Chapter 1
The Role and Objective of Financial Management
CHAPTER 1
THE ROLE AND OBJECTIVE
OF FINANCIAL MANAGEMENT
ANSWERS TO QUESTIONS:
1. Shareholder wealth is defined as the present value of the expected future returns to the
2. Profit maximization typically is defined as a more static concept than shareholder wealth
maximization. The profit maximization objective from economic theory does not normally
The marginal decision rules derived from economic theory are extremely useful to a wealth
maximizing firm. Any decision, either in the short run or the long run, that results in marginal
3. A closely-held firm is more likely to be a wealth maximizer than a corporation with wide
ownership. In the closely-held firm, the owners and the managers will share the same
objectives because the owners are the managers. In a widely-held corporation, where the
4. The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is a
function of all the future returns to the shareholders. Hence, in making decisions that maximize
5. Engaging in social responsibility activities can be justified on the basis that these activities
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Chapter 1
The Role and Objective of Financial Management
6. The separation of ownership and control in corporations may result in management
pursuing goals other than shareholder wealth maximization, such as maximization of their own
7. An agency relationship occurs when one or more individuals (the principals) hire other
individuals (the agents) to perform a service on behalf of the principals. Two of the most
8. Examples of agency costs incurred by shareholders include
• Expenditures to structure the organization in a way that will minimize the incentives for
9. Creditors (the principal) have a fixed financial claim on the resources of the firm, whereas
owners (agents) have a residual claim on the firm’s resources. As a consequence, owners may
10. The controller usually has responsibility for all accounting related functions, such as
financial accounting, cost accounting, and accounting information systems. The treasurer
11. a. Financial management employs the marginal revenue — marginal cost relationships of
b. Financial management requires an understanding of macroeconomic concepts dealing with
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Chapter 1
The Role and Objective of Financial Management
12. Earnings per share figures can be misleading because factors such as (1) reductions in the
13. The bondholders in the RJR Nabisco takeover case wanted to block the transaction because
the takeover was to be financed with a substantial increase in the amount of debt, and therefore
14. The three major factors that determine the market value of a firm’s stock are: (1) the
15. The market’s reaction may have reflected (1) an expectation that there would ultimately be
a splitting up and spin-off of the natural resources business from the steel business, thereby
16. By declaring bankruptcy, Kodak hoped to protect itself from the claims of creditors while it
sought a way to either sell or restructure its assets. Presumably, the management at Kodak
17. Firms that expect their employees to act according to a high standard of ethical behavior
18. Sole proprietorships are characterized by the virtual non-existence of agency problems
between owners and managers, because the owner and manager are usually one and the same.
Partnerships provide a greater potential for raising capital because there is more than one
owner-manager. The capital raising potential of partnerships is limited to the number of
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Chapter 1
The Role and Objective of Financial Management
Corporations have the greatest potential for owner-manager agency problems because of the
separation of ownership from control. Offsetting this corporate disadvantage is the nearly
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