Chapter 1: An Overview of Financial Management
Learning Objectives
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Chapter 1
An Overview of Financial Management
Learning Objectives
After reading this chapter, students should be able to:
◆ Explain the role of finance and the different types of jobs in finance.
◆ Identify the advantages and disadvantages of different forms of business organization.
◆ Explain the links between stock price, intrinsic value, and executive compensation.
◆ Identify the potential conflicts that arise within the firm between stockholders and managers and
between stockholders and bondholders, and discuss the techniques that firms can use to mitigate these
potential conflicts.
◆ Discuss the importance of business ethics and the consequences of unethical behavior.
Lecture Suggestions
Chapter 1 covers some important concepts, and discussing them in class can be interesting. However,
students can read the chapter on their own, so it can be assigned but not covered in class.
We spend the first day going over the syllabus and discussing grading and other mechanics relating
to the course. To the extent that time permits, we talk about the topics that will be covered in the course
and the structure of the book. We also discuss briefly the fact that it is assumed that managers try to
maximize stock prices, but that they may have other goals, hence that it is useful to tie executive
compensation to stockholder-oriented performance measures. If time permits, we think it’s worthwhile to
spend at least a full day on the chapter. If not, we ask students to read it on their own, and to keep them
honest, we ask one or two questions about the material on the first exam.
One point we emphasize in the first class is that students should print a copy of the
PowerPoint
slides for each chapter covered and purchase a financial calculator immediately, and bring both to class
regularly. We also put copies of the various versions of our “Brief Calculator Manual,” which in about 12
pages explains how to use the most popular calculators, in the copy center. Students will need to learn
how to use their calculators before time value of money concepts are covered in Chapter 5. It is important
for students to grasp these concepts early as many of the remaining chapters build on the TVM concepts.
We are often asked what calculator students should buy. If they already have a financial calculator
that can find IRRs, we tell them that it will do, but if they do not have one, we recommend either the
HP–10BII+ or 17BII+. Please see the “Lecture Suggestions” for Chapter 5 for more on calculators.
DAYS ON CHAPTER: 1 OF 56 DAYS (50–minute periods)
Answers to End-of–Chapter Questions
1-1 A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return
data. It can be estimated but not measured precisely. A stock’s current price is its market price—
1-2 Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are
indifferent between buying and selling a stock. If a stock is in equilibrium then there is no
1-3 If the three intrinsic value estimates for Stock X were different, you would have the most
confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different
1-4 If a stock’s market price and intrinsic value are equal, then the stock is in equilibrium and there is
no pressure (buying/selling) to change the stock’s price. So, theoretically, it is better that the two
be equal; however, intrinsic value is a long-run concept. Management’s goal should be to maximize
1-5 The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded on the basis of
the stock’s performance over the long run, not the stock’s price on an option exercise date. This
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Answers and Solutions
Chapter 1: An Overview of Financial Management
1-6 The different forms of business organization are proprietorships, partnerships, corporations, and
limited liability corporations and partnerships. The advantages of the first two include the ease and
low cost of formation. The advantages of corporations include limited liability, indefinite life, ease
1-7 Stockholder wealth maximization is a long-run goal. Companies, and consequently the
stockholders, prosper by management making decisions that will produce long-term earnings
1-8 Useful motivational tools that will aid in aligning stockholders’ and management’s interests include:
(1) reasonable compensation packages, (2) direct intervention by shareholders, including firing
managers who don’t perform well, and (3) the threat of takeover.
The compensation package should be sufficient to attract and retain able managers but not go
beyond what is needed. Also, compensation packages should be structured so that managers are
rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an
1-9 a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to
create a more attractive community that will make it easier to hire a productive work force.
Chapter 1: An Overview of Financial Management
Answers and Solutions
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1-10 a. No, TIAA-CREF is not an ordinary shareholder. Because it is one of the largest institutional
b. For TIAA-CREF to be effective in wielding its weight, it must act as a coordinated unit. In order
1-12 The board of directors should set CEO compensation dependent on how well the firm performs.
The compensation package should be sufficient to attract and retain the CEO but not go beyond
what is needed. Compensation should be structured so that the CEO is rewarded on the basis of
1-13 Setting the compensation policy for three division managers would be different than setting the
compensation policy for a CEO because performance of each of these managers could be more
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Answers and Solutions
Chapter 1: An Overview of Financial Management
b. The expected payoff to debtholders is (0.5 × $50 million + 0.5 × $77 million) = $63.5 million.