Answers and Solutions:
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The primary goal is assumed to be shareholder wealth maximization, which translates to
stock price maximization.
That, in turn, means maximizing the PV of future free cash
Maximizing shareholder wealth requires that the firm produce things that customers
want, and at the lowest cost consistent with high quality.
It also means holding risk
down, which will result in a relatively low cost of capital, which is necessary to maximize
the PV of a given cash flow stream.
This also gets into the issue of capital structure—how much debt should we use?
more debt the firm uses, the lower its taxes, and the fewer shares outstanding, hence less
dilution of earnings.
However, more debt means more risk.
So, it’s necessary to consider
capital structure when attempting to maximize share prices.
Dividend policy is also an issue—how much of its earnings should the firm pay out as
The answer to that question depends on a number of factors, including the
firm’s investment opportunities, its access to capital markets, its stockholders’ desires
(and their tax rates), and the kind of signals stockholders get from dividend actions.
Shareholder wealth maximization is partially consistent and partially inconsistent
with generally accepted societal goals.
It is consistent because well-run firms produce
good products at low costs, sell them at competitive prices, employ people, pay taxes, and
generally improve society.
However, without constraints, firms would tend to form
monopolies and end up charging prices that are too high and not producing enough
They might also pollute the air and water, engage in unfair labor practices, and so
So, constraints (antitrust, labor, environmental, etc. laws) should be and are imposed
That said, stock price maximization is consistent with a strong
economy, economic progress, and “the good life” for most citizens.
In standard introductory microeconomics courses, we assume that firms attempt to
In more advanced econ courses, the goal is broadened to value
maximizing, so finance and economics are indeed consistent.
As WorldCom, Enron, and other corporate scandals demonstrated very clearly,
managers do not always have stockholders’ interests as a primary goal—some managers
have their own interests.
This point is discussed further below.
An Overview of Financial Management
ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS