Fundamentals of Corporate

Solution Manual to accompany Fundamentals of Corporate Finance 2 nd edition (Australia) by Hue Hwa Au Yong and Jenny Kofoed

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© John Wiley & Sons Australia, Ltd 2013 1.2 Chapter 1 The Financial Manager and the Company Learning Objectives 1.Identify the key financial decisions facing the financial manager of any company.

2.Identify the basic forms of business organisation used in Australia, and review their respective strengths and weaknesses.

3.Describe the typical organisation of the financial function in a large company.

4.Explain why maximising the current value of the company’s shares is the appropriate goal for management.

5.Discuss how agency conflicts affect the goal of maximising shareholder value.

6.Explain why ethics is an appropriate topic in the study of corporate finance.Suggested and Alternative Approaches to the Material This chapter presents a general survey of interesting topics in corporate finance. It begins with a brief discussion of the role of the financial manager and is followed by an examination of the different legal forms of business. Although all of the most common organisational forms are discussed, the most common form for the purposes of the remainder of the text is the company form. The chapter then proceeds with the financial function of the manager and the goal of the company, which is to maximise shareholder wealth. It is this goal that requires that we recognise its conflicts such as agency and ethical problems.This chapter is intended to help students begin to understand the long list of interesting problems that confront the financial manager and shareholders of the company. While omitting this chapter from a course syllabus will not necessarily diminish the direct understanding of the material, such an omission could give the impression that the remaining material in the course is mechanical in nature. Therefore, it is recommended that the instructor devote a lecture, or a portion of a lecture, on the chapter in order to establish a proper basis for future chapter-related discussions. 2 / 4

Solution manual to accompany Fundamentals of Corporate Finance 2e

© John Wiley & Sons Australia, Ltd 2013 1.3

Summary of Learning Objectives

• Identify the key financial decisions facing the financial manager of any company.

In running a business, the financial manager faces three basic decisions: (1) which productive assets should the company buy (capital budgeting), (2) how should the company finance the productive assets purchased (financing decision), and (3) how should the company manage its day-to-day financial activities (working capital decisions). The financial manager should make these decisions in a way that maximises the current value of the company share price.

• Identify the basic forms of business organisations used in Australia, and review

their respective strengths and weaknesses.A business can organise itself in three basic ways: as a sole trader, a partnership, or a company (public or private). Most large companies elect to organise as public companies because of the ease this form offers in raising money and transferring ownership; the major disadvantages are extensive regulation by the Australian Securities and Investments Commission (ASIC). Some companies operate as private companies to escape much of the ASIC regulation but must give up access to the public capital markets. Smaller businesses tend to organise as sole traders or partnerships. The advantages of these forms of organisation include ease of formation and the fact that the income of sole traders and partnerships is taxed at the personal income tax rate. The major disadvantage is unlimited personal liability of the owners. The owners of a company select the form of organisation that they believe will best allow management to maximise the value of the company.

• Describe the typical organisation of the financial function in a large company.

The board of directors is the most powerful governing body within the company. They are elected by the owners, and their major responsibility is to represent the best interests of the owners. To this end, the board is responsible for hiring the CEO and, if circumstances are warranted, to fire the CEO. The board also advises the CEO on a wide range of matters, monitors the company’s performance, and ratifies key decisions made by management.

• Explain why maximising the current value of the company’s share price is the

appropriate goal for management.The goal of the financial manager is to maximise the current value of the company’s share price. Maximising share price value is an appropriate goal because it forces management to focus on decisions that will generate the greatest amount of wealth for shareholders. Since the value of a share (or any asset) is determined by its cash flows, management’s decisions must consider the size of the cash flow (larger is better), the timing of the cash flow (sooner is better), and the riskiness of the cash flow (given equal returns, lower risk is better).

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Chapter 1: The financial manager and the company

© John Wiley & Sons Australia, Ltd 2013 1.4

• Discuss how agency conflicts affect the goal of maximising shareholder value.

In most large companies, there is a significant degree of separation between management and ownership. As a result, there is concern that shareholders have little control over corporate managers and that management may thus be tempted to pursue its own self- interest rather than maximising the wealth of the owners. The resulting problems are called agency costs. Owners try to reduce agency costs by developing compensation agreements that link employee compensation to the company’s performance and by having independent boards of directors and external auditors monitor management.

• Explain why ethics is an appropriate topic for study in corporate finance.

Ethical behaviour is important in business. If we lived in a world where there were no ethical norms, we would discover that it would be difficult to do business. As a practical matter, the law and market forces provide important incentives that foster ethical behaviour in the business community but are not enough to ensure ethical behaviour. An ethical culture means that people have a set of moral principles—a moral compass, so to speak—that helps them to identify ethical issues and then to make ethical judgments without being told what to do.

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