Intermediate Financial Management Ch 1 Solutions
Chapter 1
An Overview of Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to stock price maximization. That, in turn, means maximizing the PV of future free cash flows. Maximizing shareholder wealth requires that the firm produce things that customers want, and at the lowest cost consistent with high quality. It also means holding risk down, which will result in a relatively low cost of capital, which is necessary to maximize the PV of a given cash flow stream. This also gets into the issue of capital structure—how much debt should we use? The more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less dilution of earnings. However, more debt means more risk. So, it’s necessary to consider capital structure when attempting to maximize share prices. Dividend policy is also an issue—how much of its earnings should the firm pay out as dividends? The answer to that question depends on a number of factors, including the firm’s investment opportunities, its access to capital markets, its stockholders’ desires (and their tax rates), and the kind of signals stockholders get from dividend actions. Shareholder wealth maximization is partially consistent and partially inconsistent with generally accepted societal goals. It is consistent because well-run firms produce good products at low costs, sell them at competitive prices, employ people, pay taxes, and generally improve society. However, without constraints, firms would tend to form monopolies and end up charging prices that are too high and not producing enough output. They might also pollute the air and water, engage in unfair labor practices, and so on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed on businesses. That said, stock price maximization is consistent with a strong economy, economic
An Overview of Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS
1-1 The primary goal is assumed to be shareholder wealth maximization, which translates to stock price maximization. That, in turn, means maximizing the PV of future free cash flows. Maximizing shareholder wealth requires that the firm produce things that customers want, and at the lowest cost consistent with high quality. It also means holding risk down, which will result in a relatively low cost of capital, which is necessary to maximize the PV of a given cash flow stream. This also gets into the issue of capital structure—how much debt should we use? The more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less dilution of earnings. However, more debt means more risk. So, it’s necessary to consider capital structure when attempting to maximize share prices. Dividend policy is also an issue—how much of its earnings should the firm pay out as dividends? The answer to that question depends on a number of factors, including the firm’s investment opportunities, its access to capital markets, its stockholders’ desires (and their tax rates), and the kind of signals stockholders get from dividend actions. Shareholder wealth maximization is partially consistent and partially inconsistent with generally accepted societal goals. It is consistent because well-run firms produce good products at low costs, sell them at competitive prices, employ people, pay taxes, and generally improve society. However, without constraints, firms would tend to form monopolies and end up charging prices that are too high and not producing enough output. They might also pollute the air and water, engage in unfair labor practices, and so on. So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed on businesses. That said, stock price maximization is consistent with a strong economy, economic