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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
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
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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- Fall '13