Solutions_Chapter_1
Chapter 1
2. A firm might cut its labour force dramatically which could reduce immediate expenses and
increase profits in the short term. Over the long term, however, the firm might not be able to serve its customers properly or it might alienate its remaining workers; if so, future profits will decrease, and the stock price will decrease in anticipation of these problems.
Similarly, a firm can boost profits over the short term by using less costly materials even if this reduces the quality of the product. Once customers catch on, sales will decrease and profits
will fall in the future. The stock price will fall.
The moral of these examples is that, because stock prices reflect present and future profitability, the firm should not necessarily sacrifice future prospects for short-term gains.
6. a, c, d.
14. a. Increased market share can be an inappropriate goal if it requires reducing prices to such
an extent that the firm is harmed financially. Increasing market share can be part of a
well-reasoned strategy, but one should always remember that market share is not a goal
in itself. The owners of the firm want managers to maximize the value of their
investment in the firm.
b. Minimizing costs can also conflict with the goal of value maximization. For example,
suppose a firm receives a large order for a product. The firm should be willing to pay
overtime wages and to incur other costs in order to fulfill the order, as long as it can sell
the additional product at a price greater than those costs. Even though costs per unit of
output increase, the firm still comes out ahead if it agrees to fill the order.
c. A policy of underpricing any competitor can lead the firm to sell goods at a price lower
than the price that would maximize market value. Again, in some situations, this strategy
might make sense, but it should not be the ultimate goal of the firm. It should be
evaluated with respect to its effect on firm value.
d. Expanding profits is a poorly defined goal of the firm. The text gives three reasons:
(i) There may be a trade-off between accounting profits in one year versus accounting
profits in another year. For example, writing off a bad investment may reduce this
year’s profits but increase profits in future years. Which year’s profits sh ould be
maximized?
(ii) Investing more in the firm can increase profits, even if the increase in profits is insufficient to justify the additional investment. In this case the increased
investment increases profits, but can reduce shareholder wealth.
(iii) Profits can be affected by accounting rules, so a decision that increases profits using one set of rules may reduce profits using another.
20. a. A fixed salary means that compensation is (at least in the short run) independent of the
firm’s success.
b. A salary linked to profits ties the employee’s compensation to this measure of the success
of the firm. However, profits are not a wholly reliable way to measure the success of the
firm. The text points out that profits are subject to differing accounting rules, and reflect
only the current year’s situation rather than the long-run prospects of the firm.
c. A salary that is paid partly in the form of the company’s shares means that the manager
earns the most when the shareholders’ wealth is maximized. This is therefore most likely
to align the interests of managers and shareholders.
d.Stock options create great incentives for managers to contribute to the firm’s success. In
some cases, however, stock options can lead to agency problems. For example, a manager with many options might be tempted to take on a very risky project, reasoning that if the
project succeeds the payoff will be huge, while if it fails, the losses are limited to the lost
value of the options. Shareholders, in contrast, bear the losses as well as the gains on the
project, and might be less willing to assume the risk.
23. As the text notes, the first step in doing well is doing good by your customers. Businesses
cannot prosper for long if they do not provide to their customers the products and services they desire. In addition, reputation effects often make it in the firm’s own interest to act ethically toward its business partners and employees since the firm’s ability to make deals and to hire skilled labour depends on its reputation for dealing fairly.
In some circumstances, when firms have incentives to act in a manner inconsistent with the public interest, taxes or fees can align private and public interests. For example, taxes or fees charged on pollution make it more costl y for firms to pollute, thereby affecting the firm’s
decisions regarding activities that cause pollution. Other “incentives” used by governments to align private interests with public interests include: legislation to provide for worker safety and product, or consumer, safety, building code requirements enforced by local governments, and pollution and gasoline mileage requirements imposed on automobile manufacturers.