Chapter 01: The Goals and Functions of Financial Management
1-1
Chapter 1
The Goals and Functions of Financial Management
Discussion Questions
1-1.
How did the recession of 2007–2009 compare with other recessions since the
Great Depression in terms of length?
It was the longest
1-2.
What effect did the recession of 2007–2009 have on government regulation?
It was greatly increased.
1-3.
What advantages does a sole proprietorship offer? What is a major drawback of
this type of organization?
A sole proprietorship offers the advantage of simplicity of decision making and
low organizational and operating costs. A major drawback is that there is
unlimited liability to the owner.
1-4.
What form of partnership allows some of the investors to limit their liability?
Explain briefly.
A limited partnership allows some of the partners to limit their liability. Under
this arrangement, one or more partners are designated general partners and have
unlimited liability for the debts of the firm; other partners are designated limited
partners and are liable only for their initial contribution. The limited partners are
normally prohibited from being active in the management of the firm.
1-5.
In a corporation, what group has the ultimate responsibility for protecting and
managing the stockholders’ interests?
The board of directors.
1-6.
What document is necessary to form a corporation?
The articles of incorporation.
1-7.
What issue does agency theory examine? Why is it important in a public
corporation rather than in a private corporation?
Agency theory examines the relationship between the owners of the firm and the
managers of the firm. In privately owned firms, management and the owners are
usually the same people. Management operates the firm to satisfy its own goals,
needs, financial requirements and the like. As a company moves from private to
public ownership, management now represents all owners. This places
management in the agency position of making decisions in the best interest of all
shareholders.
1-8.
Why are institutional investors important in today’s business world?
Because institutional investors such as pension funds and mutual funds own a
large percentage of major U.S. companies, they are having more to say about the
way publicly owned companies are managed. As a group, they have the ability to
vote large blocks of shares for the election of a board of directors, which is
suppose to run the company in an efficient, competitive manner. The threat of
being able to replace poor performing boards of directors makes institutional
investors quite influential. Since these institutions, like pension funds and mutual
funds, represent individual workers and investors, they have a responsibility to see
that the firm is managed in an efficient and ethical way.
1-9.
Why is profit maximization, by itself, an inappropriate goal? What is meant by the
goal of maximization of shareholder wealth?
The problem with a profit maximization goal is that it fails to take account of risk,
the timing of the benefits is not considered, and profit measurement is a very
inexact process. The goal of shareholders wealth maximization implies that the
firm will attempt to achieve the highest possible total valuation in the
marketplace. It is the one overriding objective of the firm and should influence
every decision.
1-10.
When does insider trading occur? What government agency is responsible for
protecting against the unethical practice of insider trading?
Insider trading occurs when anyone with non-public information buys or sells
securities to take advantage of that private information. The Securities and
Exchange Commission is responsible for protecting markets against insider
trading. In the past people have gone to jail for trading on non-public information.
This has included company officers, investment bankers, printers who have
information before it is publishers, and even truck drivers who deliver business
magazines and read positive or negative articles about a company before the
magazine is on the news stands and then place trades or have friends place trades
based on that information. The SEC has prosecuted anyone who profits from
inside information.
1-11.
In terms of the life of the securities offered, what is the difference between money
and capital markets?
Money markets refer to those markets dealing with short-term securities that have
a life of one year or less. Capital markets refer to securities with a life of more
than one year.
1-12.
What is the difference between a primary and a secondary market?
A primary market refers to the use of the financial markets to raise new funds for
the corporation. After the securities are sold to the public (institutions and
individuals), they trade in the secondary market between investors. It is in the
secondary market that prices are continually changing as investors buy and sell
securities based on the expectations of corporate prospects.
1-13.
Assume you are looking at many companies with equal risk; which ones will
have the highest stock prices?
Given companies with equal risk, those companies with expectations of high
return will have higher common stock prices relative to those companies with
expectations of poor returns.
Chapter 01: The Goals and Functions of Financial Management
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1-14.
What changes can take place under restructuring? In recent times, what group of
investors has often forced restructuring to take place?
Restructuring can result in changes in the capital structure (liabilities and equity
on the balance sheet). It can also result in the selling of low-profit-margin
divisions with the proceeds reinvested in better investment opportunities, and
sometimes restructuring results in the removal of the current management team or
large reductions in the work force. Restructuring has also included mergers and
acquisitions.
Institutional investors have been very influential in forcing restructuring to take
place in recent years.