP
IS LIMITED TO THE LIFE OF THE INDIVIDUAL WHO CREATED IT.
THE MAJOR ADVANTAGE OF A PARTNERSHIP IS ITS LOW COST AND EASE OF
FORMATION. THE DISADVANTAGES ARE SIMILAR TO THOSE ASSOCIATED WITH
PROPRIETORSHIPS: (1) UNLIMITED LIABILITY, (2) LIMITED LIFE OF THE
ORGANIZATION, (3) DIFFICULTY OF TRANSFERRING OWNERSHIP, AND (4)
DIFFICULTY OF RAISING LARGE AMOUNTS OF CAPITAL. THE TAX TREATMENT OF
A PARTNERSHIP IS SIMILAR TO THAT FOR PROPRIETORSHIPS, WHICH IS OFTEN
AN ADVANTAGE.
THE CORPORATE FORM OF BUSINESS HAS THREE MAJOR ADVANTAGES: (1)
UNLIMITED LIFE, (2) EASY TRANSFERABILITY OF OWNERSHIP INTEREST, AND
(3) LIMITED LIABILITY. WHILE THE CORPORATE FORM OFFERS SIGNIFICANT
ADVANTAGES OVER PROPRIETORSHIPS AND PARTNERSHIPS, IT DOES HAVE TWO
PRIMARY DISADVANTAGES: (1) CORPORATE EARNINGS MAY BE SUBJECT TO
DOUBLE TAXATION AND (2) SETTING UP A CORPORATION AND FILING THE MANY
REQUIRED STATE AND FEDERAL REPORTS IS MORE COMPLEX AND TIME-CONSUMING
THAN FOR A PROPRIETORSHIP OR A PARTNERSHIP.
IN A LIMITED PARTNERSHIP, THE LIMITED PARTNERS ARE LIABLE ONLY FOR
THE AMOUNT OF THEIR INVESTMENT IN THE PARTNERSHIP; HOWEVER, THE
LIMITED PARTNERS TYPICALLY HAVE NO CONTROL. THE LIMITED LIABILITY
PARTNERSHIP FORM OF ORGANIZATION COMBINES THE LIMITED LIABILITY
ADVANTAGE OF A CORPORATION WITH THE TAX ADVANTAGES OF A PARTNERSHIP.
PROFESSIONAL CORPORATIONS PROVIDE MOST OF THE BENEFITS OF
INCORPORATION BUT DO NOT RELIEVE THE PARTICIPANTS OF PROFESSIONAL
LIABILITY. S CORPORATIONS ARE SIMILAR IN MANY WAYS TO LIMITED
LIABILITY PARTNERSHIPS, BUT LLPs FREQUENTLY OFFER MORE FLEXIBILITY
AND BENEFITS TO THEIR OWNERS.

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D. WHAT IS THE PRIMARY GOAL OF THE CORPORATION?

ANSWER: THE CORPORATION’S PRIMARY GOAL IS STOCKHOLDER WEALTH MAXIMIZATION,

WHICH TRANSLATES TO MAXIMIZING THE PRICE OF THE FIRM’S COMMON STOCK.

D. 1. DO FIRMS HAVE ANY RESPONSIBILITIES TO SOCIETY AT LARGE?

ANSWER: FIRMS HAVE AN ETHICAL RESPONSIBILITY TO PROVIDE A SAFE WORKING

ENVIRONMENT, TO AVOID POLLUTING THE AIR OR WATER, AND TO PRODUCE SAFE
PRODUCTS. HOWEVER, THE MOST SIGNIFICANT COST-INCREASING ACTIONS WILL
HAVE TO BE PUT ON A MANDATORY RATHER THAN A VOLUNTARY BASIS TO ENSURE
THAT THE BURDEN FALLS UNIFORMLY ON ALL BUSINESSES.

D. 2. IS STOCK PRICE MAXIMIZATION GOOD OR BAD FOR SOCIETY?

ANSWER: THE SAME ACTIONS THAT MAXIMIZE STOCK PRICES ALSO BENEFIT SOCIETY.
STOCK PRICE MAXIMIZATION REQUIRES EFFICIENT, LOW-COST OPERATIONS THAT
PRODUCE HIGH-QUALITY GOODS AND SERVICES AT THE LOWEST POSSIBLE COST.
STOCK PRICE MAXIMIZATION REQUIRES THE DEVELOPMENT OF PRODUCTS AND
SERVICES THAT CONSUMERS WANT AND NEED, SO THE PROFIT MOTIVE LEADS TO
NEW TECHNOLOGY, TO NEW PRODUCTS, AND TO NEW JOBS. ALSO, STOCK PRICE
MAXIMIZATION NECESSITATES EFFICIENT AND COURTEOUS SERVICE, ADEQUATE
STOCKS OF MERCHANDISE, AND WELL-LOCATED BUSINESS ESTABLISHMENTS--
FACTORS THAT ARE ALL NECESSARY TO MAKE SALES, WHICH ARE NECESSARY FOR
PROFITS.

D. 3. SHOULD FIRMS BEHAVE ETHICALLY?

ANSWER: YES. RESULTS OF A RECENT STUDY INDICATE THAT THE EXECUTIVES OF MOST
MAJOR FIRMS IN THE UNITED STATES BELIEVE THAT FIRMS DO TRY TO
MAINTAIN HIGH ETHICAL STANDARDS IN ALL OF THEIR BUSINESS DEALINGS.
FURTHERMORE, MOST EXECUTIVES BELIEVE THAT THERE IS A POSITIVE
CORRELATION BETWEEN ETHICS AND LONG-RUN PROFITABILITY. CONFLICTS
OFTEN ARISE BETWEEN PROFITS AND ETHICS. COMPANIES MUST DEAL WITH

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 THESE CONFLICTS ON A REGULAR BASIS, AND A FAILURE TO HANDLE THE
SITUATION PROPERLY CAN LEAD TO HUGE PRODUCT LIABILITY SUITS AND EVEN
TO BANKRUPTCY. THERE IS NO ROOM FOR UNETHICAL BEHAVIOR IN THE
BUSINESS WORLD.

E. WHAT FACTORS AFFECT STOCK PRICES?

ANSWER: THREE FACTORS AFFECT STOCK PRICE: (1) AMOUNT OF CASH FLOWS EXPECTED
BY SHAREHOLDERS; (2) TIMING OF THE CASH FLOW STREAM; AND (3)
RISKINESS OF THE CASH FLOWS.

F. WHAT DETERMINES CASH FLOWS?

ANSWER: THREE FACTORS DETERMINE CASH FLOWS: (1) CURRENT LEVEL AND GROWTH
RATES OF SALES; (2) OPERATING EXPENSES; AND (3) CAPITAL EXPENSES.

G. WHAT FACTORS AFFECT THE LEVEL AND RISK OF CASH FLOWS?

ANSWER: FIRST, THERE ARE MANAGERIAL FACTORS, INCLUDING INVESTMENT, FINANCING,

AND DIVIDEND POLICY DECISIONS. IN ADDITION, CASH FLOWS ARE AFFECTED
BY THE EXTERNAL ENVIRONMENT.

H. WHAT ARE THE MOST IMPORTANT FINANCIAL MANAGEMENT ISSUES OF THE NEW
MILLENIUM?

ANSWER: VALUATION HAS CONTINUED AS A FOCUS IN THE NEW MILLENIUM, BUT THE
ANALYSIS HAS EXPANDED TO INCLUDE (1) INFLATION AND ITS EFFECTS ON
BUSINESS DECISIONS; (2) DEREGULATION OF FINANCIAL INSTITUTIONS AND
THE RESULTING TREND TOWARD LARGE, BROADLY DIVERSIFIED FINANCIAL
SERVICE COMPANIES; (3) THE DRAMATIC INCREASE IN BOTH THE USE OF
COMPUTERS FOR ANALYSIS AND THE ELECTRONIC TRANSFER OF INFORMATION;
AND (4) THE INCREASED IMPORTANCE OF GLOBAL MARKETS AND BUSINESS
OPERATIONS. THE TWO MOST IMPORTANT FUTURE TRENDS ARE LIKELY TO BE
THE CONTINUED GLOBALIZATION OF BUSINESS AND THE INCREASED USE OF
INFORMATION TECHNOLOGY.

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I. WHAT IS AN AGENCY RELATIONSHIP?

ANSWER: AN AGENCY RELATIONSHIP EXISTS WHENEVER A “PRINCIPAL” ENGAGES AN

“AGENT” AND GRANTS THE AGENT SOME DECISION-MAKING POWER.

I. 1. WHAT AGENCY RELATIONSHIPS EXIST WITHIN A CORPORATION?

ANSWER: WITHIN THE FINANCIAL MANAGEMENT CONTEXT, THE PRIMARY AGENCY

RELATIONSHIPS ARE THOSE (1) BETWEEN STOCKHOLDERS AND MANAGERS AND (2)
BETWEEN DEBTHOLDERS AND STOCKHOLDERS.

I. 2. WHAT MECHANISMS EXIST TO INFLUENCE MANAGERS TO ACT IN SHAREHOLDERS’

BEST INTERESTS?

ANSWER: TO REDUCE AGENCY CONFLICTS, STOCKHOLDERS MUST INCUR AGENCY COSTS,

WHICH INCLUDE ALL COSTS BORNE BY SHAREHOLDERS TO ENCOURAGE MANAGERS
TO MAXIMIZE THE FIRM’S STOCK PRICE RATHER THAN ACT IN THEIR OWN SELF-
INTERESTS. THERE ARE THREE MAJOR CATEGORIES OF AGENCY COSTS: (1)
EXPENDITURES TO MONITOR MANAGERIAL ACTIONS, SUCH AS AUDIT COSTS; (2)
EXPENDITURES TO STRUCTURE THE ORGANIZATION IN A WAY THAT WILL LIMIT
UNDESIRABLE MANAGERIAL BEHAVIOR, SUCH AS APPOINTING OUTSIDE INVESTORS
TO THE BOARD OF DIRECTORS; AND (3) OPPORTUNITY COSTS WHICH ARE
INCURRED WHEN SHAREHOLDER-IMPOSED RESTRICTIONS, SUCH AS REQUIREMENTS
FOR STOCKHOLDER VOTES ON CERTAIN ISSUES, LIMIT THE ABILITY OF
MANAGERS TO TAKE TIMELY ACTIONS THAT WOULD ENHANCE SHAREHOLDER
WEALTH.
SOME SPECIFIC MECHANISMS WHICH ENCOURAGE MANAGERS TO ACT IN
SHAREHOLDERS’ INTERESTS INCLUDE (1) PERFORMANCE-BASED INCENTIVE
PLANS, (2) DIRECT INTERVENTION BY SHAREHOLDERS, (3) THE THREAT OF
FIRING, AND (4) THE THREAT OF TAKEOVER.

I. 3. SHOULD SHAREHOLDERS (THROUGH MANAGERS) TAKE ACTIONS THAT ARE

DETRIMENTAL TO BONDHOLDERS?

ANSWER: NO. SUCH BEHAVIOR IS UNETHICAL, AND THERE IS NO ROOM FOR UNETHICAL

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 BEHAVIOR IN THE BUSINESS WORLD. SECOND, IF SUCH ATTEMPTS ARE MADE,
CREDITORS WILL PROTECT THEMSELVES AGAINST STOCKHOLDERS BY PLACING
RESTRICTIVE COVENANTS IN FUTURE DEBT AGREEMENTS. FINALLY, IF
CREDITORS PERCEIVE THAT A FIRM’S MANAGERS ARE TRYING TO TAKE
ADVANTAGE OF THEM, THEY WILL EITHER REFUSE TO DEAL FURTHER WITH THE
FIRM OR ELSE WILL CHARGE A HIGHER THAN NORMAL INTEREST RATE TO
COMPENSATE FOR THE RISK OF POSSIBLE EXPLOITATION. THUS, FIRMS WHICH
DEAL UNFAIRLY WITH CREDITORS EITHER LOSE ACCESS TO THE DEBT MARKETS
OR ARE SADDLED WITH HIGH INTEREST RATES AND RESTRICTIVE COVENANTS,
ALL OF WHICH ARE DETRIMENTAL TO SHAREHOLDERS.

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