Solution Manual for
Foundations of Financial Management, 18th Edition by Stanley Block,
Geoffrey Hirt, Bartley Danielsen
Chapter 1-21
Chapter 1
The Goals and Functions of Financial Management
Discussion Questions
1-1 What effect did the recession of 2007-2009 have on government regulation?
It was greatly increased.
1-2 What advantages does a sole proprietorship offer? What is a major drawback of this type
of organization?
A sole proprietorship offers the advantage of simplicity of decision making and low
organizational and operating costs. A major drawback is that there is unlimited liability to
the owner.
1-3 What form of partnership allows some of the investors to limit their liability? Explain
briefly.
A limited partnership allows some of the partners to limit their liability. Under this
arrangement, one or more partners are designated general partners and have unlimited
liability for the debts of the firm; other partners are designated limited partners and are
liable only for their initial contribution. The limited partners are normally prohibited from
being active in the management of the firm.
1-4 In a corporation, what group has the ultimate responsibility for protecting and managing
the stockholders’ interests?
The board of directors.
1-5 What document is necessary to form a corporation?
The articles of incorporation.
1-6 What issue does agency theory examine? Why is it important in a public corporation
rather than in a private corporation?
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, Agency theory examines the relationship between the owners of the firm and the
managers of the firm. In privately owned firms, management and the owners are usually
the same people. Management operates the firm to satisfy its own goals, needs, financial
requirements and the like. As a company moves from private to public ownership,
management now represents all owners. This places management in the agency position
of making decisions in the best interest of all shareholders.
1-7 What are institutional investors important in today’s business world?
Because institutional investors such as pension funds and mutual funds own a large
percentage of major U.S. companies, they are having more to say about the way publicly
owned companies are managed. As a group, they have the ability to vote large blocks of
shares for the election of a board of directors, which is supposed to run the company in an
efficient, competitive manner. The threat of being able to replace poor performing boards
of directors makes institutional investors quite influential. Since these institutions, like
pension funds and mutual funds, represent individual workers and investors, they have a
responsibility to see that the firm is managed in an efficient and ethical way.
1-8 Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal
of maximization of shareholder wealth?
The problem with a profit maximization goal is that it fails to take account of risk, the
timing of the benefits is not considered, and profit measurement is a very inexact process.
The goal of shareholders’ wealth maximization implies that the firm will attempt to
achieve the highest possible total valuation in the marketplace. It is the one overriding
objective of the firm and should influence every decision.
1-9 When does insider trading occur? What government agency is responsible for protecting
against the unethical practice of insider trading?
Insider trading occurs when anyone with non-public information buys or sells securities
to take advantage of that private information. The Securities and Exchange Commission
is responsible for protecting markets against insider trading. In the past, people have gone
to jail for trading on non-public information. This has included company officers,
investment bankers, printers who have information before it is published, and even truck
drivers who deliver business magazines and read positive or negative articles about a
company before the magazine is on the newsstands and then place trades or have friends
place trades based on that information. The SEC has prosecuted anyone who profits from
inside information.
1-10 In terms of the life of the securities offered, what is the difference between money and
capital markets?
Money markets refer to those markets dealing with short-term securities that have a life
of one year or less. Capital markets refer to securities with a life of more than one year.
1-11 What is the difference between a primary and a secondary market?
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, A primary market refers to the use of the financial markets to raise new funds for the
corporation. After the securities are sold to the public (institutions and individuals), they
trade in the secondary market between investors. It is in the secondary market that prices
are continually changing as investors buy and sell securities based on the expectations of
corporate prospects.
1-12 Assume you are looking at many companies with equal risk. Which ones will have the
highest stock prices?
Given companies with equal risk, those companies with expectations of high return will
have higher common stock prices relative to those companies with expectations of poor
returns.
1-13 How is the time value of money concept related to the valuation of stocks?
The value of an investment that is expected to earn money in the future can be calculated
using time-value of money principles. Corporations are expected to pay dividends to their
shareholders. The current value of these future dividends is the present value. The present
value of a stock’s future dividends should be the same as the stock’s current price.
Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financial variables that affect the price-earnings ratio.
The price-earnings ratio will be influenced by the earnings and sales growth of the
firm, the risk or volatility in performance, the debt-equity structure of the firm, the
dividend payment policy, the quality of management, and a number of other factors.
The ratio tends to be future-oriented, and the more positive the outlook, the higher it
will be.
2-2. What is the difference between book value per share of common stock and market
value per share? Why does this disparity occur?
Book value per share is arrived at by taking the cost of the assets and subtracting out
liabilities and preferred stock and dividing by the number of common shares
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, outstanding. It is based on the historical cost of the assets. Market value per share is
based on the current assessed value of the firm in the marketplace and may bear little
relationship to original cost. Besides the disparity between book and market value
caused by the historical cost approach, other contributing factors are the growth
prospects for the firm, the quality of management, and the industry outlook. To the
extent these are quite negative or positive; market value may differ widely from book
value.
2-3. Explain how depreciation generates actual cash flows for the company.
The only way depreciation generates cash flows for the company is by serving as a tax
shield against reported income. This non-cash deduction may provide cash flow equal
to the tax rate times the depreciation charged. This much in taxes will be saved, while
no cash payments occur.
2-4. What is the difference between accumulated depreciation and depreciation expense?
How are they related?
Accumulated depreciation is the sum of all past and present depreciation charges,
while depreciation expense is the current year’s charge. They are related in that the
sum of all prior depreciation expense should be equal to accumulated depreciation
(subject to some differential related to asset
write-offs).
2-5. How is the income statement related to the balance sheet?
The earnings (less dividends) reported in the income statement is transferred to the
ownership section of the balance sheet as retained earnings. Thus, what we earn in
the income statement becomes part of the ownership interest in the balance sheet.
2-6. Comment on why inflation may restrict the usefulness of the balance sheet as
normally presented.
The balance sheet is based on historical costs. When prices are rising rapidly, historical
cost data may lose much of their meaning—particularly for plant and equipment and
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