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Unformatted text preview: Chapter 1: An Overview of Financial Management Learning Objectives 1 Chapter 1 An Overview of Financial Management Learning Objectives After reading this chapter, students should be able to: Explain the role of finance, and the different types of jobs in finance. Identify the advantages and disadvantages of different forms of business organization. Explain the links between stock price, intrinsic value, and executive compensation. Discuss the importance of business ethics and the consequences of unethical behavior. Identify the potential conflicts that arise within the firm between stockholders and managers and between stockholders and bondholders and discuss the techniques that firms can use to mitigate these potential conflicts. 2 Answers and Solutions Chapter 1: An Overview of Financial Management Answers to End-of-Chapter Questions 1-1 When you purchase a stock, you expect to receive dividends plus capital gains. Not all stocks pay dividends immediately, but those corporations that do, typically pay dividends quarterly. Capital gains (losses) are received when the stock is sold. Stocks are risky, so you would not be certain that your expectations would be met—as you would if you had purchased a U.S. Treasury security, which offers a guaranteed payment every 6 months plus repayment of the purchase price when the security matures. 1-2 If investors are more confident that Company A’s cash flows will be closer to their expected value than Company B’s cash flows, then investors will drive the stock price up for Company A. Consequently, Company A will have a higher stock price than Company B. 1-3 A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It can be estimated but not measured precisely. A stock’s current price is its market price— the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock’s “true long-run value” is more closely related to its intrinsic value rather than its current price. 1-4 Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock. If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stock’s price. At any given time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued. 1-5 If the three intrinsic value estimates for Stock X were different, I would have the most confidence in Company X’s CFO’s estimate. Intrinsic values are strictly estimates, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firm’s managers have the best information about the company’s...
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This note was uploaded on 05/05/2010 for the course ECONMOICS ECON 203 taught by Professor Josephpetry during the Spring '10 term at University of Illinois, Urbana Champaign.
- Spring '10