Ans.
1.With an objective of maximizing shareholder wealth, capital will tend to be allocated to the best investment opportunities on a risk-adjusted return basis. Other decisions will also be such so as to m aximize efficiency. When all firms start doing this, productivity will increase and the economy will realize higher real growth. There will be a greater level of overall economic desire satisfaction. We can presume that people will benefit, however,this depends in part on how income is redistributed via taxation and social programs. The economic pie will grow larger and everybody would be better off if there is no reslicing. With reslicing, it is possible some people will suffer economically, but that is the result of a governmental change in redistribution. It is not due to the objective function of companies.
2.Maximizing earnings is a nonfunctional objective for the following reasons:
a. Earnings is a time vector. Unless one time vector of earnings clearly dominates all other time vectors, it is impossible to select the vector that will maximize earnings.
b. Each time vector of earning possesses a risk characteristic. Maximizing expected earnings ignores the risk parameter.
c.Earnings can be increased by selling stock and buying risk free securities. Earnings will continue to increase Since stock does not require out-of-pocket costs , earnings shall continously increase.
d. The impact of dividend policies is ignored. If all earnings are retained, future earnings shall increase because of reinvestments. However, stock prices may decrease as a result of shareholders expecting regular dividends.. Maximizing wealth takes into account all variables like earnings, the timing and risk of these earnings, and the dividend policy of the firm.
3.Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind. Thus, the function of financial management can be broken down into three major decision areas: the investment, financing, and asset management decisions.
4.Yes, zero accounting profit while the firm establishes market position is consistent with the maximization of wealth objective.Other investments where short-run profits are sacrificed for the long run also are possible.
5.The goal of the firm gives a sense of direction to the financial manager . He/she has an objective function to maximize . This helps the manager in valuing any financial decision by its impact on that goal. In the absence of such a goal, the manager would would have no objective criterion to guide his/her actions.
6.The financial manager is involved in the acquisition, financing, and management of assets. These three functional areas are all interrelated (e.g., a decision to acquire an asset necessitates the financing and management of that asset, whereas financing and management costs affect the decision to invest).
7.If managers own have sizable shares of their company, they will have a greater understanding for its valuation . Also, they may have a greater incentive to maximize shareholder wealth than they would in the absence of holding shares. However, tying up hard earned money in shares of their own company may make them more risk averse than is desirable. If the company's bottom line falls because of a risky decision , managers stand to lose not only their jobs but have a drop in the value of their assets. This could make them risk averse and be detrimental in the maximizing shareholder wealth objective.
8.Regulations imposed by the government impose constraints, however, shareholder wealth can still be maximized. It is important that wealth maximization remain the principal objective of all businesses . Only then would economic efficiency be achieved in society and peoples standard of living would improve in real terms. The effectiveness of regulations to society must be evaluated relative to the costs imposed on economic efficiency. Where effectiveness in terms of money are small when compared to costs, businesses should make this known through the political process so that the regulations can be modified.
9.Mnagers work in a competitive scenario. A company must pay them atleast what they could earn else where.This is in the interest of shareholders. In case managers are paid in excess of their economic contribution, the returns available to investors will be less. However, shareholders would sell their stock and invest elsewhere. Hence , there is a balancing factor working in the direction of equilibrating managers' pay across business firms for a given level of economic contribution.
10.When markets are competitive and efficient , greater rewards can be obtained by taking greater risk. The financial manager is constantly involved in decisions requiring a trade-off between the two. For the firm, it is important that it do well what it knows best. There is little reason to believe that diversifying in new areas in which it has no or little expertise would fetch rewards commensurate with the risk involved.
11.Corporate governance refers to the system by which corporations are managed and controlled. It encompasses the relationships among a company’s shareholders, board of directors, and senior management. These relationships provide the framework within which corporate objectives are set and performance is monitored.
The board of directors sets company-wide policy and advises the CEO and other senior executives, who manage the company’s day-to-day activities. Boards review and approve strategy, significant investments, and acquisitions. The board also oversees operating plans, capital budgets, and the company’s financial reports to common shareholders.
12.lThe controller's responsibilities are essentially accounting in nature. Cost accounting, as well as budgets and forecasts, are for internal use. External financial reporting would be provided to the shareholders , SEBI/SEC .
The treasurer's responsibilities finclude investment (capital budgeting, pension management), financing (commercial banking and investment banking relationships, investor relations, dividend disbursement), and asset management (cash management, credit management).
13.The principal advantage of the corporate form of business organization is that the corporation has limited liability. The owner of a small grocery shop may be required to personally guarantee borrowings or purchases , however, with limited liability his personal assets would remain safe, even during periods of default .
14.The liability is limited to the amount of the investment in both the limited partnership and in the corporation. However, the limited partner generally does not have a role in selecting the management or in influencing the direction of the enterprise. On a pro rata basis, stockholders are able to select management and affect the direction of the enterprise. Also, partnership income is taxable to the limited partners as personal income whereas corporate income is not taxed unless distributed to the stockholders as dividends.
15.
With both a sole proprietorship and partnership, a major drawback is the legal liability of the owners. It extends beyond the financial resources of the business to the owners personally. Fringe benefits are not deductible as an expense. Also, both forms of organization lack the corporate feature of "unlimited life." With the partnership there are problems of control and management. The ownership is not liquid when it comes to planning for individual estates. Decision making can be cumbersome. An LLC generally lacks the feature of "unlimited life," and complete transfer of an ownership interest is usually subject to the approval of at least a majority of the other LLC members.
16.Securities with a higher likelihood of capital gains have an advantage as their owner would be subject to lesser tax.Investments preferred during such tax environment include low dividend common stocks, common stocks in general, discount bonds, real estate, and other investments of this sort.
17.Different depreciation methods would end up changing the timing of tax payments. The longer such payments can be delayed, the better off the business is.
18.Financial markets help efficiently allocate savings to the ultimate users. In a macro sense, savings originate from savings-surplus economic units whose savings exceed their investment in real assets. The ultimate users of these savings are savings-deficit economic units whose investments in real assets exceed their savings. The efficiency in this process is facilitated through the financial markets. Since the savings-surplus and savings-deficit units are usually different entities, markets serve to channel these funds at the least cost and inconvenience to both. As specialization develops, efficiency increases. Loan brokers, secondary markets, and investment bankers all serve to expedite this flow from savers to users.
19.Financial intermediaries provide an indirect channel to facilitate the flow of funds from savers to ultimate users. These institutions include commercial and savings banks, life insurance companies and pension and profit-sharing funds. The basic function of an intermediary is the transformation of funds into more attractive packages for savers. Services and economies of scale are side benefits of this process. Pooling of funds, diversification of risk, transformation of maturities and investment expertise are desirable functions that financial intermediaries perform.
20.Yields on financial instruments depends upon the following;
· Differences in maturity,
· default risk,
· marketability,
· taxability,
· option features
In general, the longer the maturity, the greater the default risk, the lower the marketability and the more the return is subject to ordinary income taxation as opposed to capital gains taxation or no taxation, the higher the yield on the instrument. If the investor receives an option (e.g., a conversion feature or warrant), the yield should be lower than otherwise. Conversely, if the firm issuing the security receives an option, such as a call feature, the investor must be compensated with a higher yield. Another factor -- one not taken up in this chapter -- is the coupon rate. The lower the coupon rate, the greater the price volatility of a bond, all other things the same, and generally the higher the yield.
21.Reduced cost of financial intermediation makes markets more efficient. This cost equals the difference in interest rate between the receipts of the ultimate saver and what the ultimate borrower pays. Alongwith, the inconvenience to one or both parties is an indirect cost. When financial intermediation reduces these costs, the market becomes more efficient. Special types of financial instruments and financial processes offered in response to unsatisfied investors also help markets gain efficiency. For example, the new product might be a zero-coupon bond and the new process,automatic teller machines.
22.These exchanges serve as secondary markets wherein the buyer and seller meet to exchange shares of companies that are listed on the exchange. These markets have provided economies of time and scale in the past and have facilitated exchange among interested parties.
23.a) All other things the same, the cost of funds (interest rates) would rise. If there are no disparities in savings pattern,the effect would fall on all financial markets.
b) Given a somewhat segmented market for mortgages, it would result in mortgage rates falling and rates on other financial instruments rising somewhat.
c) It would lower the demand for common stock, bonds selling at a discount, real estate, and other investments where capital gains are an attraction for investment. Prices would fall for these assets relative to fixed income securities until eventually the expected returns after taxes for all financial instruments were in equilibrium.
d) Great uncertainty would develop in the money and capital markets and the effect would likely be quite disruptive. Interest rates would rise dramatically and it would be difficult for borrowers to find lenders willing to lend at a fixed interest rate. Disequilibrium would likely continue to occur until the rate of inflation reduced to a reasonable level.
24.Money markets serve the short-term liquidity needs of investors. The usual line of demarkation is one year; money markets include instruments with maturities of less than a year while capital markets involve securities with maturities of more than one year. However, both markets are financial markets with the same economic
purpose so the distinction of maturity is somewhat arbitrary. Money markets involve instruments that are impersonal; funds flow on the basis of risk and return. A bank loan, for example, is not a money-market instrument even though it might be short term.
24.Transaction costs curtail the efficiency of financial markets. Large transaction costs make financial markets less efficient.The costs paid to financial institutions and brokers for performing economic service is known as transaction cost. Competition among brokers and institutions could help reduce such costs.
25.
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Bank loans,
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Bond issues,
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Mortgage debt,
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Stock issues
26. Investment bankers and mortgage bankers, facilitate the matching of borrowers with savers. The broker earns a fee for this service. This fee is market determined being determined by competitive forces. In addition, security exchanges and the over-the-counter market improve the secondary market and hence the efficiency of the primary market where securities are sold originally
