Chapter 1: Exercises 2, 3, and 6
2. Explain several dimensions of the shareholder-principal conflict with manager-agents known as
the principal-agent problem. To mitigate agency problems between senior executives and
shareholders, should the compensation committee of the board devote more to executive salary
and bonus (cash compensation) or more to long-term incentives? Why? What role does each type
of pay play in motivating managers?
Shareholders want high long-term profits. Managers want job security and wonderful perks and
amenities. Since risk and return tend to be positively related, managers may wish to avoid risks
that shareholders want the managers to undertake. To encourage managers to take on risks,
compensation committees can place a greater weight of their compensation on long-term
incentives such as stock, options to buy stock, and bonus based on surpassing the performance of
comparable firms over several years. When all of the compensation is cash (for salary and fringe
benefits), mangers wish to start only low risk projects to avoid making any mistakes and stay
away from higher risk, potentially high-valued projects.
3. Corporate profitability declined by 20 percent from 2008 to 2009. What performance percentage
would you use to trigger executive bonuses for that year? Why? What issues would arise with
hiring and retaining the best managers?
When the bonus is tied to the short-run earnings of the manager’s firm, then the bonus declines
even if the manager did everything he or she could do in the midst of an economic downturn.
Accordingly, bonus pay should relate to the performance of other comparable companies for a
longer period to remove any incentive to boost short-term cash flows at the expense of long-term
profitability. The bonus is designed for mangers that exceed their industry averages over the last
several years.
6. In the context of the shareholder wealth-maximization model of a firm, what is the expected
impact of each of the following events on the value of the firm? Explain why.
The following events will change shareholder wealth:
a. More competition is likely to lower prices and thereby reduce the value of the firm.
b. In general, higher costs on the firm is likely to lower the value of the firm. If these
requirements are imposed equally on all firms, some of the cost burden will be borne by the
firm and some by consumers, depending on the nature of the demand function. If the impact
of the requirements is substantially different from one firm to another in an industry, the
value of some firms may be enhanced relative to those at a competitive disadvantage because
of the standards.
c.
If the union is effective in raising wages without improving productivity, then the value of
the firm is decreases. However, labor costs may rise but be offset by increases in
productivity, then the change in the value of the firm depends on which increased more,
wages or productivity. Unfortunately, sometimes a union may impede productivity when
unions succeed in getting work rules that slow output or increase the number of workers
needed to do a job.
d. Inflation tends to increase costs and increase prices. The full impact is indeterminate
depending on the ability of the firm to pass along higher costs to consumers and on the
specific impact of inflation on a firm's costs.
e. Lower costs, other things equal, will raise the value of the firm. At some point, competitors
eventually also adopt this new technology.
Chapter 2: Exercises 1, 5, and 6
1. For each of the determinants of demand in Equation 2.1, identify an example illustrating the
effect on the demand for hybrid gasoline-electric vehicles such as the Toyota Prius. Then do the
same for each of the determinants of supply in Equation 2.2. In each instance, would equilibrium
market price increase or decrease? Consider substitutes such as plug-in hybrids, the Nissan Leaf
and Chevy Volt, and complements such as gasoline and lithium ion laptop computer batteries.
Equation [2.1] is the demand function: QD = f( P, PS, PC, Y, A, AC, N, CP, PE, TA, T/S, …). If the quantity
demanded is the Toyota Prius, the P is the price of the car and as the price rises we would expect a decline
in the quantity sold; PS is the price of substitutes and as the price of the Chevy Malibu rises we would
expect the quantity of the Priuses to rise; PC is the price of complements and we would expect that as the
price of things like replacement batteries rises we would see a decline in the quantity of Priuses sold; Y is
income and we’d expect as income rises to sell more Priuses as they are normal goods; A is advertising
and we’d also expect more Priuses sold as advertising and promotional expenditures rises; AC is
competitors’ advertising and we’d expect a negative impact on the quantity of the Prius sold as AC rises;
N is the size of the target market or population and we’d expect that larger markets will sell more Priuses;
CP is consumer preferences for greener transportation which should help the Prius seen as being greener;
PE is the expected future price of hybrid cars and we’d expect that the greater the resale price of the car
that more will wish to buy it; TA is the purchase adjustment time period that tends to show that more
Priuses are sold if the time period permitted for analysis is longer; and T/S involves taxes on or subsidies
for hybrid cars that we say in periods when there are tax subsidies to buy hybrids that car sales of hybrids
rises. Equation [2.2] is the supply function: QS = f(P, PI, PUI, T, EE, F, RC, PE, T/S, …). P is price, PI is
inputs like metal, PUI is the price of unused inputs like fiberglass, T is technological improvement like
robots; EE is exit or entry of other automakers, RC is the regulatory cost of compliance, PE is the
expected future price of the Prius, TA and T/S are already mentioned. In general, we should not include
variables other than price in both the supply function and the demand function because they then become
endogenously determined. It is more common to include these only in the supply function.
5. Two investments have the following expected returns (net present values) and standard
deviation of returns:
PROJECT EXPECTED RETURNS STANDARD DEVIATION
A $ 50,000 $ 40,000
B $250,000 $125,000
Comparing two projects, Project B appears riskier because it has a larger standard
deviation ($125,000) than Project A, but that does not consider relative risk. Actually,
Project A is riskier because it has a larger coefficient of variation than Project B does.
CVA = vA = $40,000/$50,000 = 0.80
CVB = vB = $125,000/$250,000 = 0.50
Because the two projects are significantly different in size, the coefficient of variation (a relative
measure of risk) is more appropriate.
6. The manager of the aerospace division of General Aeronautics has estimated the price it can
charge for providing satellite launch services to commercial firms. Her most optimistic estimate (a
price not expected to be exceeded more than 10 percent of the time) is $2 million. Her most
pessimistic estimate (a lower price than this one is not expected more than 10 percent of the time)
is $1 million. The expected value estimate is $1.5 million. The price distribution is believed to be
approximately normal.
General Aeronautics question involving distributions.
c.
a.
Because the price distribution is normal, the expected price is halfway between the most
optimistic price and the most pessimistic price, or $1.5 million.
b.
From Table 1, the z value corresponding to leaving 10 percent in the lower tail of a normal
distribution is approximately 1.28. Therefore, 1.28 standard deviations correspond to a
distance of $500,000 below the mean ($1 million minus $1.5 million). Hence one
standard deviation is equal to:
1.28 = -$500,000, or  = $390,625.
z = ($1.2 million  $1.5 million) / $390,625 = 0.77, so from Table 1, we can find the p(z <
0.77) = 22.06%