1. 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:
a. 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.
b. Each time vector of earning possesses a risk characteristic.
Maximizing expected earnings ignores the risk parameter.
Chapter 1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 8
c. 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.
d. 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.
3. 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.
4. 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.
5. 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.
Chapter1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 9
6. 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).
7. 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 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.
8. 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
Chapter1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 10
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.
9. 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.
10. 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.
Chapter 1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 11
11. 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. Boards review and approve strategy, significant
investments, and acquisitions. The board also oversees operating
plans, capital budgets, and the company’s financial reports to
common shareholders.
12. 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).
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:
a. 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.
b. Each time vector of earning possesses a risk characteristic.
Maximizing expected earnings ignores the risk parameter.
Chapter 1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 8
c. 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.
d. 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.
3. 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.
4. 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.
5. 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.
Chapter1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 9
6. 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).
7. 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 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.
8. 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
Chapter1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 10
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.
9. 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.
10. 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.
Chapter 1: The Role of Financial Management © Pearson Education Limited 2005
Van Horne and Wachowicz: Fundamentals of Financial Management, 12e 11
11. 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. Boards review and approve strategy, significant
investments, and acquisitions. The board also oversees operating
plans, capital budgets, and the company’s financial reports to
common shareholders.
12. 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).
