978-0133546408 Chapter 1 Solution Manual

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Part 1

Introduction to Managerial Finance

Chapters in This Part

Chapter 1 The Role of Managerial Finance

Chapter 2 The Financial Market Environment

Chapter 1

The Role of Managerial Finance

 Instructor’s Resources

Overview

This chapter introduces the students to the field of finance and explores career opportunities in both financial services

and managerial finance. The three basic legal forms of business organization (sole proprietorship, partnership, and

corporation) and their strengths and weaknesses are described. The managerial finance function is defined and

differentiated from economics and accounting. A discussion of the financial manager’s goals—maximizing

shareholder wealth and preserving stakeholder wealth—and the role of ethics in meeting these goals is presented.

The chapter then summarizes the three key activities of the financial manager: financial analysis and planning,

making investment decisions, and making financing decisions. The chapter includes discussion of the agency

problem—the conflict that exists between managers and owners in a large corporation.

This chapter, and all that follow, emphasizes how the chapter content plays a vital role in the student’s professional

and personal life. Each chapter includes an early discussion of the relevance of the topic to majors in accounting,

information systems, management, marketing, and operations. Throughout each chapter are detailed examples of

how the chapter’s topic relates to the student’s financial life. These pedagogic tools should motivate students to

grasp quickly an understanding of the chapter content and employ it in both their professional and personal lives.

 Answers to Review Questions

1. Finance is the art and science of managing money. Finance affects all individuals, businesses, and

governments in the process of the transfer of money through institutions, markets, and instruments. At the

2. Financial services is the area of finance concerned with the design and delivery of advice and financial

products to individuals, businesses, and governments. It involves a variety of interesting career opportunities

2 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

within the areas of banking, personal financial planning, investments, real estate, and insurance. Managerial

finance is concerned with the duties of the financial manager working in a business. Managerial finance

3. Sole proprietorships are the most common form of business organization, while corporations are

4. Stockholders are the owners of a corporation, whose ownership, or equity, takes the form of common

stock or, less frequently, preferred stock. They elect the board of directors, which has the ultimate authority to

guide corporate affairs and set general policy. The board is usually composed of key corporate personnel and

shares.

5. The most popular form of limited liability organizations other than corporations are:

Limited partnerships—A partnership with at least one general partner with unlimited liability and one or

S corporation—If certain requirements are met, the S corporation can be taxed as a partnership but

receive most of the benefits of the corporate form of organization.

Limited liability company (LLC)—This form of organization is like an S corporation in that it is taxed as

Limited liability partnership (LLP)—A partnership form authorized by many states that gives the partners

These firms generally do not have large numbers of owners. Most typically they have fewer than

100 owners.

6. Virtually every function within a firm is in some way connected with the receipt or disbursement of cash.

The cash relationship may be associated with the generation of sales through the marketing department, the

7. The goal of a firm, and therefore of all managers, is to maximize shareholder wealth. This goal is

8. Profit maximization is not consistent with wealth maximization due to: (1) the timing, (2) earnings that do not

represent cash flows available to stockholders, and (3) a failure to consider risk.

Chapter 1: The Role of Managerial Finance 3

9. Risk is the chance that actual outcomes may differ from expected outcomes. Financial managers must

10. In recent years, the magnitude and severity of “white collar crime” has increased dramatically, with a

corresponding emphasis on prosecution by government authorities. As a result, the actions of all corporations

and their executives have been subjected to closer scrutiny. The increased scrutiny of this type of crime has

11. The treasurer or the chief financial manager typically manages a firm’s cash, investing surplus funds when

available and securing outside financing when needed. The treasurer also oversees a firm’s pension plans and

12. Finance is often considered a form of applied economics. Firms operate within the economy and must be

aware of the economic principles, changes in economic activity, and economic policy. Principles developed in

13. Accountants operate on an accrual basis, recognizing revenues at the point of sale and expenses when

incurred. The financial manager focuses on the actual inflows and outflows of cash, recognizing revenues

14. The two key activities of the financial manager as related to a firm’s balance sheet are

Investment decisions generally refer to the items that appear on the left-hand side of the balance sheet

15. Corporate governance refers to a system of organizational control that is used to define and establish lines of

responsibility and accountability among major participants in a corporation. These participants include the

The Sarbanes-Oxley Act of 2002 is directed toward reducing the apparent conflicts of interest that exist in

16. Agency problems arise when managers deviate from the goal of maximization of shareholder wealth by

placing their personal goals ahead of the goals of shareholders. These problems in turn give rise to agency

4 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

managers fail to make the best investment decision or when managers have to be monitored to ensure that the

best investment decision is made, because either situation is likely to result in a lower stock price.

17. Structuring expenditures are currently the most popular way to deal with the agency problem—and also the

most powerful and expensive. Compensation plans can be either incentive or performance plans. Incentive

plans tie management performance to share price. Managers may receive stock options giving them the right

In practice, recent studies have been unable to document any significant correlation between CEO

compensation and share price.

18. Market forces—for example, shareholder activism from large institutional investors—can reduce or avoid the

agency problem because these groups can use their voting power to elect new directors who support their

The threat of hostile takeovers also acts as a deterrent to the agency problem. Hostile takeovers occur

Institutional investors are a powerful source of shareholder involvement in the monitoring of managers to

reduce the agency problem. Institutions hold large quantities of shares in many of the corporations in their

 Suggested Answer to Focus on Ethics Box: Critics See Ethical

Dilemmas in Google Glass

Is the goal of maximization of shareholder wealth necessarily ethical or unethical?

What responsibility, if any, does Google have to protect the privacy of those who interact with other people

wearing Glass?

Google has a responsibility to ensure that its products and users of its product protect the privacy of those who

interact with the users of Google’s products. Google Glass poses an ethical challenge as users could seemingly

Chapter 1: The Role of Managerial Finance 5

 Answers to Warm-Up Exercises

E1-1. Comparison of advantages and disadvantages of a partnership versus incorporation.

Answer: While Jack and Ann disagree over whether or not their firm should incorporate or remain as a

partnership, each form of business organization has its advantages and disadvantages. One advantage of

a partnership is that income is taxed at each partner’s individual tax rate that includes 10%, 15%, 25%,

While taxation of income is a key factor in deciding which form of business organization to select, two

other factors are also important. In a partnership, each partner has unlimited liability and may have to

cover debts of other partners, while corporate owners have limited liability that guarantees that they

If a third party was asked to decide which legal form of business A&J Tax Preparation should take, it

would be useful to have the following information:

Marital status and tax situation of each partner

Expectation of the longevity of the firm

Age of the current owners

E1-2 Timings of cash flows

Answer: Based on the information provided, the choice is not obvious. Even though the second project is expected

to provide the larger overall increase in earnings and, therefore, is the more profitable project, the goal of

E1-3. Cash flow vs. accrued profits

Answer: It is not unusual for a firm to be profitable yet experience a cash crunch. The most common cause is when

expenses have a shorter due date than expected revenue. In such cases, the firm must arrange

short-term financing to meet its debt obligations before the revenue arrives. If the forthcoming cash

E1-4. Sunk costs

6 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

Answer: Marginal cost-benefit analysis ignores sunk costs, so the $2.5 million dollars is irrelevant to the current

decision that must be made. At this point there are two questions that must be answered. First, will the

$10,000 additional investment generate a PV of expected revenue that will exceed the $10,000

investment? In other words, will the project generate a positive net present value? If it does, the project

E1-5. Agency costs

Answer: Agency costs are the costs borne by stockholders to maintain a governance structure that ensures

against dishonest acts of management, and gives managers the financial incentive to maximize share

price. One example of agency costs is stock options, which are used to provide an incentive for

managers to work diligently for the benefit of the firm. Tips are similar to stock options in that they are

One solution that may work for Donut Shop, Inc., is to institute a profit-sharing plan that reaches down to

the employee level where the slowdown and inefficiency are occurring. A profit-sharing plan is designed

to motivate the employees and could alleviate the aggravation caused by the no-tip policy, but must be

 Solutions to Problems

P1-1. Liability comparisons

LG 2; Basic

a. Ms. Harper has unlimited liability.

P1-2. Accrual income vs. cash flow for a period

LG 4; Basic

a. Sales $760,000

b. Cash receipts $690,000

Chapter 1: The Role of Managerial Finance 7

c. The cash flow statement is more useful to the financial manager. The accounting net income includes

P1-3. Cash flow statement

LG 4; Intermediate

a. Total cash inflow: $450  $4,500  $4,950

b. Net cash flow: Total cash inflows – Total cash outflows = $4,950  $4,357  $593

d. If Jane has a surplus in August, she should compare these cash flows to those of other months and

verify that August’s cash flows are typical. She may, for instance, observe the existence of large

P1-4. Marginal cost-benefit analysis and the goal of the firm

PG 3, 5; Challenge

a. Marginal benefits of new robotics  Marginal benefits of original robotics  Marginal benefits of

proposed robotics

b. Marginal cost of new robotics – Sales price of current robotics = Marginal cost of proposed robotics

c. Net benefits of new robotics  Marginal benefits of proposed robotics  Marginal cost of proposed

robotics

e. Ken Allen should determine whether there will be additional training necessary with the new robotics,

P1-5. Identifying agency problems, costs, and resolutions

LG 4; Intermediate

a. In this case the employee is being compensated for unproductive time. The company must pay

b. The costs to the firm are in the form of opportunity costs. Money budgeted to cover the inflated costs

c. The manager may negotiate a deal with the merging competitor that is extremely beneficial to the

8 Gitman/Zutter Principles of Managerial Finance, Brief, Seventh Edition

d. Generally, part-time or temporary workers are not as productive as full-time employees. These workers

P1-6. Ethics Problem

LG 3; Intermediate

The phrase “ethical constraints” is quite broad. The company may be referring to legal issues, and the fact

that it will comply with laws. For example, it may be implying that it will not be using illegal immigrants and

 Case

Case studies are available on www.myfinancelab.com.

Assessing the Goal of Sports Products, Inc.

a. Maximization of shareholder wealth, which means maximization of share price, should be the primary goal

b. Yes, there appears to be an agency problem. Although compensation for management is tied to profits, it is

c. The firm’s approach to pollution control seems to be questionable ethically. While it is unclear whether their

acts were intentional or accidental, it is clear that they are violating the law—an illegal act potentially leading to

d. From the information given there appears to be a weak corporate governance system. The fact

that management is able to measure and reward their performance on profits indicates that no one

e. Some specific recommendations for the firm include:

Tie management, and possibly employee, compensation to share price or a performance-based measure and

Comply with all federal and state laws as well as accepted standards of conduct or moral judgment.

(Other answers are, of course, possible.)

Chapter 1: The Role of Managerial Finance 9

 Spreadsheet Exercise

The answer to Chapter 1’s Monsanto spreadsheet problem is located on the Instructor’s Resource Center

at www.pearsonhighered.com/irc under the Instructor’s Manual.

 Group Exercise

Group exercises are available on www.myfinancelab.com.

Notes for Adopters

The motivation for these group exercises is to place the learning goals of each chapter within the context of a

fictitious firm while giving students a valuable set of teamwork skills. Creativity is encouraged, while the strong

links of each assignment to a real-world, shadow firm should ground each group’s work in reality. Any of these

The first issue for adopters to address is group composition and size. Should students self-separate or be divided by

their instructor? How big should the groups be? This is a semester-long assignment and students will need to get

along with their fellow group members. If students choose their own groups it may, though not always, reduce the

Group size does matter and these exercises were designed for a workload spread across a minimum of three

students. Larger groups would lessen the homework load; however, the issue of free-riding is often more prevalent

Group leadership is another issue. The best situation might be rotating the CEO/leader, where each group member

Chapter 1

This first chapter asks students to name their fictitious firm and describe its business. As this firm is going public,

students are asked to explain why it is appropriate for them to go public and also discuss different managerial roles

within the corporation. The group must choose a shadow firm to follow that is publicly held, allowing them to

gather a substantial amount of information about it on the Internet. This publicly traded firm should be in an

industry related to their fictitious firm.

The most important counsel students could get at the outset is to spend time making these initial decisions. Later

work is going to build on these choices, and careful choosing is paramount. For example, in choosing the shadow

firm, students should pick a well-established firm whose information, including financials, will be easily found.

This also impacts their decisions regarding their own fictitious firm. Throughout many of the subsequent chapters,

students will be taking real-world information from their shadow firm and applying it to their fictitious firm;

dressing their own firm with the clothes of the shadow firm. Students should feel comfortable in these clothes, so

encouraging them to choose industries they’re familiar with, or interested in, is helpful.