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s01 - THE ROLE AND OBJECTIVE OF FINANCIAL MANAGEMENT...

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Chapter 1 THE ROLE AND OBJECTIVE OF FINANCIAL MANAGEMENT ANSWERS TO QUESTIONS: 1. Shareholder wealth is defined as the present value of the expected future returns to the owners (that is, shareholders) of the firm. These returns can take the form of periodic dividend payments and/or proceeds from the sale of the stock. Shareholder wealth is measured by the market value (that is, the price that the stock trades in the marketplace) of the firm's common stock. 2. Profit maximization typically is defined as a more static concept than shareholder wealth maximization. The profit maximization objective from economic theory does not normally consider the time dimension or the risk dimension in the measurement of profits. In contrast, the shareholder wealth maximization objective provides a convenient framework for evaluating both the timing and the risks associated with various investment and financing strategies. The marginal decision rules derived from economic theory are extremely useful to a wealth maximizing firm. Any decision, either in the short run or the long run, that results in marginal revenues exceeding the marginal costs of the decision will be consistent with wealth maximization. When a decision has consequences extending beyond a year in time, the marginal benefits and marginal costs of that decision must be evaluated in a present value framework. 3. A closely-held firm is more likely to be a wealth maximizer than a corporation with wide ownership. In the closely-held firm, the owners and the managers will share the same objectives because the owners are the managers. In a widely-held corporation, where the ownership and management functions are separate, it is likely that managers may pursue objectives that are more self-serving than owner-serving. Examples of alternative objectives that might be pursued in this situation are extreme risk-averse behavior, size maximization, satisficing, or personal utility function maximization. A more complete discussion of alternative objectives may be found in McGuigan, Moyer, and Harris, Managerial Economics , 8th edition (South-Western, l999), Chapter l. 4. The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is a function of all the future returns to the shareholders. Hence, in making decisions that maximize shareholder wealth, management must consider the long-run impact on the firm and not just focus on short-run (i.e., current period) effects. For example, a firm could increase short-run earnings and dividends by eliminating all research and development expenditures.
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This document was uploaded on 11/12/2008.

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s01 - THE ROLE AND OBJECTIVE OF FINANCIAL MANAGEMENT...

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