TOPIC

1
INTRODUCTION TO
FINANCIAL
MANAGEMENT
Answers to Concepts Review and Critical Thinking Questions
Q1.1
The Financial Management Decision Process.What are thethree types of financial management decisions? For each
type of decision, give an example of abusiness transaction that would be relevant.

1.
Capital budgeting/Investment Decisions(deciding on whether to expand amanufacturing plant),
2.
C
apital structure
/Financing Decisions
(deciding whether
to issue new equity and use the proceeds to r
etire outstanding debt), and
3.
W
orking
capital management
(modifying the firm’s credit collection policy with its
customers).
Q1.5
Goal of Financial Management.
What goal should always motivate the actions
of the firm's financial manager?
To maximize
the current market value (share price) of the equity of the firm
(whether it’s publicly traded or not).
Q1.6
Agency Problems.
Who owns a corporation? Describe the process whereby the
owners control the firm's management. What is the main reason that an
agency
relationship exists in the corporate form of organization? In this context, what kinds
of problems can arise?
In the corporate form of ownership, the
shareholders are the owners of the firm
.
firm. The shareholders elect the directors of the corporation,who in turn appoint the firm’smanagement. This separation
ofownership from control in the corporate form of organization is what causes agency problems to exist.
Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such
events occur, they may contradict the goal of maximizing the share price of the
equity of the
2
Q1.7
Primary versus Secondary Markets.
You've probably noticed coverage in the
financial press of an
initial public offering (IPO
)
of a company's securities. Web
search company Google is a relatively recent example. Is an IPO a primary
-
market
transaction or a secondary
-
market transaction
?
A primary market transaction.
Q1.10
Ethics and Firm Goals.
Can our goal of maximizing the v
alue of the stock
conflict with other goals, such as avoiding unethical or illegal behavior? In
particular, do you think subjects such as customer and employee safety, the
environment, and the general good of society fit in this framework, or are they
esse
ntially ignored? Try to think of some specific scenarios to illustrate your answer.
An argument can be made either way.
At one extreme
, we could argue that in a
market economy, all of these things are priced. This implies an optimal level of
ethical and/
or illegal behavior and the framework of stock valuation explicitly
includes these.
At the other extreme
, we could argue that these are non
-
economic
phenomena and are best handled through the political process. The following is a
classic (and highly releva
nt) thought question that illustrates this debate: “A firm has
estimated that the cost of improving the safety of one of its products is $30 million.
However, the firm believes that improving the safety of the product will only save
$20 million in product
liability claims. What should the firm do?”
Q1.11
International Firm Goal.
Would our goal of maximizing the value of the stock
be different if we were thinking about financial management in a foreign country?
Why or why not?
The goal will be the same,
but the best course of action toward that goal may require
adjustments due different social, political, and economic climates.
Q1.13
Agency Problems and Corporate Ownership
. Corporate ownership varies
around the world. Historically, individuals have own
ed the majority of shares in
public corporations in the United States. In Germany and Japan, however, banks,
other large financial institutions, and other companies own most of the stock in
public corporations. Do you think
agency problems
are likely to be
more or less
severe in Germany and Japan than in the United States? Why? In recent years, large
financial institutions such as mutual funds and pension funds have been becoming
the dominant owners of stock in the United States, and these institutions are
becoming more active in corporate affairs. What are the implications of this trend for
agency problems and corporate control?
We would expect agency problems to be less severe in other countries, primarily due to the
relatively small percentage of indivi
dual ownership. Fewer individual owners should reduce
the number of diverse opinions concerning corporate goals. The high percentage of
institutional ownership might lead to a higher degree of agreement between owners and
managers on decisions concerning r
isky projects. In addition, institutions may be able to
implement more effective monitoring mechanisms than can individu
al owners, given an
institution
’ deeper resources and experiences with their own management. The increase in
institutional ownership of
stock in the United States and the growing activism of these large
shareholder groups may lead to a reduction in agency problems for U.S. corporations and a
more efficient market for corporate control.

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect
the directors of the corporation, who in turn appoint the firm's management. This separation of ownership
from control in the corporate form of organization is what causes agency problems to exist. Management
may act in its own or someone else's best interests, rather than those of the shareholders. If such events
occur, they may contradict the goal of maximizing the share price of the equity of the firm.

The lower percentage of individual ownership in other countries, such as Germany andJapan, should lead to less agency
problems. In these situations, there are more institutionalowners and fewer individual owners, leading to an overall smaller
number of shareholdersper company. This should reduce the number of differing opinions surrounding corporategoals and
actions. The increase of institutional ownership, particularly with the expertise thatcomes with participating in the market as a
firm, should lead to a higher degree of agreementamongst owners and management regarding what is acceptable and what is not
acceptable,especially in terms of risky projects. The increase of institutional...

In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect
the directors of the corporation, who in turn appoint the firm's management. This separation of ownership
from control in the corporate form of organization is what causes agency problems to exist. Management
may act in its own or someone else's best interests, rather than those of the shareholders. If such events
occur, they may contradict the goal of maximizing the share price of the equity of the firm.

Corporate ownership varies around

the world. Historically, individuals have owned the majority of shares in public
corporations in the United States. In Germany and Japan, however, banks, other
large financial institutions, and other companies own most of the stock in public
corporations. Do you think agency problems are likely to be more or less severe in
Germany and Japan than in the United States?
8. Agency Problems and Corporate Ownership In recent years, large financial
institutions such as mutual funds and pension funds have become the dominant
owners of stock in the United States, and these institutions are becoming more
active in corporate affairs. What are the implications of this trend for agency
problems and corporate control?
9. Executive Compensation Critics have charged that compensation to top managers
in the United States is simply too high and should be cut back. For example,
focusing on large corporations, Larry Ellison of Oracle has been one of the best-
compensated CEOs in the United States, earning about $130 million in 2010 alone
and over $1 billion during the 2006 \u2013 2010 period. Are such amounts excessive? In
answering, it might be helpful to recognize that superstar athletes such as Tiger
Woods, top earners in the entertainment field such as James Cameron and Oprah
Winfrey, and many others at the top of their respective fields earn at least as much,
if not a great deal more.
10. Goal of Financial Management Why is the goal of financial management to
maximize the current share price of the company \u2019 s stock? In other words, why isn \u2019 t
the goal to maximize the future share price?
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20
CHAPTER 2
Financial Statements
and Cash Flow
A write-off by a company frequently means that the value of the company\u2019s assets has declined. For
example, in 2010, Bank of America announced a total of $34 billion in write-offs for bad loans. In
addition, the company announced a $10.5 billion write-off because recent legislation had reduced
the value of its credit card business. The write-offs made by Bank of America during 2010 followed
write-offs of $33.7 billion in 2009 and $16.2 billion in 2008. Of course, Bank of America was not
alone. Moody\u2019s Investor Services estimated that banks had written off $476 billion during 2009 and
2010, and it expected bank write-offs of $286 billion during 2011.
So did stockholders in these banks lose hundreds of billions of dollars (or more) because of the
write-offs? The answer is probably not. Understanding why ultimately leads us to the main subject
of this chapter: that all-important substance known as cash flow .
The Balance Sheet
The balance sheet is an accountant\u2019s snapshot of a firm\u2019s accounting value on a partic-
ular date, as though the firm stood momentarily still. The balance sheet has two sides:
On the left are the assets and on the right are the liabilities and stockholders\u2019 equity .
The balance sheet states what the firm owns and how it is financed. The accounting
definition that underlies the balance sheet and describes the balance is:
Assets ; Liabilities 1 Stockholders\u2019 equity
We have put a three-line equality in the balance equation to indicate that it
must always hold, by definition. In fact, the stockholders\u2019 equity is defined to
be the difference between the assets and the liabilities of the firm. In principle,
equity is what the stockholders would have remaining after the firm discharged
its obligations.
Table 2.1 gives the 2012 and 2011 balance sheet for the fictitious U.S. Composite
Corporation. The assets in the balance sheet are listed in order by the length of
time it normally would take an ongoing firm to convert them into cash. The asset
side depends on the nature of the business and how management chooses to con-
duct it. Management must make decisions about cash versus marketable securities,
credit versus cash sales, whether to make or buy commodities, whether to lease or
purchase items, the types of business in which to engage, and so on. The liabilities
and the stockholders\u2019 equity are listed in the order in which they would typically be
paid over time.
The liabilities and stockholders\u2019 equity side reflects the types and proportions of
financing, which depend on management\u2019s choice of capital structure, as between
debt and equity and between current debt and long-term debt.
When analyzing a balance sheet, the financial manager should be aware of three
concerns: liquidity, debt versus equity, and value versus cost.
2.1
Two excellent sources
for company fi nancial
information are
fi nance.yahoo.com
and
money.cnn.com .
ExcelMaster
coverage online
This section will
introduce cell formatting
and trace dependents
and precendents.
For updates on the
latest happenings
in finance, visit www.
rwjcorporatefinance.
blogspot.com
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Chapter 2 Financial Statements and Cash Flow 21
LIQUIDITY
Liquidity refers to the ease and quickness with which assets can be converted to cash
(without significant loss in value). Current assets are the most liquid and include cash
and assets that will be turned into cash within a year from the date of the balance
sheet. Accounts receivable are amounts not yet collected from customers for goods or
services sold to them (after adjustment for potential bad debts). Inventory is composed
of raw materials to be used in production, work in process, and finished goods. Fixed
assets are the least liquid kind of assets. Tangible fixed assets include property, plant,
and equipment. These assets do not convert to cash from normal business activity,
and they are not usually used to pay expenses such as payroll.
Some fixed assets are not tangible. Intangible assets have no physical existence
but can be very valuable. Examples of intangible assets are the value of a trademark
or the value of a patent. The more liquid a firm\u2019s assets, the less likely the firm is to
Annual and quarterly
fi nancial statements
for most public U.S.
corporations can be
found in the EDGAR
database at
www.sec.gov .
Table 2.1 The Balance Sheet of the U.S. Composite Corporation
U.S. COMPOSITE CORPORATION
Balance Sheet
2012 and 2011
($ in millions)
Assets 2012 2011
Liabilities (Debt) and
Stockholders\u2019 Equity 2012 2011
Current assets:
Cash and equivalents
Accounts receivable
Inventory
Other
Total current assets
Fixed assets:
Property, plant, and equipment
Less accumulated depreciation
Net property, plant, and
equipment
Intangible assets and others
Total fixed assets
Total assets
$  140
294
269
      58
$   761
$1,423
     550
873
     245
$1,118
$1,879
$   107
270
280
      50
$   707
$1,274
     460
814
     221
$1,035
$1,742
Current liabilities:
Accounts payable
Notes payable
Accrued expenses
Total current liabilities
Long-term liabilities:
Deferred taxes
Long-term debt*
Total long-term liabilities
Stockholders\u2019 equity:
Preferred stock
Common stock ($1 par value)
Capital surplus
Accumulated retained earnings
Less treasury stock\u2020
Total equity
Total liabilities and
stockholders\u2019 equity\u2021
$   213
50
     223
$   486
$   117
     471
$   588
$ 39
55
347
390
       26
$   805
$ 1,879
$   197
53
     205
$   455
$   104
     458
$   562
$     39
32
327
347
       20
$   725
$1,742
*Long-term debt rose by $ 471 million 2 $ 458 million 5 $13 million. This is the difference between
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