PROBLEMS IN BUSINESS FINANCE 382 (Rev Sp15)
STUDENT LECTURE NOTE 1 Fa13CR
I. Financial Management Overview
A. The three primary areas and opportunities in Finance:
1. Capital Markets and Institutions: Potential employment opportunities with _____, insurance companies, mutual funds and investment banks.
2. Investments: Probably the most obvious job
opportunity is to work for a _________ ____ either
in sales or as a security analyst. Could also do similar
work for banks, mutual funds or insurance
companies in analyzing or managing investment
portfolios.
3. Corporate financial management: Presents the
greatest number of different job opportunities as it is
important in all types of businesses. Different types
of decisions made by financial managers:
 Asset acquisition or sale, including mergers

 Management of current assets and liabilities
 How to finance investment projects
 How to raise project financing
 Payment of dividends versus retaining earnings
 Which customers merit credit and the credit
terms extended
1
B. Forms of Business Organization
1. Traditional Sole Proprietorships
a. Simple and inexpensive to organize
b. __________ liability for owner
c. Subject to few government regulations
d. Difficult to obtain large sums of capital
e. Business avoids corporate income taxes
f. Life is limited to the life of the individual who
created it
2. Limited Liability Corporation: an Alternative to
Traditional Sole Proprietorships1
a. LLCs are permitted in most states.
b. The LLC gives its owners, like those of S Corps,
_________ liability and taxation as a partnership.
c. Unlike an S Corp, the LLC can own more than
80% of another corporation, and corporations,
partnerships, or non-U.S. residents can own LLC
shares.
d. LLCs work well for corporate joint ventures or
projects developed through a subsidiary.
3. Traditional Partnerships
a. Can arise formally or informally
b. Low cost and ease of formation
c. ___________ liability for all partnership debts,
and all partners are liable for the business debts
d. Difficult to liquidate or sell a partner’s share
1
Source: L.J. Gitman (2006), Principals of Managerial Finance, Brief, 4th Edition, (as well as the
information on LLPs and S Corps).
2
e. Limited partners possible but at least one partner
must have _________ liability
f. Tax treatment same as ____ proprietorship
g. Difficulty in raising large amounts of capital
means that at some point, the founders of a sole
proprietorship or partnership may incorporate.
4. Limited Liability Partnership: an Alternative to
Traditional Partnerships
a. LLPs are permitted in many states; governing
statutes vary by state.
b. All LLP partners have ________ liability.
c. They are liable for their own acts of malpractice,
not for those of other partners.
d. The LLP is taxed as a partnership.
e. LLPs are frequently used by legal and accounting
professionals.
f. In recent years this organizational form has begun
to
replace
professional
corporations-corporations formed by groups of professionals
such as attorneys and accountants that provide
limited liability except for that related to
malpractice--because of the tax advantages it
offers.
5. Corporations (C Corps)
a. A company is a separate legal entity created by the
state, separate and distinct from its owners.
b. Has unlimited life
c. Shareholders have no personal liability for debts,
i.e., liability is _________.
3
d. More expensive to setup and operate as it subject
to greater governmental regulations.
e. Transfer of ownership is easy as shares can be
readily issued and traded.
f. Can draw upon more sources of capital, it can offer
debenture securities and shares of stock.
g. Corporate income is subject to double taxation.
6. Sub-chapter S Corporations (S Corps): an
Alternative to C Corps
a. A tax-reporting entity that (under Subchapter S of
the Internal Revenue Code) allows certain
corporations with 75 or fewer stockholders to
choose to be taxed as ______________.
b. Its stockholders receive the organizational benefits
of a corporation and the tax advantages of a
partnership.
c. But S Corps lose certain tax advantages related to
pension plans.
C. THE Most Important Concepts in Finance
1. 1st Fundamental Concept: Manage the Risk/Return
Tradeoff
a. The Financial Manager’s overall goal is to ensure
the firm’s competitiveness and to avoid risk—in
essence to manage the Risk/Return Tradeoff.
b. Statement of the Risk/Return Tradeoff
“An investor can not expect to earn _____average returns unless they accept _______-than4
average risk. Conversely, investments with _____than-average risk may be expected to yield _____than-average returns.”
2. 2nd Fundamental Concept: The Goal of the Finance
Function
a. The goal of the Finance function is to maximize
________ (wealth) of the firm’s _______ (shareholders).
b. Managers should help to do so—although since
they don’t always do this, there is a need to monitor
them.  This is the essence of the Agency Problem
as described in the next lecture.
c. It has been argued that sometimes management
tries to maximize firm size, rather than firm value.
By creating a large, rapidly growing firm,
managers may:
 Increase their job security, as chances of a hostile
takeover may be reduced;
 Increase their own power, status and salaries; and
 Create more opportunities for their lower- and
middle-level employees.
d. The goal expressed above translates into:
Maximization of the firm’s _______ _______.
 Total Value of Firm Equity 
Share Price  
.
Number
of
Equity
Shares


e. What about Profit Maximization as Goal?
5
(1.1)
The proper goal must consider:
i. ________ of Returns; (Ex. 1.1 below)
ii. __________ of Returns; and (Ex. 1.2 below)
iii. Adopt a _________ Viewpoint. (Ex. 1.3 below)
f. It can be proven that welfare maximization is a
superior objective because it correctly considers all
three factors above, whereas profit maximization
may not.
3. Maximization of Share Price and Corporate
Scandals2
a. Enron, ImClone, WorldCom, Tyco, Sunbeam,
Adelphia, etc. … the list of corporate scandals
seems to suggest that maximization of share price is
____ a good choice for the goal of the finance
function.
b. Given resulting lowered stock values for these
firms, or in some cases bankruptcies, it would seem
that if share-price maximization was the goal then
these firms’ managements did an extremely ______
job of achieving this objective.
c. The exact reasons for these managements’ failures
vary from firm to firm. However, some common
problems emerge.
i. First, management compensation packages were
______ designed. Specifically, stock option and
stock grant plans were linked to short-term stock
price performance which provided management
2
This discussion draws upon E.F. Brigham and P.R. Daves (2010), Intermediate Financial Management,
10th Edition, pg. 8.
6
with the incentive to manipulate short-term
earnings without regard to the firm’s long run
viability.
ii. Second, it is extremely difficult for firms to take
actions that legally drive up short-term stock
prices but not harm it in the long-term.
 This is because firm value is based on the
discounted present value of both short- and
long-term cash flows.
 Since old-fashioned legal activities to drive up
stock price (like increasing sales, reducing
capital requirements and cutting costs) were
not available to these firms, management
began engaging in questionable (irregular)
accounting practices.
iii. Third, as these managers found that they seemed
to getting away with irregular account-ting
practices they apparently developed a mindset
that the (legal accounting) rules did ___ apply to
them or that they would not get ______. Thus,
they began breaking even more rules, until they
finally did get caught.
d. Abraham Lincoln once observed that “You can’t
fool all of the people, all of the time.” Stock prices
for these firms did rise, at least temporarily. As the
evidence about these firms’ illegal activities
became known, Lincoln’s assertion was proven
correct. These firms’ stock prices fell precipitously
even to the extent of firm ruination.
e. Lessons to be Learned from the Scandals
7
i. First, since people respond to incentives, even
poorly-designed ones, it is extremely critical that
incentive-based compensation is designed to
ensure a proper ____-_____ focus.
ii. Second, managers should not be allowed to
commit even small _______ violations. Clearly,
evidence from these companies shows that small
violations lead to large ones.
iii. Third, top financial managers (CEO and/or
CFO) should not be allowed to take _________
(allow irregularities). The internal and external
auditors, as well as other managers cannot
overlook anything that doesn’t conform to the
FASB or POASCB accounting rules.
4. Corporate Citizenship and the Stakeholder View
of the Firm3
a. Maximizing the wealth of ____________ should be
the major goal of the financial manager.
b. However, there are many interested parties who
believe that companies have a higher responsibility
to society at large to improve how their firms are
both perceived, recognized and actually providing
real benefits beyond those accruing to shareholders.
c. __________ are those people or groups that a firm
affects or is affected by their decisions.
3
This section draws upon Chapter 11 in Corporate Governance, 3rd. Edition (2010) by K.A. Kim, J.R.
Nofsinger and D.J. Mohr.
8
 The primary stakeholders would include:
stockholders, employees, creditors, suppliers and
customers.
 The secondary stakeholders would include: the
community,
society,
the
environment,
competitors and the government.
d. Under a stakeholder view the objective of
management is to maximize sustainable
_____________ wealth (the utility of both primary
and secondary stakeholders) by optimizing these
relationships.
e. Corporate Social Responsibility (CSR): Archie
Carroll4 has suggested four levels of CSR in order
of decreasing priority.
i. Level I: Economic˗most importantly a firm must
_______ by producing goods and/or services at a
______.
ii. Level II: Legal˗firms are expected to operate
according to the applicable laws.
iii. Level III: Ethical˗beyond even the legal code,
society expects firms to act within societal norms
and customs. An example might be expectations
that firm decisions will not hurt the environment.
iv. Level IV: Philanthropy˗corporate contributions
of time (community service) and money
(charitable donations) are increasingly desired by
stakeholders.
4
A.B. Carroll (1979), “A Three-Dimensional Conceptual Model of Corporate Performance,” Academy of
Management Review Vol. 4: pp. 497-505 and A.B. Carroll (1999), “Corporate Social Responsibility:
Evolution of a Definitional Construct,” Business & Society Vol. 38, No. 4: pp. 268-295.
9
II. Agency Theory, Business Ethics, Securities Exchange
Commission, and the Sarbanes-Oxley Act of 2002
A. Agency Theory
1. In a corporation the shareholders employ ______
(managers) to run the business, thus managers have an
obligation to shareholders to act in the owners’ best
interest.
2. Agency conflicts may arise:
 Between Shareholders and Managers
 Between ____________ and ____________
 Between Management and Employees
3. However, managers’ interests may be different from
the shareholders’ interests, like maximizing their own
benefits, financial and otherwise (perquisites, eg.
Corporate benefits like executive jets, limos, firstclass travel, expense accounts, executive assistants,
penthouses, generous retirement packages, etc.).
4. Companies must incur costs to ensure managers act in
the interests of ____________.
5. These costs are divided into three categories.
 __________ costs such as employing auditors.
 _______ costs such as the cost of preparing
financial reports.
 A residual ____ resulting from the remaining
divergence of interests.
6. Potential Anti-takeover Management-Related Issues/
Costs
10
 Proxy fight: contested vote between management
and discontented shareholders attempting to elect
their slate of Board members. Costs are in the form
of lobbying efforts by both sides to gain votes.
 Greenmail: a share repurchase which is effectively
a bribe (stock price premium unavailable to nontargeted stockholders) paid to a potential acquirer to
prevent them from pursuing a takeover.
 Golden parachutes: an automatic payment made to
management, by the acquirer, if a target firm is
acquired. These are also sometimes triggered by
managers being fired.
 Poison pills: strategies designed to make a target
firm less attractive after being acquired, eg. targetfirm stockholders being able to purchase shares at a
deep discount after their firm is acquired.
 Restricted voting rights automatically deprive a
shareholder of voting rights if they acquire more
than a specific amount of the target firm’s stock.
7. Minimize Agency Costs by Motivating Management
through their Compensation
a. Managerial Compensation: Remunerate managers
in ways that more closely align their interests with
that of ____________, i.e., give them performance
incentives that are more valuable when the firm
performs well, eg. when they meet performance
targets, like ROA, ROE, increased share price, etc.
b. Performance-based Compensation and Targets
 Performance-based Bonuses: non-guaranteed
salary awards linked to incentive targets
11
 Performance shares/restricted stock awards
(RSAs): Executives receive a number of shares
dependent upon the companies’ performance.
 Executive stock options: Options allow managers
to ________ stock at some future point in time at
a specific exercise price.
 Economic Value Added (EVA): A relatively new
measure of managerial performance. It measures
a firm’s true profitability, since it overcomes the
accounting convention that does not correctly take
into account the cost of equity.
8. Internal/External Factors Motivating Management
a. Direct Intervention by Shareholders: Institutional shareholders, which have large ownership
positions are taking greater interest in firm
management. Most notable change is lobbying for
_______ independence of the Board.
b. Threat of Being Fired: Previously, difficult for
widely-dispersed shareholders to pose much of a
threat to management. Increasing pressure posed by
dissidents through growing shareholder ________.
c. Threat of Hostile Takeovers: Most likely to occur
when firm’s stock is ___________, i.e., managers
are not employing firm’s assets as effectively as
they could/should. If hostile takeover succeeds,
current management team is likely to be replaced.
B. Business Ethical Considerations5
5
This discussion draws upon E.F. Brigham and P.R. Daves (2010), Intermediate Financial Management,
10th Edition, pg. 6.
12
1. Business ethics relate to a firm’s attitude towards
conducting its business in the best interests of its
stockholders, employees, customers and society while
complying with all laws related to its business
operations.
2. The commitment to business ethics may be assessed
by determining whether laws, regulations and moral
standards are adhered to by all employees from the
most senior executive to the lowest-level employee.
3. A firm’s goal should be to consider both the letter and
spirit of the laws concerned with business practice
when making any financial or other firm decisions.
4. The laws that need to be considered generally relate to
aspects that may consist of the following:
 Product safety and quality,

 Fair marketing and selling practices,
 Use of confidential information for personal gain,
 Community involvement, and
 Illegal payments (bribes) to obtain business.
5. Other Ethical Issues
a. Ethical Dilemmas: Choosing to earn profits
(responsibility to shareholders) at all costs vs.
responsibility to customers and/or society may be a
difficult tradeoff to balance.
Ex. 1:
Merck’s research indicated that its Vioxx pain medicine might be causing
heart attacks, but the evidence was not overwhelmingly clear. The product was
helping some patients. At what point does Merck release this information,
given that delay may hurt sales (or conceivably lead to lawsuits), but possibly
prevent beneficial use by other patients?
13
b. Ethical Responsibility: How do managers decide
whether costs to the firm (and stockholders)
outweigh benefits in terms of protecting customers
from any problems with their products?
Ex. 2:
A Snitch in Time Spares the Fine: Toyota’s Response to the NHTSA Penalty
Announcement, April 6th, 2010
“The latest turn of events in the Toyota recall debacle, hence dubbed “Pedalgate” has Toyota situated squarely in the cross-hairs of a none-too-amused
NHTSA and potentially facing the largest fine (to-date) in automotive recall
history, a hefty $16.4 million dollars! Toyota is accused of knowingly trying
to conceal a “dangerous defect” in its vehicles and “slow reporting” of the
faulty accelerator problem to the NHTSA; if these accusations pan out Toyota
could be held directly responsible for several motorists’ deaths, exposing the
auto manufacturer to a spate of litigation and class action lawsuits”.
Source:http://www.automotiveaddicts.com/10777/toyotas-response-to-nhtsapenalty-fine-announcement
c. Protecting Ethical Employees
i. Employees who discover illegal actions or are
given questionable orders have several possible
actions:
 Should they obey or refuse to obey their boss’s
orders?
 Should they report the situation to a higher
management representative, or
 Should they report the situation to the Board of
Directors, the Auditors or a Federal Prosecutor?
ii. A provision in the Sarbanes-Oxley Act of 2002 is
included to protect “whistle-blowers’. If an
employee reports corporate abuses and is later
14
penalized he or she may ask OSHA to investigate
the situation.
iii. Wrongful employee penalizations may require
that firms _________ employees and ________
them for back pay. Penalties may also be
involved.
C. Sarbanes-Oxley Act of 2002
1. The Public Company Accounting Reform and
Investor Protection Act of 2002 (commonly called
the Sarbanes-Oxley Act of 2002 or SOX) was created
in response to several notable accounts of firms which
went bankrupt including: most notably Enron,
WorldCom, Tyco, Global Crossing and other firms.
2. Management at these firms were involved in
numerous activities that were not in the best interests
of shareholders including:
 Stealing corporate assets,
 Engaging in fraudulent transactions to enrich
themselves at shareholder expense, and
 Systematically misleading shareholders and the
financial markets by releasing inaccurate financial
statements.
3. Auditing firms sometimes were complicit in these
deceptions by overlooking questionable accounting
practices in exchange for lucrative consulting fees.
4. Stock analysts also misled the public regarding the
prospects of poorly-performing firms under pressure
from their investment bank employers.
5. These actions all violated then-existing ethical
standards, but also suggested that the penalties for the
15
violations were not strong enough to deter the
violators.
D. Highlights of the Sarbanes-Oxley Act of 20026
1. The Public Company Accounting Oversight Board
(PCAOB) is established to _______ auditors and
establish quality control and ethical standards for
audits (Title I).
2. Auditors are required to be truly independent meaning
they may not provide __________ _______ to the
firms they audit (Title II).
3. The CEO and CFO are required to review and
_______ annual and quarterly statements as to their
completeness and accuracy. They must also attest that
the Board’s internal audit committee is composed of
truly “independent” board members. (Title III, Sec.
302). Penalties for certifying known false statements
may be up to a $5 million fine, 20 years in prison, or
both.
4. Executives may be required to _________ certain
bonuses or equity-based compensation if financial
statements turn out to be falsified and require
restatement (Sec. 304).
5. Off-balance-sheet transactions require more extensive
reporting. Further, restrictions are placed on personal
loans from the firm to executives (Title IV, Sec.
401(a)).
6. Management is required to ______ whether the
internal financial controls are effective. The external
6
This discussion draws upon Brigham and Daves (2010), Intermediate Financial Management, 10th
Edition, pgs. 16-17.
16
auditor must also state whether it ______ with
management’s evaluation of effectiveness (Sec. 404).
7. Material changes in financial condition must be
promptly and publicly disclosed in plain English (Sec.
409).
8. Alteration, destruction or concealment of exculpatory
documents that might be used in an investigation
becomes a criminal act. Conspiring to do so also is
criminalized. (Sec. 902).
E. 3rd Fundamental Concept:
The Time Value of Money  A dollar received
today is worth _____ than that same dollar
received at some point in the future, because
today’s dollar can be invested now and will earn
interest in the interim.
Ex. 1.1
Consider the two mutually-exclusive investment projects
described below. Answer the following questions.
Assume that the return you require on either project is
7.5%.
Project A: After-tax profit of $500,000 is received at
the end of Year 10.
Project B: After-tax profits of $50,000 are received at
the end of each of the next 10 years.
a) What is the average annual profit on each project?
Which project do you prefer on this basis?
17
b) Calculate the present values of the two projects.
Which project do you prefer?
c) Compare the two projects on the basis of their future
values at the end of year ten, which do you prefer?
A1.1a) Average annual profit equals _________ for both
projects, so on this basis you are indifferent.
A1.1b) Note: Refer to Time Value formulas at the end of
this LN for a refresher as necessary.
PVProject A
= $500,000 * (PVIF 7.5%/1, 10*1)




1

= $500,000 * 
10*1
   .075  
 
 1  
1

 

= $500,000 * (0.4851939)
= $__________.
Numerical Approach - Calculator Sequence:
0.075 [] 1 [=] [+] 1[=] [yx] [(] 10 [x] 1 [)] [=] [1/x] [x]
500000 [=]
PVProject B
= $50,000 * (PVIFA 7.5%/1, 10*1)
18
 

1
1




10*1 
(1  (0.075 / 1))  
= $50,000 *  
 0.075 






 1 


= $50,000 * (6.8640809)
= $__________.
Numerical Approach - Calculator Sequence:
.075 [÷] 1 [=] [+] 1 [=] [yx] [(] 10 [x] 1 [)] [=] [1/x] [+/-]
[+] 1 [=] [÷] [(] .075 [÷] 1 [)] [=] [x] 50000
Conclusion: The comparison of the present values shows
that the PV of Project B exceeds that of Project A, by a
substantial amount, thus Project __ is preferred.
A1.1c) FVProject A = $500,000, because this is already a
future value.
FVProject B
= $50,000 * (FVIFA 7.5%/1, 10*1)
 (1  (0.075 / 1))10*1   1
= $50,000 * 

(0.075 / 1)


= $50,000 * (14.147087)
= $___________.
Numerical Approach - Calculator Sequence:
0.075 [] 1 [=] [+] 1 [=] [yx] [(] 10 [x] 1 [)] [=] [-] 1 [=] []
[(] .075 [] 1 [)] [=] [x] 50000 [=]
19
Conclusion: Not surprisingly, the comparison of the
future values also shows that the FV of Project B exceeds
that of Project A, by a substantial amount, thus Project __
is preferred.
Ex. 1.2
Suppose you have $1000 to invest. You are going to
invest it in one of two possible investments described
below which will yield the gain described at the end of
one year. Use this information to answer the following
questions. Base your answers on the percentage return
on investment.
Investment 1): A sure gain of $500 more; or
Investment 2): A gamble that offers a 50% chance of
earning a $1000 gain and a 50% chance of an additional
gain of zero.
a) Determine which investment you would prefer if you
are not taking risk into account? Hint: Compare
expected returns.
b) If risk is considered does that change your answer?
Hint: Compare standard deviations.
 $1500  
A1.2a) E(R1) = 
  1 *1.00 = 0.50 = ____%.
 $1000  
 $2000  
 $1000  

1
*
0
.
50
E(R2) = 
+
 

  1 * 0.50

 $1000  
 $1000  
20
= (100% * 0.50) + (0% * 0.50) = ____%.
Conclusion: The expected returns on the two projects are
equal, thus you would be __________between the two
investments if risk is not considered.
A1.2b) σ2(R1) = [(0.50 – 0.50)2 * 1.00] = ___.
σ(R1) = 0 = ___%.
σ2(R2) = [[(1.00 – 0.50)2 * 0.50] + [[(0 – 0.50)2 * 0.50]]
= _____.
σ(R2) =
0.25 = ____%.
Conclusion: Although the expected returns on the two
projects are equal, clearly, the standard deviations of
returns are different. Investment 1 is riskless so it is
preferred.
Ex. 1.3
On October 17, 1973, following the 1973 Yom Kippur
War the Organization of Petroleum Exporting Companies
(OPEC) imposed an oil embargo on the United States.
This led to a severe recession in much of the Western
World, including the U.S. Between 10/17/73 and the end
of November the Dow Jones index fell 15%. Gasoline
prices went from 30 cents per gallon to $1.20 and gasoline
lines snaked their way around city blocks.
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a) In 1973 what kind of gas mileage do you suppose an
average American car was getting?
b) Can you think of any cars generally that were both
more fuel efficient and also more dependable?
c) Speculate on the results of this quadrupling in gas
prices on demand for U.S. vehicles vis-à-vis their
more efficient foreign competitors.
d) What is the implication for the long-term outlook of
U.S. automakers?
A1.3a) A guess would be about 8-10 mpg. Less for big,
luxury cars like Cadillacs, Continentals, etc.
A1.3b) Obviously, foreign autos, especially Japanese
imports.
A1.3c) U.S. automakers lost market share to the Japanese
imports big-time, and they still have not regained it.
A1.3d) U.S. automakers did not see any long-term trend
away from the big, fuel inefficient cars they
expected to be able to build forever. Certainly, they
did not foresee the huge increase in gas prices.
Failing to adopt a long-run viewpoint cost them lots
of lost sales and loyal customers.
22
Future Value of a Single Payment:
  r   t*m 
FVt = PV0  1      = PV0 * FVIFr%/m,t*m.
  m   
Present Value of a Single Payment:


1
PV0 = FVt  
= FVt * PVIFr%/m,t*m.
t*m 
 (1(r/m)) 
Future Value of an Annuity:
 (1  (r/m)) t*m  1
FVA = A  
 = A * FVIFA r%/m,t*m.
(r/m)


Present Value of an Annuity:
  1

1

  (1  ( r/m)) t*m  
PVA = R 
 = R * PVIFA r%/m,t*m.
(r/m)




Where: r = annual interest rate,
t = number of years, and
m = number of compounding periods per
year.
23