Chapter 1
An Overview of Financial Management
ANSWERS TO END-OF-CHAPTER QUESTIONS




1-1 a. A proprietorship, or sole proprietorship, is a business owned by one individual. A partnership exists when two or more persons associate to conduct a business. In contrast, a corporation is a legal entity created by a state. The corporation is separate and distinct from its owners and managers.

b. In a limited partnership, limited partners’ liabilities, investment returns and control are limited, while general partners have unlimited liability and control. A limited liability partnership (LLP), sometimes called a limited liability company (LLC), combines the limited liability advantage of a corporation with the tax advantages of a partnership. A professional corporation (PC), known in some states as a professional association (PA), has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability.

c. Stockholder wealth maximization is the appropriate goal for management decisions. The risk and timing associated with expected earnings per share and cash flows are considered in order to maximize the price of the firm’s common stock.

d. Social responsibility is the concept that businesses should be partly responsible for, and thus bear the costs of, the welfare of society at large. Business ethics can be thought of as a company’s attitude and conduct toward its employees, customers, community, and stockholders. A firm’s commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to such factors as product safety and quality, fair employment practices, and the like.

e. Normal profits are those profits close to the average for all firms within an industry. Similarly, a normal rate of return is a return on investment that is close to the return earned by an average firm in the industry. Firms with normal profits cannot easily increase their social responsibility costs unless the entire industry does so.

f. An agency problem arises whenever a manager of a firm owns less than 100 percent of the firm’s common stock, creating a potential conflict of interest called an agency conflict. The fact that the manager will neither gain all the benefits of the wealth created by his or her efforts nor bear all of the costs of perquisite consumption will increase the incentive to take actions that are not in the best interests of the nonmanager shareholders.

g. Economic Value Added (EVA) is a method used to measure a firm’s true profitability. EVA is found by taking the firm’s after-tax operating profit and subtracting the annual cost of all the capital a firm uses. If the firm generates a positive EVA, its management has created value for its shareholders. If the EVA is negative, management has destroyed shareholder value.

h. Performance shares are shares of the firm’s stock given to executives on the basis of performance as measured by earnings per share, return on assets, return on equity, and so on. Executive stock options are performance-based incentive plans popular in the 1950s and 1960s which allowed managers to purchase stock at some time in the future at a given price. This type of plan lost favor in the 1970s; they generally did not pay in the 1970s because the stock market declined.

i. A hostile takeover, when management does not want the firm to be taken over, is most likely to occur when a firm’s stock is undervalued relative to its potential because of poor management. The managers of the acquired firm are generally fired, or lose the autonomy they had prior to the acquisition.

j. Profit maximization is merely maximizing the net income (earnings) of the firm. Because of factors such as risk, timing of earnings, number of shares outstanding, and so on, profit maximization does not necessarily lead to stockholder wealth maximization.

k. Earnings per share (EPS) is the net income of the firm divided by the number of shares of common stock outstanding (generally the average number of shares outstanding over some period, say a quarter or year).

l. Dividend policy is, basically, the decision regarding how much of current earnings should be paid to stockholders as dividends rather than retained and reinvested in the firm.

1-2 Sole proprietorship, partnership, and corporation are the three principal forms of business organization. The advantages of the first two include the ease and low cost of formation. The advantages of the corporation include limited liability, indefinite life, ease of ownership transfer, and access to capital markets.
The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to file state and federal reports for registration, which are expensive, complex and time-consuming.

1-3 No. The normal rate of return on investment would vary among industries, principally due to varying risk. The normal rate of return would be expected to change over time due to (1) underlying changes in the industry and (2) business cycles.

1-4 An increase in the rate of inflation would most likely increase the relative importance of the financial manager. Virtually all of the manager’s functions, from obtaining funds for the firm to internal cost accounting, become more demanding in periods of high inflation. Usually, uncertainty is also increased by inflation, hence, the effects of a poor decision are magnified.

1-5 Stockholder wealth maximization is a long-run goal. Companies, and consequently the stockholders, prosper by management making decisions which will produce long-term increases in earnings. Actions that are continually short-sighted often "catch up" with a firm and, as a result, it may find itself unable to compete effectively against its competitors. 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 in the 1970s and 1980s which was accused of continuing to build large "gas guzzler" automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

1-6 Even though firms follow generally accepted accounting principles, there is still sufficient margin for firms to use different procedures. Leasing and inventory (LIFO versus FIFO) accounting are two of the many areas where procedural differences could complicate relative performance measures.

1-7 The management of an oligopolistic firm would be more likely to engage voluntarily in "socially conscious" practices, since they usually generate above-normal profits. Competitive firms would be less able to engage in such practices unless they were cost-justified. Investors would be more likely to invest in firms not contributing large sums of money to charity; thus, the socially-oriented firm is put at a disadvantage in the capital markets. For this reason, even highly profitable, publicly-owned firms are generally constrained against taking unilateral cost-increasing social actions.

1-8 Profit maximization does not reflect (1) the timing of profits and (2) the riskiness of different operating plans. However, both of these factors are reflected in stock price maximization. Thus, profit maximization would not necessarily lead to stock price maximization.

1-9 Such factors as a compensation system that is based on management performance (bonuses tied to profits, stock option plans) as well as the possibility of being removed from office (voted out of office, an unfriendly tender offer by another firm) serve to keep management’s focus on stockholders’ interests.

1-10 a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more attractive community which will make it easier to hire a productive work force. This corporate philanthropy could be received by stockholders negatively, especially those stockholders not living in its headquarters city. Stockholders are interested in actions that maximize share price, and if competing firms are not making similar contributions, the "cost" of this philanthropy has to be borne by someone--the stockholders. Thus, stock price could decrease.

b. Companies must make investments in the current period in order to generate future cash flows. Stockholders should be aware of this, and assuming a correct analysis had been done, they should react positively to the decision. The foreign plant is in this category. This is covered in depth in Part IV of the text. Assuming that the correct capital budgeting analysis had been made, the stock price would increase in the future.

c. Provided that the rate of return on assets exceeds the interest rate on debt, greater use of debt will raise the expected rate of return on stockholders’ equity. Also, the interest on debt is tax deductible, which provides a further advantage. However, (1) greater use of debt will have a negative impact on the stockholders if the company’s return on assets falls below the cost of debt, and (2) increased use of debt increases the chances of going bankrupt. The effects of the use of debt, called "financial leverage," are spelled out in detail in Chapters 15 and 16.

d. Today (2001), nuclear generation of electricity is regarded as being quite risky. Therefore, if the company has a heavy investment in nuclear generators, its risk will be high, and its stock price will be adversely affected. However, this negative impact could be offset by higher profits if the nuclear generators provided significantly lower costs.

e. The company will be retaining more earnings, so its growth rate should go up, which should increase its stock price. The decline in dividends, however, will pull the stock price down. It is unclear whether the net effect on its stock will be an increase or a decrease in its price, but the change will depend on whether stockholders prefer dividends or increased growth.

1-11 The executive wants to demonstrate strong performance in a short period of time. Strong performance can be demonstrated either through improved earnings and/or a higher stock price. The current board of directors is well served if the manager works to increase the stock price; however, the board is not well served if the manager takes short-run actions which bump up short-run earnings, at the expense of long-run profitability and the company’s stock price. Consequently, the board may want to rely more on stock options and less on performance shares which are tied to accounting performance.

1-12 As the stock market becomes more volatile, the link between the stock price and the ability of senior management is weakened. Therefore, in this environment, companies may choose to de-emphasize the awarding of stock and stock options, and rely more on bonuses and performance shares which are tied to other performance measures besides the company’s stock price. Moreover, in this environment, it may be harder to attract or retain top talent if the compensation were tied too much to the company’s stock price.

1-13 a. No, the TIAA-CREF is not an ordinary shareholder. Because it is the largest institutional shareholder in the United States and it controls $125 billion in pension funds, its voice carries a lot of weight. This "shareholder" in effect consists of many individual shareholders whose pensions are invested with this group.

b. The owners of TIAA-CREF are the individual teachers whose pensions are invested with this group.

c. For the TIAA-CREF to be effective in yielding its weight, it must act as a coordinated unit. In order to do this, the fund’s managers should solicit from the individual shareholders their "votes" on the fund’s practices, and from those "votes" act on the majority’s wishes. In so doing, the individual teachers whose pensions are invested in the fund have in effect determined the fund’s voting practices.
CYBERPROBLEM


1-14 The detailed solution for the cyberproblem is available on the instructor’s side of the Harcourt College Publishers’ web site: http://www.harcourtcollege.com/finance/theory10e.
MINI CASE



Take a Walk on the Wild Side

JOE BIRDSONG OPENED TAKE A WALK ON THE WILD SIDE 17 YEARS AGO; THE STORE IS LOCATED IN NANTAHALA, NC, AND SELLS HIKING, RAFTING, AND KAYAKING EQUIPMENT. TODAY, TAKE A WALK ON THE WILD SIDE HAS 50 EMPLOYEES INCLUDING HIS DAUGHTER ANNE, WHO WORKS PART TIME IN THE STORE TO HELP PAY FOR HER COLLEGE EDUCATION.
JOE’S BUSINESS HAS BOOMED IN RECENT YEARS, AND HE IS LOOKING FOR NEW WAYS TO TAKE ADVANTAGE OF HIS INCREASING BUSINESS OPPORTUNITIES. ALTHOUGH JOE’S FORMAL BUSINESS TRAINING IS LIMITED, ANNE WILL SOON GRADUATE WITH A DEGREE AN MBA. JOE HAS OFFERED HER THE OPPORTUNITY TO JOIN THE BUSINESS AS A FULL-FLEDGED PARTNER. ANNE IS INTERESTED, BUT SHE IS ALSO CONSIDERING OTHER CAREER OPPORTUNITIES IN FINANCE.
RIGHT NOW, ANNE IS LEANING TOWARDS STAYING WITH THE FAMILY BUSINESS, PARTLY BECAUSE SHE THINKS IT FACES A NUMBER OF INTERESTING CHALLENGES AND OPPORTUNITIES. ANNE IS PARTICULARLY INTERESTED IN FURTHER EXPANDING THE BUSINESS AND THEN INCORPORATING IT. JOE IS INTRIGUED BY HER IDEAS, BUT HE IS ALSO CONCERNED THAT HER PLANS MIGHT CHANGE THE WAY IN WHICH HE DOES BUSINESS. IN PARTICULAR, JOE HAS A STRONG COMMITMENT TO SOCIAL ACTIVISM, AND HE HAS ALWAYS TRIED TO STRIKE A BALANCE BETWEEN WORK AND PLEASURE. HE IS WORRIED THAT THESE GOALS WILL BE COMPROMISED IF THE COMPANY INCORPORATES AND BRINGS IN OUTSIDE SHAREHOLDERS.
ANNE AND JOE PLAN TO TAKE A LONG WEEKEND OFF TO SIT DOWN AND THINK ABOUT ALL OF THESE ISSUES. ANNE, WHO IS HIGHLY ORGANIZED, HAS OUTLINED A SERIES OF QUESTIONS FOR THEM TO ADDRESS:


A. WHAT THREE QUESTIONS DOES FINANCIAL MANAGEMENT SEEK TO ANSWER?

ANSWER: (1) WHAT CAUSES A COMPANY TO HAVE A PARTICULAR STOCK VALUE? (2) HOW CAN MANGERS MAKE CHOICES THAT ADD VALUE TO THEIR COMPANIES? (3) HOW CAN MANAGERS ENSURE THAT THEIR COMPANIS DON’T RUN OUT OF CASH WHILE EXECUTIG THEIR PLANS?


B. WHAT KINDS OF CAREER OPPORTUNITIES ARE OPEN TO FINANCE MAJORS?

ANSWER: CAREER OPPORTUNITIES FOR FINANCE MAJORS EXIST IN THREE INTERRELATED AREAS: (1) INSTITUTIONS AND CAPITAL MARKETS, WHICH DEALS WITH SECURITIES MARKETS AND FINANCIAL INSTITUTIONS; (2) INVESTMENTS, WHICH FOCUSES ON THE DECISIONS OF BOTH INDIVIDUAL AND INSTITUTIONAL INVESTORS AS THEY CHOOSE SECURITIES FOR THEIR INVESTMENT PORTFOLIOS; AND (3) FINANCIAL MANAGEMENT, OR “BUSINESS FINANCE,” WHICH INVOLVES THE ACTUAL MANAGEMENT OF FIRMS.
IN THE INSTITUTIONS AND CAPITAL MARKETS AREA, MANY FINANCE MAJORS GO TO WORK FOR FINANCIAL INSTITUTIONS, INCLUDING BANKS, INSURANCE COMPANIES, MUTUAL FUNDS, AND INVESTMENT BANKING FIRMS. FINANCE GRADUATES WHO GO INTO INVESTMENTS OFTEN WORK FOR A BROKERAGE HOUSE EITHER IN SALES OR AS A SECURITY ANALYST. OTHERS WORK FOR BANKS, MUTUAL FUNDS, OR INSURANCE COMPANIES IN THE MANAGEMENT OF THEIR INVESTMENT PORTFOLIOS; FOR FINANCIAL CONSULTING FIRMS WHICH ADVISE INDIVIDUAL INVESTORS OR PENSION FUNDS ON HOW TO INVEST THEIR FUNDS; OR FOR AN INVESTMENT BANKER WHOSE PRIMARY FUNCTION IS TO HELP BUSINESSES RAISE NEW CAPITAL. THE JOB OPPORTUNITIES IN FINANCIAL MANAGEMENT RANGE FROM MAKING DECISIONS REGARDING PLANT EXPANSIONS TO CHOOSING WHAT TYPES OF SECURITIES TO ISSUE TO FINANCE EXPANSION. FINANCIAL MANAGERS ALSO HAVE THE RESPONSIBILITY FOR DECIDING THE CREDIT TERMS UNDER WHICH CUSTOMERS MAY BUY, HOW MUCH INVENTORY THE FIRM SHOULD CARRY, HOW MUCH CASH TO KEEP ON HAND, WHETHER TO ACQUIRE OTHER FIRMS, AND HOW MUCH OF THE FIRM’S EARNINGS TO PLOW BACK INTO THE BUSINESS VERSUS PAY OUT AS DIVIDENDS.


C. 1. WHAT ARE THE ALTERNATIVE FORMS OF BUSINESS ORGANIZATION?

ANSWER: THE THREE MAIN FORMS OF BUSINESS ORGANIZATION ARE (1) SOLE PROPRIETORSHIPS, (2) PARTNERSHIPS, AND (3) CORPORATIONS. IN ADDITION, SEVERAL HYBRID FORMS ARE GAINING POPULARITY. THESE HYBRID FORMS ARE THE LIMITED PARTNERSHIP, THE LIMITED LIABILITY PARTNERSHIP, THE PROFESSIONAL CORPORATION, AND THE S CORPORATION.


C. 2. WHAT ARE THEIR ADVANTAGES AND DISADVANTAGES?

ANSWER: THE PROPRIETORSHIP HAS THREE IMPORTANT ADVANTAGES: (1) IT IS EASILY AND INEXPENSIVELY FORMED, (2) IT IS SUBJECT TO FEW GOVERNMENT REGULATIONS, AND (3) THE BUSINESS PAYS NO CORPORATE INCOME TAXES. THE PROPRIETORSHIP ALSO HAS THREE IMPORTANT LIMITATIONS: (1) IT IS DIFFICULT FOR A PROPRIETORSHIP TO OBTAIN LARGE SUMS OF CAPITAL; (2) THE PROPRIETOR HAS UNLIMITED PERSONAL LIABILITY FOR THE BUSINESS’S DEBTS, AND (3) THE LIFE OF A BUSINESS ORGANIZED AS A PROPRIETORSHIP IS LIMITED TO THE LIFE OF THE INDIVIDUAL WHO CREATED IT.
THE MAJOR ADVANTAGE OF A PARTNERSHIP IS ITS LOW COST AND EASE OF FORMATION. THE DISADVANTAGES ARE SIMILAR TO THOSE ASSOCIATED WITH PROPRIETORSHIPS: (1) UNLIMITED LIABILITY, (2) LIMITED LIFE OF THE ORGANIZATION, (3) DIFFICULTY OF TRANSFERRING OWNERSHIP, AND (4) DIFFICULTY OF RAISING LARGE AMOUNTS OF CAPITAL. THE TAX TREATMENT OF A PARTNERSHIP IS SIMILAR TO THAT FOR PROPRIETORSHIPS, WHICH IS OFTEN AN ADVANTAGE.
THE CORPORATE FORM OF BUSINESS HAS THREE MAJOR ADVANTAGES: (1) UNLIMITED LIFE, (2) EASY TRANSFERABILITY OF OWNERSHIP INTEREST, AND (3) LIMITED LIABILITY. WHILE THE CORPORATE FORM OFFERS SIGNIFICANT ADVANTAGES OVER PROPRIETORSHIPS AND PARTNERSHIPS, IT DOES HAVE TWO PRIMARY DISADVANTAGES: (1) CORPORATE EARNINGS MAY BE SUBJECT TO DOUBLE TAXATION AND (2) SETTING UP A CORPORATION AND FILING THE MANY REQUIRED STATE AND FEDERAL REPORTS IS MORE COMPLEX AND TIME-CONSUMING THAN FOR A PROPRIETORSHIP OR A PARTNERSHIP.
IN A LIMITED PARTNERSHIP, THE LIMITED PARTNERS ARE LIABLE ONLY FOR THE AMOUNT OF THEIR INVESTMENT IN THE PARTNERSHIP; HOWEVER, THE LIMITED PARTNERS TYPICALLY HAVE NO CONTROL. THE LIMITED LIABILITY PARTNERSHIP FORM OF ORGANIZATION COMBINES THE LIMITED LIABILITY ADVANTAGE OF A CORPORATION WITH THE TAX ADVANTAGES OF A PARTNERSHIP. PROFESSIONAL CORPORATIONS PROVIDE MOST OF THE BENEFITS OF INCORPORATION BUT DO NOT RELIEVE THE PARTICIPANTS OF PROFESSIONAL LIABILITY. S CORPORATIONS ARE SIMILAR IN MANY WAYS TO LIMITED LIABILITY PARTNERSHIPS, BUT LLPs FREQUENTLY OFFER MORE FLEXIBILITY AND BENEFITS TO THEIR OWNERS.




D. WHAT IS THE PRIMARY GOAL OF THE CORPORATION?

ANSWER: THE CORPORATION’S PRIMARY GOAL IS STOCKHOLDER WEALTH MAXIMIZATION, WHICH TRANSLATES TO MAXIMIZING THE PRICE OF THE FIRM’S COMMON STOCK.


D. 1. DO FIRMS HAVE ANY RESPONSIBILITIES TO SOCIETY AT LARGE?

ANSWER: FIRMS HAVE AN ETHICAL RESPONSIBILITY TO PROVIDE A SAFE WORKING ENVIRONMENT, TO AVOID POLLUTING THE AIR OR WATER, AND TO PRODUCE SAFE PRODUCTS. HOWEVER, THE MOST SIGNIFICANT COST-INCREASING ACTIONS WILL HAVE TO BE PUT ON A MANDATORY RATHER THAN A VOLUNTARY BASIS TO ENSURE THAT THE BURDEN FALLS UNIFORMLY ON ALL BUSINESSES.


D. 2. IS STOCK PRICE MAXIMIZATION GOOD OR BAD FOR SOCIETY?

ANSWER: THE SAME ACTIONS THAT MAXIMIZE STOCK PRICES ALSO BENEFIT SOCIETY. STOCK PRICE MAXIMIZATION REQUIRES EFFICIENT, LOW-COST OPERATIONS THAT PRODUCE HIGH-QUALITY GOODS AND SERVICES AT THE LOWEST POSSIBLE COST. STOCK PRICE MAXIMIZATION REQUIRES THE DEVELOPMENT OF PRODUCTS AND SERVICES THAT CONSUMERS WANT AND NEED, SO THE PROFIT MOTIVE LEADS TO NEW TECHNOLOGY, TO NEW PRODUCTS, AND TO NEW JOBS. ALSO, STOCK PRICE MAXIMIZATION NECESSITATES EFFICIENT AND COURTEOUS SERVICE, ADEQUATE STOCKS OF MERCHANDISE, AND WELL-LOCATED BUSINESS ESTABLISHMENTS--FACTORS THAT ARE ALL NECESSARY TO MAKE SALES, WHICH ARE NECESSARY FOR PROFITS.


D. 3. SHOULD FIRMS BEHAVE ETHICALLY?

ANSWER: YES. RESULTS OF A RECENT STUDY INDICATE THAT THE EXECUTIVES OF MOST MAJOR FIRMS IN THE UNITED STATES BELIEVE THAT FIRMS DO TRY TO MAINTAIN HIGH ETHICAL STANDARDS IN ALL OF THEIR BUSINESS DEALINGS. FURTHERMORE, MOST EXECUTIVES BELIEVE THAT THERE IS A POSITIVE CORRELATION BETWEEN ETHICS AND LONG-RUN PROFITABILITY. CONFLICTS OFTEN ARISE BETWEEN PROFITS AND ETHICS. COMPANIES MUST DEAL WITH THESE CONFLICTS ON A REGULAR BASIS, AND A FAILURE TO HANDLE THE SITUATION PROPERLY CAN LEAD TO HUGE PRODUCT LIABILITY SUITS AND EVEN TO BANKRUPTCY. THERE IS NO ROOM FOR UNETHICAL BEHAVIOR IN THE BUSINESS WORLD.


E. WHAT FACTORS AFFECT STOCK PRICES?

ANSWER: THREE FACTORS AFFECT STOCK PRICE: (1) AMOUNT OF CASH FLOWS EXPECTED BY SHAREHOLDERS; (2) TIMING OF THE CASH FLOW STREAM; AND (3) RISKINESS OF THE CASH FLOWS.


F. WHAT DETERMINES CASH FLOWS?

ANSWER: THREE FACTORS DETERMINE CASH FLOWS: (1) CURRENT LEVEL AND GROWTH RATES OF SALES; (2) OPERATING EXPENSES; AND (3) CAPITAL EXPENSES.


G. WHAT FACTORS AFFECT THE LEVEL AND RISK OF CASH FLOWS?

ANSWER: FIRST, THERE ARE MANAGERIAL FACTORS, INCLUDING INVESTMENT, FINANCING, AND DIVIDEND POLICY DECISIONS. IN ADDITION, CASH FLOWS ARE AFFECTED BY THE EXTERNAL ENVIRONMENT.

H. WHAT ARE THE MOST IMPORTANT FINANCIAL MANAGEMENT ISSUES OF THE NEW MILLENIUM?

ANSWER: VALUATION HAS CONTINUED AS A FOCUS IN THE NEW MILLENIUM, BUT THE ANALYSIS HAS EXPANDED TO INCLUDE (1) INFLATION AND ITS EFFECTS ON BUSINESS DECISIONS; (2) DEREGULATION OF FINANCIAL INSTITUTIONS AND THE RESULTING TREND TOWARD LARGE, BROADLY DIVERSIFIED FINANCIAL SERVICE COMPANIES; (3) THE DRAMATIC INCREASE IN BOTH THE USE OF COMPUTERS FOR ANALYSIS AND THE ELECTRONIC TRANSFER OF INFORMATION; AND (4) THE INCREASED IMPORTANCE OF GLOBAL MARKETS AND BUSINESS OPERATIONS. THE TWO MOST IMPORTANT FUTURE TRENDS ARE LIKELY TO BE THE CONTINUED GLOBALIZATION OF BUSINESS AND THE INCREASED USE OF INFORMATION TECHNOLOGY.


I. WHAT IS AN AGENCY RELATIONSHIP?

ANSWER: AN AGENCY RELATIONSHIP EXISTS WHENEVER A “PRINCIPAL” ENGAGES AN “AGENT” AND GRANTS THE AGENT SOME DECISION-MAKING POWER.


I. 1. WHAT AGENCY RELATIONSHIPS EXIST WITHIN A CORPORATION?

ANSWER: WITHIN THE FINANCIAL MANAGEMENT CONTEXT, THE PRIMARY AGENCY RELATIONSHIPS ARE THOSE (1) BETWEEN STOCKHOLDERS AND MANAGERS AND (2) BETWEEN DEBTHOLDERS AND STOCKHOLDERS.


I. 2. WHAT MECHANISMS EXIST TO INFLUENCE MANAGERS TO ACT IN SHAREHOLDERS’ BEST INTERESTS?

ANSWER: TO REDUCE AGENCY CONFLICTS, STOCKHOLDERS MUST INCUR AGENCY COSTS, WHICH INCLUDE ALL COSTS BORNE BY SHAREHOLDERS TO ENCOURAGE MANAGERS TO MAXIMIZE THE FIRM’S STOCK PRICE RATHER THAN ACT IN THEIR OWN SELF-INTERESTS. THERE ARE THREE MAJOR CATEGORIES OF AGENCY COSTS: (1) EXPENDITURES TO MONITOR MANAGERIAL ACTIONS, SUCH AS AUDIT COSTS; (2) EXPENDITURES TO STRUCTURE THE ORGANIZATION IN A WAY THAT WILL LIMIT UNDESIRABLE MANAGERIAL BEHAVIOR, SUCH AS APPOINTING OUTSIDE INVESTORS TO THE BOARD OF DIRECTORS; AND (3) OPPORTUNITY COSTS WHICH ARE INCURRED WHEN SHAREHOLDER-IMPOSED RESTRICTIONS, SUCH AS REQUIREMENTS FOR STOCKHOLDER VOTES ON CERTAIN ISSUES, LIMIT THE ABILITY OF MANAGERS TO TAKE TIMELY ACTIONS THAT WOULD ENHANCE SHAREHOLDER WEALTH.
SOME SPECIFIC MECHANISMS WHICH ENCOURAGE MANAGERS TO ACT IN SHAREHOLDERS’ INTERESTS INCLUDE (1) PERFORMANCE-BASED INCENTIVE PLANS, (2) DIRECT INTERVENTION BY SHAREHOLDERS, (3) THE THREAT OF FIRING, AND (4) THE THREAT OF TAKEOVER.


I. 3. SHOULD SHAREHOLDERS (THROUGH MANAGERS) TAKE ACTIONS THAT ARE DETRIMENTAL TO BONDHOLDERS?

ANSWER: NO. SUCH BEHAVIOR IS UNETHICAL, AND THERE IS NO ROOM FOR UNETHICAL BEHAVIOR IN THE BUSINESS WORLD. SECOND, IF SUCH ATTEMPTS ARE MADE, CREDITORS WILL PROTECT THEMSELVES AGAINST STOCKHOLDERS BY PLACING RESTRICTIVE COVENANTS IN FUTURE DEBT AGREEMENTS. FINALLY, IF CREDITORS PERCEIVE THAT A FIRM’S MANAGERS ARE TRYING TO TAKE ADVANTAGE OF THEM, THEY WILL EITHER REFUSE TO DEAL FURTHER WITH THE FIRM OR ELSE WILL CHARGE A HIGHER THAN NORMAL INTEREST RATE TO COMPENSATE FOR THE RISK OF POSSIBLE EXPLOITATION. THUS, FIRMS WHICH DEAL UNFAIRLY WITH CREDITORS EITHER LOSE ACCESS TO THE DEBT MARKETS OR ARE SADDLED WITH HIGH INTEREST RATES AND RESTRICTIVE COVENANTS, ALL OF WHICH ARE DETRIMENTAL TO SHAREHOLDERS.