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Critical Thinking Questions
1.1 Describe the cash flows between a firm and its stakeholders.
Cash flows are generated by a firm’s productive assets that were purchased through either
issuing debt or raising equity. These assets generate revenues through the sale of goods
and services. A portion of this revenue is then used to pay wages and salaries to
employees, pay suppliers, pay taxes, and pay interest on the borrowed money. The
leftover money, residual cash, is then either reinvested back in the business or is paid out
to stockholders in the form of dividends.
1.2 What are the three fundamental decisions financial management team is concerned with,
and how do they affect the firm’s balance sheet?
The primary financial management decisions every company faces are capital budgeting
decisions, financing decisions, and working capital management decisions. Capital
budgeting addresses the question of which productive assets to buy; thus, it affects the
asset side of the balance sheet. Financing decisions focus on raising the money the firm
needs to buy productive assets. This is typically accomplished by selling long-term debt
and equity. Finally, working capital decisions involve how firms manage their current
The Financial Manager and the Firm
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assets and liabilities. The focus here is seeing that a firm has enough money to pay its
bills and that any spare money is invested to earn interest.
1.3 What is the difference between stockholders and stakeholders?
Stockholders, also referred to as shareholders, are the owners of the company. A
stakeholder, on the other hand, is anyone with a claim on the assets of the firm, including,
but not limited to, shareholders. Stakeholders are the firm’s employees, suppliers,
creditors, and the government.
1.4 Suppose that a group of accountants want to start their own accounting company. What
organizational form of business would they choose, and why?
Most lawyers, accountants, and doctors form what are known as limited liability
partnerships. These formations combine the tax advantages of partnerships with the
limited liability of corporations.
1.5 What does double taxation in the corporate setting mean?
According to the tax law, owners of corporate stock are subject to taxation twice. A
company’s income is taxed initially at the corporate level, and then the shareholders and
investors are taxed on the dividends they receive from the company.
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1.6 Explain why profit maximization is not the best goal for a company. What is an
appropriate goal?
Although profit maximization appears to be the logical goal for any company, it has
many drawbacks. First, profit can be defined in a number of different ways, and
variations in net income for similar firms can vary widely. Second, accounting profits do
not exactly equal cash flows. Third, profit maximization does not account for timing and
ignores risk associated with cash flows. An appropriate goal for financial managers who
do not have these objections is to maximize the value of the firm’s current stock price. In
order to achieve this goal, management must make financial decisions so that the total
value of cash inflows exceeds the total value of cash outflows.
1.7 In determining the price of a firm’s stock, what are some of the external and internal
factors that affect price? What is the difference between these two types of variables?
External factors that affect the firm’s stock price are: (1) economic shocks, such as
natural disasters or wars, (2) the state of the economy, such as the level of interest rates,
and (3) the business environment, such as taxes or regulations. On one hand, external
factors are variables over which the management has no control. On the other hand,
internal factors that affect the stock price can be controlled by management to some
degree, because they are firm specific, such as financial management decisions, product
quality and cost, and the line of business management has selected to enter. Finally,
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perhaps the most important internal variable that determines the stock price is the
expected cash flow stream: its magnitude, timing, and riskiness.
1.8 Identify the causes of agency costs. What are some ways a company can control these
factors?
Agency costs are the costs that result from a conflict of interest between the agent and the
principal. They can either be direct, such as lavish dinners or trips, or indirect, which are
usually missed investment opportunities. A company can control these costs by tying
management compensation to company’s performance or by establishing an independent
board of directors. Outside factors that contribute to the minimization of agency costs are
the threat of corporate raiders that can take over a company not performing up to
expectations and the competitive nature of the management labor market.
1.9 What is the Sarbanes-Oxley Act, and what are its main goals that affect the board of
directors?
The Sarbanes-Oxley Act of 2002 focuses on reducing agency costs in corporations and
restoring ethical conduct in the business sector. With respect to the board of directors, the
concern was that boards were no longer independent of management. As a result, the act
has a number of provisions to strengthen board independence and its investigative
powers. For example, boards must restructure so that a majority of the members are
outside directors, the external auditor reports to the audit committee, the audit committee
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has greater oversight powers, and board members are legally responsible to represent
shareholders.
1.10 Give an example of a conflict of an interest in a business setting other than the one
involving the real estate agent discussed in the text.
For example, imagine a situation in which you are a financial officer at a growing
software company and your firm has decided to hire outside consultants to formulate a
global expansion strategy. Coincidentally, your wife works for one of the major
consulting firms that your company is considering hiring. In this scenario, you have a
conflict of interest, because instinctively, you might be inclined to give the business to
your wife’s firm, because it will benefit your family’s financial situation if she lands the
contract, regardless of whether it makes the best sense for your firm.
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Questions and Problems
1.1 Capital: What are the two basic sources of funds for all businesses?
Solution: The two basic sources of funds for all businesses are debt and equity.
1.2 Management role: What is working capital management?
Solution: It is the management of current assets, such as inventory, and current liabilities, such
as money owed to suppliers.
1.3 Cash flows: Explain the difference between profitable and unprofitable firms.
Solution: A profitable firm is able to generate more than enough cash through its productive
assets to cover its operating expenses, taxes, and payments to creditors. Unprofitable
firms fail to do this, and therefore they may be forced to declare bankruptcy.
1.4 Management role: What are the three major decisions that most concern financial
managers?
Solution: Financial managers are most concerned about the capital budgeting decision, the
financing decision, and the working capital decision.
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1.5 Cash flows: What is the general decision rule for a firm considering undertaking a
project? Give a real-life example.
Solution: A firm should undertake a capital project only if the value of its future cash flows
exceeds the cost of the project.
1.6 Management role: What is capital structure, and why is it important to a company?
Solution: Capital structure shows how a company is financed; it is the mix of debt and equity
on the liability side of the balance sheet. It is important as it affects the risk and the
value of the company. In general, companies with higher debt-to-equity proportions
are riskier because debt comes with legal obligations to pay periodic payments to
creditors and to repay the principal at the end.
1.7 Management role: What is working capital management, and what are some of the
working capital decisions that a financial manager faces?
Solution: Working capital management is the day-to-day management of a firm’s current assets
and liabilities to make sure that there is enough cash to cover operating expenses and
there is spare cash to earn interest. The financial manager has to make decisions about
the inventory levels or terms of collecting payments (receivables) from customers.
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1.8 Organizational form: What are the three forms of business organization discussed in
this chapter?
Solution: The three forms of business organization we discussed are sole proprietorship,
partnership, and corporation.
1.9 Organizational form: What are the advantages and disadvantages of a sole
proprietorship?
Solution: Advantages:
• It is the easiest business type to start.
• It is the least regulated.
• Owners keep all the profits and do not have to share the decision-making
authority with anyone.
• All income is taxed as personal income, which is usually in a lower tax bracket
than corporate income.
Disadvantages:
• The proprietor has an unlimited liability for all business debt and financial
obligations of the firm.
• The amount of capital that can be invested in the firm is limited by the
proprietor’s wealth.
• It is difficult to transfer ownership (requires sale of the business).
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1.10 Organizational form: What is a partnership, and what is the biggest disadvantage of this
business organization? How can it be avoided?
Solution: A partnership consists of two or more owners legally joined together to manage a
business. The major disadvantage to partnerships is that all partners have unlimited
liability for the organization’s debts and legal obligations no matter what stake they
have in the business. One way to avoid this is to form a limited partnership in which
only general partners have unlimited liability and limited partners are only
responsible for business obligations up to the amount of capital they contributed to
the partnership.
1.11 Organizational form: Who are the owners in a corporation, and how is their ownership
represented?
Solution: The owners of a corporation are its stockholders or shareholders, and the evidence of
their ownership is represented by shares of common stock. Other types of ownership
do exist and include preferred stock.
1.12 Organizational form: Explain what is meant by stockholders’ limited liability.
Solution: Limited Liability for a stockholder means that the stockholder’s legal liability extends
only to the capital contributed or the amount invested.
1.13 Organizational form: What is double taxation?
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Solution: The owners of a corporation are subject to double taxation—first at the corporate
level and then again at a personal level when they are given dividends.
1.14 Organizational form: What is the business organization form preferred by most
physicians, lawyers, and accountants, and why?
Solution: Most lawyers, accountants, and doctors form what are known as limited liability
partnerships. These formations combine the tax advantages of partnerships with the
limited liability of corporations.
1.15 Finance function: What is the most important governing body within a business
organization? What responsibilities does it have?
Solution: The most important governing body within an organization is the board of directors.
Its main role is to represent the shareholders. The board also hires (and occasionally
fires) the CEO and advises him or her on major decisions.
1.16 Finance function: Almost all public companies hire a certified public accounting firm to
perform an independent audit of the financial statements. What exactly does an audit
mean?
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Solution: An independent CPA firm that performs an audit of a firm ensures that the financial
numbers are reasonably accurate, that accounting principles have been adhered to
year after year and not in a manner that distorts the firm’s performance, and that the
accounting principles used are in accordance with generally accepted accounting
principles (GAAP).
1.17 Firm’s goal: What are some of the drawbacks to setting profit maximization as the main
goal of a company?
Solution:
• It is difficult to determine what is meant by profits.
• It does not address the size and timing of cash flows—it does not account for the
time value of money.
• It ignores the uncertainty of risk of cash flows.
1.18 Firm’s goal: What is the appropriate goal of financial managers? Can managers’
decisions affect this goal in any way? If so, how?
Solution: The appropriate goal of financial managers should be to maximize the current value
of the firm’s stock price. Managers’ decisions affect the stock price in many ways as
the value of the stock is determined by the future cash flows the firm can generate.
Managers can affect the cash flows by, for example, selecting what products or
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services to produce, what type of assets to purchase, or what advertising campaign to
undertake.
1.19 Firm’s goal: What are the major factors affecting stock price?
Solution: The following factors affect the stock price: the firm, the economy, economic shocks,
the business environment, expected cash flows, and current market conditions.
1.20 Agency conflicts: What is an agency relationship, and what is an agency conflict? How
can agency conflicts be reduced in a corporation?
Solution: Agency relationships develop when a principal hires an agent to perform some
service or represent the firm. An agency conflict arises when the agent’s interests and
behaviors are at odds with those of the principal. Agency conflicts can be reduced
through the following three mechanisms: management compensation, control of the
firm, and the board of directors.
1.21 Firm’s goal: What starts to happen when if a firm is poorly managed and its stock price
falls substantially below its maximum?
Solution: If the stock price falls below its maximum potential price, it attracts corporate raiders,
who look for fundamentally sound but poorly managed companies they can buy, turn
around, and sell for a handsome profit.
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1.22 Agency conflicts: What are some of the regulations pertaining to boards of directors that
were put in place to reduce agency conflicts?
Solution: Some of the regulations include:
a. The majority of board members must be outsiders.
b. A separation of the CEO and chairman of the board positions is recommended.
c. The CEO and CFO must certify all financial statements.
1.23 Business ethics: How could business dishonesty and low integrity cause an economic
downfall? Give an example.
Solution: Business dishonesty and lack of transparency lead to corruption, which in turn creates
inefficiencies in an economy, inhibits the growth of capital markets, and slows the
rate of economic growth. For example, until the mid-1990s the Russian market had a
difficult time attracting investors as there was no reliable financial information on any
of the companies. Only after the Russians made a conscious decision to make their
records and motives transparent were they able to draw foreign investments.
1.24 Agency conflicts: What are some possible ways to resolve a conflict of interest?
Solution: One way to resolve a conflict of interest is by complete disclosure. As long as both
parties are aware of the fact that, for example, both parties in a lawsuit are
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represented by the same firm, disclosure is sufficient. Another way to avoid a conflict
of interest is for the company to remove itself from serving the interest of one of the
parties. This is, for example, the case with accounting firms not being allowed to
serve as consultants to companies for which they perform audits.
1.25 Business ethics: What ethical conflict does insider trading present?
Solution: Insider trading is an example of information asymmetry. The main idea is that
investment decisions should be made on an even playing field. Insider trading is
morally wrong and has also been made illegal.
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Sample Test Problems
1.1 Why is value maximization superior to profit maximization as a goal for the firm?
Solution: While profit maximization appears to be a logical goal at first glance, it has some
serious drawbacks. First, the common notion of profit being the difference between
revenues and expenses can be distorted by some creative accounting measures.
Second, as we will see throughout the text, accounting profits are quite different from
cash flows. Cash flows will be the focus of investors and therefore managers. Third,
profit maximization does not recognize when cash flows occur. Finally, profit
maximization as a goal ignores the risk involved in generating the cash flows. When
analysts and investors determine the value of a firm’s stock, they consider (1) the size
of the expected cash flows, (2) the timing of the cash flows, and (3) the riskiness of
the cash flows. Thus, value maximization as a goal overcomes all the shortcomings
we recognized with regard to profit maximization as a goal.
1.2 The major advantages of debt financing is:
a. it allows a firm to use creditors’ money.
b. interest payments are more predictable than dividend payments.
c. interest payments are not required when a firm is not doing well.
d. interest payments are tax deductible.
Solution: d (interest payments are tax deductible.)
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1.3 Identify three fundamental decisions that a finance manager has to make in running a
firm.
Solution:
Management decides what type of products or services to produce and what productive
assets to purchase.
. Managers also make financing decisions that concerns the mix of debt to equity, debt
collection policies, and policies for paying suppliers, to mention a few.
1.4 What are agency costs? Explain.
Solution: Agency costs are the costs that result from a conflict between a firm’s management
and its owners or shareholders. When management acts in ways that do not benefit
shareholders, it results in agency costs. These costs could be either direct or indirect.
When a management action results in a loss of cash flow to the firm, it is an indirect
cost. Direct costs result from inappropriate actions or expenses by management that
lower the firm’s income and cash flows.
1.5 Identify four of the seven mechanisms that align the goals of managers to those of
stockholders.
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Solution: Four mechanisms that can help align the behavior of managers with the goals of
corporate shareholders are: (1) management compensation, (2) control of the firm, (3)
management labor markets, and (4) an independent board of directors.
Firms have come up with compensation plans tied to the performance of the firm
to give managers an incentive to make decisions consistent with the goal of
shareholders’ wealth maximization. Another incentive comes in the form of a
takeover threat by corporate raiders, which will lead to firing the current management
being. A third incentive comes through the labor market, which will make it difficult
for poorly performing management to find another job. Finally, the presence of
independent directors on the firm’s board will prevent managers from acting solely in
their own interest.
