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.
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Answers and Solutions: 1 - 1
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.
Answers and Solutions: 1 - 2
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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
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Answers and Solutions: 1 - 3
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 (1998), 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
Answers and Solutions: 1 - 4
The Dryden Press items and derived items copyright © 1999 by The Dryden Press
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.
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Answers and Solutions: 1 - 5
MINI CASE
SUPPOSE YOU WENT HOME FOR A QUICK VISIT EARLY IN THE TERM, AND, OVER THE
COURSE OF THE WEEKEND YOUR BROTHER, WHO RECEIVED HIS MBA THREE YEARS AGO,
ASKED YOU TO TELL HIM ABOUT THE COURSES YOU ARE TAKING.
AFTER YOU TOLD HIM
THAT FINANCIAL MANAGEMENT WAS ONE OF THE COURSES, HE ASKED YOU THE FOLLOWING
QUESTIONS:
A.
WHAT KINDS OF CAREER OPPORTUNITIES ARE OPEN TO FINANCE MAJORS?
ANSWER:
CAREER OPPORTUNITIES FOR FINANCE MAJORS EXIST IN THREE INTERRELATED
AREAS: (1) MONEY 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 MONEY 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.
COMPANIES
IN
THE
OTHERS WORK FOR BANKS, MUTUAL FUNDS, OR INSURANCE
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.
Mini Case: 1 - 6
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B.
WHAT ARE THE MOST IMPORTANT FINANCIAL MANAGEMENT ISSUES OF THE 1990s?
ANSWER:
VALUATION HAS CONTINUED AS A FOCUS IN THE 1990s, 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
IMPORTANCE OF GLOBAL MARKETS AND BUSINESS OPERATIONS.
INCREASED
THE TWO MOST
IMPORTANT FUTURE TRENDS ARE LIKELY TO BE THE CONTINUED GLOBALIZATION OF
BUSINESS AND THE INCREASED USE OF INFORMATION TECHNOLOGY.
C.
WHAT ARE THE PRIMARY RESPONSIBILITIES OF A CORPORATE FINANCIAL STAFF?
ANSWER:
THE FINANCIAL MANAGER’S TASK IS TO ACQUIRE AND USE FUNDS SO AS TO
MAXIMIZE
THE
FORECASTING
FIRM’S
AND
VALUE.
PLANNING,
SPECIFIC
(2)
MAKING
ACTIVITIES
MAJOR
INCLUDE:
INVESTMENT
(1)
FINANCING
DECISIONS, (3) COORDINATING AND CONTROLLING, (4) DEALING WITH THE
FINANCIAL MARKETS, AND (5) MANAGING RISK.

D.
1. WHAT ARE THE ALTERNATIVE FORMS OF BUSINESS ORGANIZATION?

ANSWER:
THE
THREE
MAIN
FORMS
OF
BUSINESS
ORGANIZATION
ARE
PROPRIETORSHIPS, (2) PARTNERSHIPS, AND (3) CORPORATIONS.
SEVERAL HYBRID FORMS ARE GAINING POPULARITY.
THE
LIMITED
PARTNERSHIP,
THE
LIMITED
(1)
SOLE
IN ADDITION,
THESE HYBRID FORMS ARE
LIABILITY
PARTNERSHIP,
THE
PROFESSIONAL CORPORATION, AND THE S CORPORATION.

D.
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
PROPRIETORSHIP
BUSINESS
ALSO
HAS
PAYS
NO
THREE
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CORPORATE
IMPORTANT
INCOME
TAXES.
LIMITATIONS:
(1)
THE
IT
IS
Mini Case: 1 - 7
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
DIFFICULTY OF RAISING LARGE AMOUNTS OF CAPITAL.
OWNERSHIP,
AND
(4)
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.
E.
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.
Mini Case: 1 - 8
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E.
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.
E.
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.
E.
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.
PROFITS AND ETHICS.
CONFLICTS OFTEN ARISE BETWEEN
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.
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Mini Case: 1 - 9
F.
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.
G.
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.
H.
WHAT FACTORS AFFECT THE LEVEL AND RISKINESS 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.
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?

Mini Case: 1 - 10
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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 SELFINTERESTS.
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.
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Mini Case: 1 - 11