BUAD 306: Business Finance, Spring 2010
Solutions to HW1
In a corporation, the shareholders are the owners of the firm. The shareholders elect the
directors of the corporation, who in turn appoint the firm’s management. This separation of
ownership from control in the corporation is what causes agency problems to exist.
Management may act in its own or so
meone else’s best interests, rather than those of the
shareholders. If such events occur, they may contradict the goal of maximizing the share price
of the equity of the firm.
If financial markets are efficient, then the current stock value reflects the risk, timing, and
cash flows, both short-term
long-term. So, if markets are efficient,
then the statement is false.
Market values can never be negative. To understand why, recall that corporations (which are
the firms that can issues shares) have limited liability: if you own shares in a company, you can
only lose the money you have put in the company, but no more. Remember that market value
equals stock price times the number of shares, so the market value is negative only when the
stock price is negative.
Now, imagine that the stock price is negative, let's say -$20. Then, for every share you buy, you
would also receive a check for $20. Since, under limited liability, nobody can be forced to give
more money to the company no matter what happens, you could pocket the $20 and forget
about any problems with the company. If you can make money from buying one share, why not
buy millions of shares? If stock prices could be negative, all of us would become billionaires! Of
course this doesn't happen: in reality, stock prices cannot fall below zero. That is the result of