BFN3104

Chapter 1
Questions
1.

What is finance? What is corporate financial management? What are the three
major questions that financial managers address?
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 firms 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?

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2.

What are three problems associated with using profit maximization as the goal of
the firm? What is shareholder wealth maximization? How does shareholder wealth
maximization deal with these three problems?
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,
must 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 shares owned. Shareholders wealth
maximization deals with these three problems by focusing profit motives squarely on the
owners. First, shareholders 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, shareholders wealth depends explicitly on
timing of future cash flows. Finally, our process for measuring shareholders wealth
accounts for risk differences.

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3.

Distinguish between investing decisions and financing decisions within the area
of corporate financial management. Give one example of each.
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.

4.

Explain the four rights of common stockholders. Which of the four rights is often
missing in modern corporations?
The four types of common stockholders right are:

Dividend right Shareholders get an identical per share amount of any dividends

Voting right Shareholders have the right to vote on certain matters, such as the
election of directors.

Liquidation right Shareholders have the right to a proportional share of the firms
residual value in the event of liquidation. The residual value is what remains after all
of the corporations other obligations have been settled.

Preemptive right In some corporations, shareholders have the right to subscribe

proportionately to any new issue of the corporations shares. Such offerings are called
rights offering.

Preemptive rights are often left out of modern corporate charters.

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Problems
1. Consider the fictionalized account of Henrys car firm.
a. Describe some of the conflicts of interest between Henry and the bank.
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 rapid. If Henry borrows a great deal off 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 banks risk
will be increased, which will decrease the value of its claim.
b. Describe some of the conflicts of interest between Henry and the other
shareholders.
If Henry uses an expense account to pay personal expenses (such as meals and dry
cleaning clothes), the cost decrease the value of the others shareholders = claim. If
Henry takes unnecessary trips at firm expense, the cost decreases the value of the
others shareholders claim. If Henry doesnt put in much effort running the business,
the value of the other shareholders claim will be decreased.
c.

Describe some of the conflicts of interest between the mangers and Henry.
If the managers-pay themselves an excessive salary, the other shareholders bear the
cost. If mangers travel in excessively expensive style (such as staying in more
expensive than reasonable hotels), the others shareholders bear the cost. If the
mangers have excessively fancy offices, the other shareholders bear part of the cost.

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