Download Q2- A basic rationale for the objective of maximizing the wealth

Q1- Why should a company primarily concentrate on wealth maximization
instead of profit maximization?
Ans1- Maximizing wealth takes into account all factors which influence the
market price of the stock. Maximizing earning is not all inclusive because it
does not take account of the timing of the earning, of the business and
financial risk of the firm and of dividend policy. While shareholder wealth and
corporate profitability tend to be correlated over times, the two will deviate
for the reasons cited above. As the shareholder wealth is more inclusive, we
should use it.
Q2- A basic rationale for the objective of maximizing the wealth position of
the stockholder as a primary business goal is that such an objective may
reflect the most efficient use of society’s economic resources and thus, leads
to a maximization of society’s economic wealth”. Briefly evaluate this
observation.
Ans2- If capital is allocated on a risk adjusted return basis; it will flow to the
most productive investment opportunities. In this way, the economic growth
of the society will be maximized as the most efficient investment projects are
undertaken. As the shareholder wealth is determined by the risk-return nature
of the company, only a wealth maximization objective will result in savings in
our society being efficiently allocated to productive investment opportunities.
Q3- Beta-Max Corporation is considering two investment proposals. One
involves the development of 10 discount record stores in Chicago. Each store
is expected to provide an annual after tax profit of $35,000 for 8 years, after
which the lease will expire and the store will terminate. The other proposal
involves a classical record of the month club. Here, the company will devote
many efforts to teaching the public to appreciate classical music.
Management estimates that the after-tax profits will be zero for 2 years,
after which they will grow by $40,000 a years through year 10 and remain
level thereafter. The life of the second project is 15 years. On the basis of this
information, which project would you prefer?
Ans3- The first project is expected to provide $350,000 in annual profit over 8
years or $2.8 million in total. The second project is expected to have the
following after-tax profits:
Year
Profits
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0
0
$40,000
80,000
120,000
160,000
200,000
240,000
280,000
320,000
320,000
320,000
320,000
320,000
320,000
Total
$3,040,000
While the second project is expected to provide greater total profits, these
profits are received further in the future than are the profits for the first
project. Also, there may be more uncertainty associated with the second
project. Because of these factors, most people prefer the first proposal.
Q4- What are the major functions of the financial manager? What do these
functions have in common?
Ans4- The major functions of the financial manager are the investment
decision, the financing decision, and the dividend decision. The subsets under
each are given in the chapter. These decisions share the common thread that
they affect the value of the company’s stock. Together they determine the
stock’s value.
Q5- Should the managers of a company own sizeable amounts of stock in the
company? What are the pros and cons?
Ans5- If the managers have sizeable stock positions in the company, they will
have a greater understanding for the valuation of the company. Moreover,
they may have incentive to maximize shareholder wealth than they would be
in the absence of stock holding. However, to the extent persons have not only
there human capital but, also most of their financial capital tied up in the
company, they may be more risk averse than is desirable. If the company
deteriorates because a risky decision proves bad, they stand to lose not only
their jobs but, also have a drop in the value of their assets. Excessive risk
aversion can work to determine of maximizing shareholder wealth as can
excessive risk seeking if the manager is particularly a risk prone.
Q6- In recent years, there have been number of environmental, pollution,
hiring and other regulations imposed on businesses. In view of these
changes, is maximization of shareholder wealth still a realistic objective?
Ans6- Regulation imposed by the government constitutes constraints against
which shareholder wealth can still be maximized. It is important that wealth
maximization remain the principal goal of the firms if economic efficiency is to
be achieved in society and people are expected to have increasing real
standards of livings. The benefits of regulations to society must be evaluated
relative to the costs imposed on economic efficiency. Where benefits are small
relative to the costs, businesses need to make this known through political
process so that the regulations can be modified. Presently there is
considerable attention being given to deregulations. Many things have been
done to make regulations less onerous and to allow competitive markets to
work more effectively.
Q7 As an investor do you believe that some managers are paid too much? Do
not their rewards come at your expense?
Ans7- As in other thing, there is a completive market for good managers. A
company must pay them their opportunity cost, and indeed this is the interest
of the stockholders. To the extent managers are paid in excess of their
economic contribution, the returns available to investor will be less. However,
the stock holders can sell their stock and invest elsewhere. Therefore, there is
a balancing force that works in the direction of equilibrating managers’ pay
across business firms for a given level of economic contribution.
Q8- How does the notion of risk and reward governs the behaviour of the
financial managers?
Ans8- In completive and efficient marks, greater rewards can only be achieved
with greater risk. The financial manager is constantly involved in decisions
involving a trade-off between the two. For a company, it is important that it
does well what it knows well. If it gets into a new area where it has no
expertise there is little reason to believe that the rewards will be
commensurate with the risk that is involved.