Chapter 2: The Objective in Corporate Finance



Chapter 2: The Objective in Corporate Finance

CC 2.1: Managers involved in making acquisitions often argue that the immediate response of stockholders to acquisition announcements is flawed because stockholders do not have the information to make this judgment. Do you agree?

Answer: While it is true that managers have substantially more information than stockholders, they tend to be more biased and less objective than stockholders. This bias affects the judgment of managers and can lead them to make poor acquisition decisions.

CC 2.2: If you are convinced that financial markets are not efficient, do you have to abandon the objective of value maximization? Why or why not?

Answer: If financial markets are not efficient, then we may not be able to justify the objective function of maximizing stock prices. However, we can still focus on maximization of stockholder wealth or firm value.

CC 2.3: Corporate governance is best left to managers, since they are much more likely to think about the long term than stockholders. Comment.

Answer: While there are stockholders who have short time horizons, the same can be said about some managers. In fact, it is unfair to argue that stockholders are always more short term in their demands than managers. The evidence (some of which is cited in the text) is that stockholders are often willing to accept lower earnings and cash flows in the near term for higher growth in the long term.

CC 2.4: The interests of institutional investors and individual investors may sometimes diverge. Can you think of a scenario where the two groups might have conflicting interests?

Answer: Institutional investors may have more information than individual investors, and their tax status can be very different. These differences may cause conflicts of interests between these two groups of investors. Consider the scenario, where pension funds and individual investors both hold stock in a firm, which is considering returning the cash in the form of dividends. Pension funds, which are tax exempt, may want the dividends paid, and individual investors might not

CC 2.5: Many emerging financial markets are characterized by the absence of good information about firms, thin trading and extreme volatility. What are the consequences for value maximization in these markets? What about stock price maximization?

Answer: In emerging markets that are not very efficient, stock price maximization may not be the right objective for firms. Value maximization, however, does not require assumptions about market efficiency and still is the correct objective.

Chapter 3: The Time Value of Money

CC 3.1: In computing the future value of $ 50,000 in the example above, we assumed that interest earned was allowed to remain in the account and earn more interest. What would the future value be if you intended to withdraw all the interest income from the account each year?

Answer: The account will have $ 50,000 at the end of the period. If we count the interest income, we would make $ 3,000 in interest income each year from the account, resulting in a total of $ 80,000. (The difference of $9,542 is the compounding effect)

CC 3.2: How much would you need to save each year for the next 40 years to arrive at a future value of $ 400,000 if you saved at the beginning of each year instead of the end?

Answer: You would need to save less. In fact, it will be $1,544 discounted back one year at 8%, which would be equal to $1,430.

CC 3.3: Assume that you run the lottery and you want to ensure that 50% of ticket revenues go towards education, while preserving the nominal prizes at $40 million. How much can you afford to pay out each year, assuming a discount rate of 10%?

Answer: The present value of the payments over the next 30 years has to be equal $20 million (50% of $ 40 million). There are a number of possible combinations that will provide this present value. For instance, paying $ 1 million a year for the next 14 years, and $ 1.625 million a year for the following 16 years, will yield a nominal value of $ 40 million and a present value of $ 20 million.

CC 3.4: If both the growth rate and the discount rate increase by 1%, will the present value of the gold to be extracted from this mine increase or decrease? Why?

Answer: The present value of the gold to be extracted from the mine would increase to $16,229,046. The present value effect (of a higher discount rate) is dominated by the growth effect ( of a higher growth rate), but only because r ................
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