ABMF4024 BUSINESS FINANCE October 9, 2010

Question 1
Shareholder wealth is defined by the market value (the price the stock is trading for on the stock
market) of the shareholders’ common stock holdings, it’s a function of all future return. The manager
must consider the long run impact and not just focus on the short run. For example, if the company
ignore the long run impact (e.g. R%D), then in the future the firm cannot produce new product and get
lower earning. Therefore long term goal is important.

*Short run → focus on earnings and dividend; Long run → focus on R&D

Question 2
Due to separation of ownership and interest, managers tend to pursue other goal. For example
managers may maximize their personal utility (welfare). Therefore management provides the manager
with the job survival (job security) to ensure that the managers being motivate to increase the firm
value.

Question 3
Earnings per share are not a consistently good measurement of a firm’s performance, because it does
not specify the timing or duration of expected returns. It also does not consider risk and does not allow
for the effect of dividend policy on the market price of the stock, which this is all stockholder will
consider on.

Question 4
The major factors that determine the value of stock are projected cash flows to shareholders, timing of
the cash flow stream, and riskiness of the cash flows.

The firm’s stock price will directly affected by the expected cash flows, if the cash inflows are expected
to be higher or the cash outflows is expected to be lower, the higher the firm’s stock price will be.

The value of an investment made by the firm is depends on the timing of cash flow, the shorter the
period of return is better, because we can earn interest on money we received today.

Investor will seek for investments that have higher return than a risk-less asset; it is because the concept
of high risk higher returns.

Question 5
To ensure that the shareholder’s and manager interest are aligned, we can use motivational tools:

I. Reasonable cooperation package → the managerial compensation plans are based on the
company’s performance, this will encourage manager to put more effort on the firm’s
performance. Others than that, the manager will also offered with the executive stock option.
II. Direct intervention by shareholder → shareholders can intervene directly with managers by
talking with managers and make suggestion about how the business should be run.
III. Threat of firing → those managers who underperform or their action affect the firm’s value,
management may fire them.
ABMF4024 BUSINESS FINANCE October 9, 2010

IV. Threat of takeover → when the stock underworked this may give chance to corporate raiders to
take over the firm. If such attempt by corporate raiders success, the managers will be replace.

Question 6
Agencies is defined by one or more individuals, called principals, hire another individual or called agent
to perform some services and delegate decision making authority to the agent. For example, I wish to
purchase a house, so I seek for a person with professional knowledge to help me take care of all the step
and procedure. I am the principal and that person is an agent.

Agency cost is a type of internal cost that must be paid to an agent acting on behalf of a principal. It
usually arises due to conflicts of interest between shareholder and management.

Question 7
a) It is not an appropriate goal. This is because one should not consider market shares as a goal
itself. Furthermore, the important goal is shareholder’s maximization wealth.
b) It is not an appropriate goal, because if the firm selling product prices lower than competitor,
they cannot maximize their market value.
c) It is not an appropriate goal, because the firm will only consider it to maximize shareholder’s
wealth which concern on amount of risk and timing of cash flow.

Question 8
a) Fixed salary → compensation which is independent of firm’s success.
b) Salary linked to profit → ties to the employee’s compensation and result of firm’s success.
However, profit itself subject to different accounting rules and cannot be reliable measure of
firm’s success.
c) Salary that is paid partly in the form of the company’s shares → here, the managers earn only
after they maximized shareholder’s wealth. At the point, it is most likely align to manager’s
shareholders interest.

Question 9
Different companies have different risk based on the business operation. For example, firm operate in
biotechnology have high investment in R&D, hence it has relatively high risk and their stock price will
high as well.

Other factors: heavy use of debt financing vs. equity financing, and stock price instability.

Question 10
A firm’s intrinsic value is an estimate of a stock’s “true” value based on accurate risk and return data. It
can be estimated but not measured precisely. A stock’s current price is its market price—the value
based on perceived but possibly incorrect information as seen by the marginal investor. From these
definitions, you can see that a stock’s “true long-run value” is more closely related to its intrinsic value
rather than its current price.
ABMF4024 BUSINESS FINANCE October 9, 2010

Question 11
The primary goal of the corporation is to maximize the stockholders wealth, which transfers to
maximizing the price of the firm’s stock.

a) REFERE TO NOTE!
b) REFERE TO NOTE!