Instructors Manual - Fundamentals of Financial Management Thirteenth...

Instructor’s Manual Fundamentals of Financial Management Thirteenth edition James C. Van Horne John M. Wachowicz, Jr. 1 / 4

9 © Pearson Education Limited 2008

The Role of Financial Management

Increasing shareholder value over time is the bottom line of every move we make.

ROBERT GOIZUETA

Former CEO, The Coca-Cola Company 2 / 4

Chapter 1: The Role of Financial Management

10 © Pearson Education Limited 2008

ANSWERS TO QUESTIONS

• With an objective of maximizing shareholder wealth, capital will tend to be allocated to the

most productive investment opportunities on a risk-adjusted return basis. Other decisions will also be made to maximize efficiency. If all firms do this, productivity will be heightened and the economy will realize higher real growth. There will be a greater level of overall economic want satisfaction. Presumably people overall will benefit, but this depends in part on the redistribution of income and wealth via taxation and social programs. In other words, the economic pie will grow larger and everybody should be better off if there is no reslicing. With reslicing, it is possible some people will be worse off, but that is the result of a governmental change in redistribution. It is not due to the objective function of corporations.

2. Maximizing earnings is a nonfunctional objective for the following reasons:

• Earnings is a time vector. Unless one time vector of earnings clearly dominates all other

time vectors, it is impossible to select the vector that will maximize earnings.

• Each time vector of earning possesses a risk characteristic. Maximizing expected

earnings ignores the risk parameter.

• Earnings can be increased by selling stock and buying treasury bills. Earnings will

continue to increase since stock does not require out-of-pocket costs.

• The impact of dividend policies is ignored. If all earnings are retained, future earnings

are increased. However, stock prices may decrease as a result of adverse reaction to the absence of dividends.Maximizing wealth takes into account earnings, the timing and risk of these earnings, and the dividend policy of the firm.

• Financial management is concerned with the acquisition, financing, and management of

assets with some overall goal in mind. Thus, the function of financial management can be broken down into three major decision areas: the investment, financing, and asset management decisions.

• Yes, zero accounting profit while the firm establishes market position is consistent with the

maximization of wealth objective. Other investments where short-run profits are sacrificed for the long-run also are possible.

• The goal of the firm gives the financial manager an objective function to maximize. He/she

can judge the value (efficiency) of any financial decision by its impact on that goal. Without such a goal, the manager would be "at sea" in that he/she would have no objective criterion to guide his/her actions.

• The financial manager is involved in the acquisition, financing, and management of assets.

These three functional areas are all interrelated (e.g., a decision to acquire an asset necessitates the financing and management of that asset, whereas financing and management costs affect the decision to invest).

• If managers have sizable stock positions in the company, they will have a greater

understanding for the valuation of the company. Moreover, they may have a greater incentive to maximize shareholder wealth than they would in the absence of stock holdings.However, to the extent persons have not only human capital but also most of their financial 3 / 4

Van Horne and Wachowicz, Fundamentals of Financial Management, 13 th edition, Instructor’s Manual 11 © Pearson Education Limited 2008 capital tied up in the company, they may be more risk averse than is desirable. If the company deteriorates because a risky decision proves bad, they stand to lose not only their jobs but have a drop in the value of their assets. Excessive risk aversion can work to the detriment of maximizing shareholder wealth as can excessive risk seeking, if the manager is particularly risk prone.

• Regulations imposed by the government constitute constraints against which shareholder

wealth can still be maximized. It is important that wealth maximization remain the principal goal of firms if economic efficiency is to be achieved in society and people are to have increasing real standards of living. The benefits of regulations to society must be evaluated relative to the costs imposed on economic efficiency. Where benefits are small relative to the costs, businesses need to make this known through the political process so that the regulations can be modified. Presently there is considerable attention being given in Washington to deregulation. Some things have been done to make regulations less onerous and to allow competitive markets to work.

• As in other things, there is a competitive market for good managers. A company must pay

them their opportunity cost, and indeed this is in the interest of stockholders. To the extent managers are paid in excess of their economic contribution, the returns available to investors will be less. However, stockholders can sell their stock and invest elsewhere.Therefore, there is a balancing factor that works in the direction of equilibrating managers’ pay across business firms for a given level of economic contribution.

• In competitive and efficient markets, greater rewards can be obtained only with greater risk.

The financial manager is constantly involved in decisions involving a trade-off between the two. For the company, it is important that it do well what it knows best. There is little reason to believe that if it gets into a new area in which it has no expertise that the rewards will be commensurate with the risk that is involved. The risk-reward trade-off will become increasingly apparent to the student as this book unfolds.

• Corporate governance refers to the system by which corporations are managed and

controlled. It encompasses the relationships among a company’s shareholders, board of directors, and senior management. These relationships provide the framework within which corporate objectives are set and performance is monitored.The board of directors sets company-wide policy and advises the CEO and other senior executives, who manage the company’s day-to-day activities. The Board reviews and approves strategy, significant investments, and acquisitions. The board also oversees operating plans, capital budgets, and the company’s financial reports to common shareholders.

• The controller’s responsibilities are primarily accounting in nature. Cost accounting, as well

as budgets and forecasts, would be for internal consumption. External financial reporting would be provided to the IRS, the SEC, and the stockholders.The treasurer’s responsibilities fall into the decision areas most commonly associated with financial management: investment (capital budgeting, pension management), financing (commercial banking and investment banking relationships, investor relations, dividend disbursement), and asset management (cash management, credit management).

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