Complete Solution Manual For Fundamentals of Financial Management 16th edition by Eugene F. Brigham and Joel F. Houston Chapter 1 An Overview of Financial Management Learning Objectives After reading this chapter, students should be able to do the following : Explain the role of finance and the different types of jobs in finance. Identify the advantages and disadvantag es 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 b ondholders , 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 briefly discuss the fact that it is assumed that managers try to maximize stock prices, but that they may have other goa ls, 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 th em 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 an d 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 2 Lecture Suggestions © 2022 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly a ccessible website, in whole or in part, except for use as permitted in a license distri buted with a certain product or service or othe rwise on a password -protected website for classroom use. how to use their calcu lators before time value of money c oncepts 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 st udents should buy. If they a lready 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 17B II+. Please see the ―Lecture Suggestions ‖ for Chapter 5 for more on cal culators. 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 pre cisely. A sto ck’s current pr ice is its market price —
the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock ’s ―true‖ long-run value is more closely related to its intrinsic valu e rather than i ts current 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 funda mental imbalan ce, hence no pr essure for a change in the stock ’s price. At any gi ven time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are differ ent, so stocks can be tempora rily undervalued or overvalued . Investor optimism a nd pessimism, along with imperfect knowledge about the true intrinsic value, leads to deviations between the actual prices and intrinsic values. 1-3 If the three intrinsic va lue estimates for Stock X wer e different, you would have the most confidence in C ompany X ’s CFO ’s estimate. Intrinsic values are strictly estimates , and d ifferent analysts with different data and different views of the future will form different estimates of the intrinsic value for a ny given stock. However, a firm ’s managers have the best information about the company ’s future prospects , so managers ’ estimates of intrinsic value are generally better than the estimates of outside investors . 1-4 If a stock ’s market pric e and intrinsic value are equal, then the stock is in equilibrium a nd 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 t o maximize the firm ’s intrinsic value, not its curre nt price. So, maximizing the intrinsic value will maximize the average price over the long run but not necessarily the current price at each point in time. So, stockholders in general wou ld probably exp ect the firm ’s market price to be under the intrinsi c value—realizing that if management is doing its job that current price at any point in time would not necessarily be maximized. However, the CEO would prefer that the marke t price be hig h—
since it is t he current price that he will receive when exercisin g his stock options. In addition, he will be retiring after exercising those options, so there will be no repercussions to him (with respect to his job) if the market price d rops—unless he did something illegal during his tenure as CEO . 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 based on the stock’s performance over the long run, not the stock ’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over several years so th e CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the g rowth rate in reported profits than the intrinsic value, althou gh reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable , compensation must be based o n the stock ’s market price —but the price used should be an aver age over time rather than on a sp ecific date. 1-6 The different forms of business organization are proprietorship s, partnership s, corporation s, and limited liabil ity corporations and partnersh ips. The advantages of the first two include the ease and low cost of formation. The advantages of corporation s include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. Limited liability companies and partne rships have limi ted liability like corporations. The disadvanta ges of a proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disa dvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of t ransferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) sett ing up a corporation and filin g required state and federal reports, which are complex and tim e-consuming . Among t he disadvantage s of limited liability corporations and partnerships are difficulty in raising capita l and the complex ity of setting them up. 1-7 Stockholder wealth maximiz ation is a long -run goal. Companies, and consequently the stockholders, prosper by man agement making decisions that will produce long -term earnings increases. Actions that are continually shortsighted often ―catch up ‖ with a firm and, as a result, it may find itself unable to compete effectively against its competi tors. There has been much criticism in recent years that U.S. firms are too short -run profit -oriented. A prime example is the U.S. auto industry, which has been a ccused of continuing to build large ―gas guzzler ‖ automobiles because they had higher profit margins rather than retooling for smaller, more fuel -efficient models. 1-8 Useful motivational tools that will aid in aligning stockholders ’ and management ’s inte rests 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 manage rs but not go beyond what is n eeded. Also, compensation packages should be structured so tha t managers are rewarded based on the stock ’s performance over the long run, not the stock ’s price on an option exercise date. This means that option s (or direct s tock awards) should be phased in over several years so managers will have an incentive to kee p the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock ’s market price —but the price used sh ould be an average over time rather t han on a sp ecific date. Stockholders can intervene directly with ma nagers. Today, the majority of stock is owned by institutional investors and these institutional money managers have the clout to exercise considerable influence over firms ’ operations. F irst, they can talk with managers and make suggestions about how th e business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who h as owne d $2,000 of a company ’s stock for one year can sponsor a proposal that must be voted on at the annual stockholders ’ meeting, even if management opposes the proposal. Although shareholder -
sponsored proposals are non -binding, the results of such vote s are c learly heard by top management. Shareholder activism has increasingly played an important part ensuring that managers act in shareholders ’ interests. Indeed, in 2 014, activists established a recor d level of influence when they were granted a board seat in 73% of the p roxy fights that occurred that year . GE is one of a small group of companies that has volunt arily made it easier for shareholders to secure a board seat. The firm’s new plan allows shareholder groups holding at least 3% of the company ’s stock t o directly nominate c andidates for its board. If a firm’s stock is undervalued, then corporate raiders w ill see it to be a bargain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target ’s executives 4 Lecture Suggestions © 2022 Cengage Learning ®. May not be scanned, copied or duplicated, or posted to a publicly a ccessible website, in whole or in part, except for use as permitted in a license distri buted with a certain product or service or othe rwise on a password -protected website for classroom use. will almost c ertainl y be fired. This situation gives managers a strong incentive to take actions to maximize their s tock’s price . 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 w ill make it easier to hire a productive work force. This corporate philanthropy could be receive d by stockholders negatively, especially those stockholders not living in its headquarters city. Stockholders are interested in actions that maximize s hare pr ice, and if competing firms are not making s imilar contributions, the ―cost‖ of this philanthr opy must be borne by someone —the stockholders. Thus, stock price could decrease . b. Companies must make investments in the current period to generate future cash flows. Stockholders should be aw are of this, and assuming a correct analysis has been performe d, they should react positively to the decision. The international plant is in this category. Capital budgeti ng is covered in depth in Part 4 of the tex t. Assuming that the correct capital budgetin g analysis has been made, the stock price should increas e in the future . c. U.S. Treasury bonds are considered safe investments, while common stock s are far riskier . If the company were to switch the emerg ency funds from Treasury bonds to stocks, stockho lders should see this as increasing the firm ’s risk beca use stock returns are not guaranteed —
sometimes they increase and sometimes they decline . The firm might need the funds when the price s of their invest ments were low and not have the needed emergency funds. Consequently, the firm ’s stock price would proba bly fall . 1-10 a. No, TIAA -CREF is not an ordinary shareholder. Because it is one of the largest institutional shareholders in the U nited States and it controls more than 900 billion in pension fund s, its voice carries a lot of weight. This ―shareholder ‖ in effect consists of many individual shareholders whose pensions are invested with this group . b. For TIAA -CREF to be effective in wielding its weig ht, it must act as a coordinated unit. To do this, the fund ’s managers should solicit from the individua l shareholders their ―votes‖ on the fund’s practices, and from those ―votes‖ act on the majority ’s wishes. In so doing, th e individual teache rs whose pensions are invested in the fund have , in effect , determined the fund’s voting practices. 1-11 Earnings per share in the current year will decline due to the cost of the investment made in the current year and no significant p erformance impact i n the short run. However, the company ’s stock price should increase due to the significant cost savings expected in the future. 1-12 The board of directors should set CEO compensation dependent on how well the firm performs. The compe nsation package sho uld be sufficient to attract and retain the CEO b ut not go beyond what is needed. Compensation should be structur ed so that the CEO is rewarded based on the stock’s performance over the long run, not the stock ’s price on an option exercise date. T his means that options (or direct stock awards) s hould be phased in over several years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then perfo rmance pay could be based on changes in intrinsic value. Since intrinsic value is not observable, compensation must be based on the stock ’s market price—but the price used should be an average over time rather than on a s pecific date. The board should pr obably set the CEO ’s compensation as a mix betwee n a fixed salary and stock options. The actions of the vice president of Co mpany X would be different than if he were CEO of some other company .
