For example a firm in a highly competitive technology

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Unformatted text preview: espondingly favorable change in stock price. Only when earnings increases are accompanied by increased future cash flows would a higher stock price be expected. For example, a firm in a highly competitive technology-driven business could increase its earnings by significantly reducing its research and development expenditures. As a result the firm’s expenses would be reduced, thereby increasing its profits. But because of its impaired competitive position, the firm’s stock price would drop, as many well-informed investors sell the stock in recognition of lower future cash flows. In this case, the earnings increase was accompanied by lower future cash flows and therefore a lower stock price. 2. Another criticism of profit maximization is the potential for profit manipulation through the creative use of elective accounting practices. CHAPTER 1 The Role and Environment of Managerial Finance 15 Risk risk The chance that actual outcomes may differ from those expected. Hint This is one of the most important concepts in the book. Investors who seek to avoid risk will always require a bigger reward for taking bigger risks. risk-averse Seeking to avoid risk. Profit maximization also disregards risk—the chance that actual outcomes may differ from those expected. A basic premise in managerial finance is that a tradeoff exists between return (cash flow) and risk. Return and risk are in fact the key determinants of share price, which represents the wealth of the owners in the firm. Cash flow and risk affect share price differently: Higher cash flow is generally associated with a higher share price. Higher risk tends to result in a lower share price because the stockholder must be compensated for the greater risk. For example, if a lawsuit claiming significant damages is filed against a company, its share price typically will drop immediately. This occurs not because of any nearterm cash flow reduction but in response to the firm’s increased risk—there’s a chance that the firm...
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