,Module 1: Finance in business
Self-study problems
1.1 Give an example of a financing decision and a capital budgeting decision.
Financing decisions determine how a company will raise capital. Examples of financing
decisions would be securing a bank loan or the sale of debt in the public capital markets.
Capital budgeting involves deciding which productive assets the company invests in,
such as buying a new plant or investing in a renovation of an existing facility.
1.2 What is the decision criterion for financial managers when selecting a capital
project?
Financial managers should only select a capital project if the value of the project’s future
cash flows exceeds the cost of the project. In other words, managers should only take on
investments that will increase the company’s value and thus increase the shareholders’
wealth.
1.3 What are some ways to manage working capital?
Working capital is the day-to-day management of a company’s short-term assets and
liabilities. It can be managed through maintaining the optimal level of inventory, keeping
track of all the receivables and payables, deciding to whom the company should extend
credit, and making appropriate investments with excess cash.
1.4 Which one of the following characteristics does not pertain to companies?
a. Can enter into contracts
b. Can borrow money
c. Are the easiest type of business to form
d. Can be sued
e. Can own shares in other companies
c. Are the easiest type of business to form – companies have a complex business
structure.
1.5 What are typically the main components of an executive compensation package?
The three main components of an executive compensation package are: base salary,
bonus based on accounting performance, and some compensation tied to the company’s
share price.
, Module 1: Finance in business
Critical thinking questions
1.1 Describe the cash flows between a company and its stakeholders.
Cash flows are generated by a company’s productive assets that were purchased through
either issuing debt or raising equity. These assets generate revenues through the sale of
goods and services. A portion of this revenue is then used to pay wages and salaries to
employees, pay suppliers, pay taxes, and pay interest on the borrowed money. The
leftover money, residual cash, is then either reinvested back in the business or is paid out
to shareholders in the form of dividends.
1.2 What are the three fundamental decisions the financial management team is
concerned with, and how do they affect the company’s balance sheet?
The primary financial management decisions every company faces are capital budgeting
decisions, financing decisions, and working capital management decisions. Capital
budgeting addresses the question of which productive assets to buy; thus, it affects the
asset side of the balance sheet. Financing decisions focus on raising the money the
company needs to buy productive assets. This is typically accomplished by selling long-
term debt and equity. Finally, working capital decisions involve how companies manage
their current assets and liabilities. The focus here is seeing that a company has enough
money to pay its bills and that any spare money is invested to earn interest.
1.3 What is the difference between shareholders and stakeholders?
Shareholders are the owners of the company. A stakeholder, on the other hand, is anyone
with a claim on the assets of the company, including, but not limited to, shareholders.
Stakeholders are the company’s employees, suppliers, creditors, and the government.
1.4 Explain why profit maximisation is not the best goal for a company. What is an
appropriate goal?
Although profit maximisation appears to be the logical goal for any company, it has
many drawbacks. First, profit can be defined in a number of different ways, and
variations in profit for similar companies can vary widely. Second, accounting profits do
not exactly equal cash flows. Third, profit maximisation does not account for timing and
ignores risk associated with cash flows. An appropriate goal for financial managers who
do not have these objections is to maximise the value of the company’s current share
price. In order to achieve this goal, management must make financial decisions so that the
total value of cash inflows exceeds the total value of cash outflows.
, Solutions manual to accompany: Finance essentials 1e by Kidwell et al.
1.5 In determining the price of a company’s shares, what are some of the external and
internal factors that affect price? What is the difference between these two types of
variables?
External factors that affect the company’s share price are: (1) economic shocks, such as
natural disasters or wars, (2) the state of the economy, such as the level of interest rates,
and (3) the business environment, such as taxes or regulations. On one hand, external
factors are variables over which the management has no control. On the other hand,
internal factors that affect the share price can be controlled by management to some
degree, because they are company specific, such as financial management decisions,
product quality and cost, and the line of business management has selected to enter.
Finally, perhaps the most important internal variable that determines the share price is the
expected cash flow stream: its magnitude, timing, and riskiness.
1.6 Identify the sources of agency costs. What are some ways a company can control
these factors?
Agency costs are the costs that result from a conflict of interest between the agent and the
principal. They can either be direct, such as lavish dinners or trips, or indirect, which are
usually missed investment opportunities. A company can control these costs by tying
management compensation to company’s performance or by establishing an independent
board of directors. Outside factors that contribute to the minimization of agency costs are
the threat of corporate raiders that can take over a company not performing up to
expectations and the competitive nature of the managerial labour market.
1.7 What is CLERP 9 and what are its main goals?
CLERP 9 is the outcome of a review of corporate reporting and disclosure laws in
Australia. The main goal of CLERP 9 is to strengthen the law in the areas of corporate
governance, disclosure and regulation of audit and financial reporting. Among others,
CELRP 9 will strengthen the standard for auditor independence, including requiring the
rotation of auditors of listed companies after 5 years, strengthen the obligations of
auditors to report breaches of the law to ASIC, and enhance disclosure and accountability
to shareholders, including on executive and director remuneration.
