UNIVERSITI BRUNEI DARUSSALAM

School of Business and Economics

BA-3201 – Financial Management – Semester January 2024

Tutorial 02 – Financial Markets and Institutions – Questions

After studying this chapter, you should understand:

LO1 The basic types of financial management decisions and the role of the financial manager.
LO2 The goal of financial management.
LO3 The financial implications of the different forms of business organization.
LO4 The conflicts of interest that can arise between managers and owners.

Question 01 – The Financial Management Decision Process [LO1]

The Financial Management Decision Process [LO1] What are the three types of financial
management decisions? For each type of decision, give an example of a business transaction
that would be relevant.

Investment Decision – purchasing new equipment/machinery to increase efficiency/save time. An

investment decision refers to the process of allocating resources, typically capital, to different assets,
projects, or opportunities with the expectation of generating returns. In the context of a business or
individual, investment decisions involve assessing various options and choosing where to allocate
financial resources for the purpose of achieving specific financial goals.

Financing Decision – securing a bank loan to fund the manufacture of a new branch. A financing decision
refers to choices made by a business regarding how to raise capital or funds to support its operations
and investments. This decision involves selecting the sources of funding, such as issuing stocks,
obtaining loans, or using other financial instruments, to meet the company's financial needs and goals.

Dividend Decision – when a company declares a quarterly dividend of $0.50 per share, dividend
decisions involve a company’s choice to distribute a portion off its profits to shareholders

Question 02 – Sole Proprietorships and Partnerships [LO3]

Sole Proprietorships and Partnerships [LO3] What are the four primary disadvantages of the
sole proprietorship and partnership forms of business organization? What benefits are there
to these types of business organization as opposed to the corporate form?

Sole Proprietorship:

1. Limited Capital: Sole proprietorships may face challenges in raising capital since the business
relies solely on the owner's personal funds and ability to borrow.
2. Unlimited Liability: The owner has unlimited personal liability for the business debts. In case of
financial difficulties, personal assets, including those not involved in the business, may be at risk.
 3. Limited Expertise and Management Skills: Sole proprietors may lack expertise in certain areas,
and the success of the business heavily depends on the skills and knowledge of a single
individual.
4. Limited Growth Potential: Due to the limitations on capital and resources, sole proprietorships
may face constraints in terms of growth and expansion compared to larger, more diversified
business structures.

Partnership:

1. Unlimited Liability: Like sole proprietorships, partnerships often involve unlimited personal
liability for the debts and obligations of the business. Each partner is personally responsible for
the actions of the other partners.
2. Conflict in Decision-Making: Partnerships may experience conflicts in decision-making, especially
in situations where partners have differing opinions or priorities.
3. Limited Capital and Resources: Similar to sole proprietorships, partnerships may find it
challenging to raise substantial capital. The business's financial resources are limited to the
contributions of the partners and any loans they can secure.
4. Shared Profits: Profits are typically shared among partners based on the agreed-upon
percentage, which may lead to dissatisfaction if there are disparities in contributions or efforts.

Sole proprietorships and partnerships offer certain benefits that may make them preferable in
certain situations when compared to the corporate form. Here are some advantages of sole
proprietorships and partnerships:

Sole Proprietorship:

1. Simplicity and Ease of Formation: Establishing a sole proprietorship is straightforward and

involves minimal legal formalities. This simplicity reduces administrative burdens and costs.
2. Direct Decision-Making: The owner has complete control over business decisions, allowing for
quick and efficient decision-making without the need for extensive consultations.
3. Tax Advantages: Sole proprietors often benefit from pass-through taxation, meaning business
profits and losses are reported on the owner's personal tax return, potentially leading to
simplified tax obligations.
4. Flexibility: The owner has the flexibility to adapt the business to changing circumstances
without the need for extensive approvals or corporate formalities.

Partnership:

1. Ease of Formation: Similar to sole proprietorships, partnerships are relatively easy to establish,
with fewer legal formalities compared to corporations.
2. Shared Management and Decision-Making: Partnerships allow for shared management
responsibilities and decision-making, distributing the workload and potentially benefiting from
the diverse skills and perspectives of the partners.
 3. Tax Advantages: Like sole proprietorships, partnerships often enjoy pass-through taxation,
avoiding the double taxation associated with corporations.
4. Flexibility in Profit Distribution: Partnerships offer flexibility in distributing profits among
partners based on the terms of the partnership agreement, allowing for a customized approach
that aligns with the partners' contributions.

Considerations:

 Cost and Complexity: Sole proprietorships and partnerships are generally less expensive to
establish and have lower ongoing compliance costs compared to corporations.
 Direct Relationship with Customers: In smaller businesses, the personal touch and direct
relationship between the owner or partners and customers can be a competitive advantage.
 Adaptability: These forms of business organization can be more adaptable to changes in the
market or business strategy, as there are fewer formalities and layers of decision-making.

Question 03 – Corporations [LO3]

What is the primary disadvantage of the corporate form of organization? Name at least two
advantages of corporate organization.

Primary Disadvantage of the Corporate Form:

1. Double Taxation: One of the primary disadvantages of the corporate form is the issue of double
taxation. Corporations are taxed at the corporate level on their profits, and then shareholders
are taxed again on the dividends they receive. This can result in a higher overall tax burden
compared to other business structures like sole proprietorships or partnerships.

Advantages of Corporate Organization:

1. Limited Liability: Shareholders in a corporation enjoy limited liability, meaning their personal
assets are generally protected from the company's debts and liabilities. The shareholders' losses
are typically limited to the amount invested in the company, promoting a level of financial
protection.

2. Access to Capital: Corporations have the advantage of easier access to capital compared to
other business structures. They can raise funds by issuing stocks and bonds in the financial
markets, allowing for the attraction of investment from a wide range of investors. This ability to
tap into larger pools of capital can facilitate expansion, research and development, and other
strategic initiatives.

3. Perpetual Existence: A corporation has a perpetual existence, meaning its life is not tied to the
life of its owners or founders. The death or departure of shareholders does not necessarily
affect the continuity of the business. This provides stability and continuity, making it easier for
corporations to plan for the long term.
 4. Ease of Transferability of Ownership: Ownership in a corporation is typically represented by
shares of stock, and the transfer of ownership is relatively easy. Shareholders can buy or sell
their shares without affecting the company's operations. This liquidity in the market for
corporate shares can be attractive to investors.

Question 04 – Corporate Finance Organization [LO4]

In a large corporation, what are the two distinct groups that report to the chief financial
officer? Which group is the focus of corporate finance?

In a large corporation, the two distinct groups that typically report to the Chief Financial Officer (CFO)
are:

1. Controller's Group (or Corporate Controller): This group is responsible for financial accounting,
reporting, and compliance. The controller's team manages the company's financial statements,
ensures adherence to accounting standards, and handles regulatory filings. They focus on
historical financial data and the accurate representation of the company's financial position.

2. Treasury Department: This group is responsible for managing the company's finances, including
cash flow, liquidity, and financial risk. The treasury team often handles tasks such as cash
management, capital structure decisions, risk management (including hedging), and investment
of excess funds. They are concerned with the company's present and future financial position.

Question 05 – Goal of Financial Management [LO2]

What goal should always motivate the actions of a firm’s financial manager?

The primary goal that should always motivate the actions of a firm's financial manager is to maximize
shareholder wealth or shareholder value. This concept is often expressed in terms of maximizing the
firm's stock price.

Question 06 – Agency Problems [LO4]

Who owns a corporation? Describe the process whereby the owners control the firm’s
management. What is the main reason that an agency relationship exists in the corporate
form of organization? In this context, what kinds of problems can arise?

Shareholders: Shareholders are the ultimate owners of a corporation. They invest capital in the
company by purchasing shares of its stock.

Process of Owner Control in a Corporation:

1. Board of Directors:

 Shareholders elect a board of directors to represent their interests.

  The board hires and oversees top executives, including the CEO.

 Board members make key decisions and ensure the company is managed in the best
interest of shareholders.

2. Shareholder Voting:

 Shareholders vote on significant matters during annual meetings (e.g., election of

directors, major decisions).

 Each share typically represents one vote, and shareholders have the power to influence
major company decisions.

3. Proxy Voting:

 Shareholders who cannot attend meetings can vote by proxy, appointing someone to
vote on their behalf.

4. Annual Reports and Disclosures:

 Companies provide annual reports and disclosures, giving shareholders insights into
financial performance and key initiatives.

 Shareholders use this information to assess management's performance.

5. Market Forces:

 Shareholders can influence management decisions by buying or selling shares based on

their confidence in the company.

Agency Relationship in Corporate Form:

The main reason an agency relationship exists in the corporate form is due to the separation of
ownership and management. Shareholders (owners) hire managers to run the company on their behalf.
This creates an agency relationship where the managers (agents) act on behalf of the owners
(principals).

Problems Arising from Agency Relationships:

1. Principal-Agent Conflict:

 The interests of managers may not always align perfectly with those of shareholders,
leading to conflicts. Managers may prioritize their own interests or pursue goals that do
not maximize shareholder wealth.

2. Agency Costs:

 Agency costs refer to the expenses incurred to monitor and control managerial
behavior. Shareholders may need to invest resources in mechanisms (like audits,
monitoring systems) to ensure managers act in their best interest.

3. Moral Hazard:
  Managers might take excessive risks or engage in unethical behavior if they believe they
won't bear the full consequences of their actions. This is known as moral hazard and can
be a problem in the agency relationship.

4. Information Asymmetry:

 Information asymmetry occurs when managers possess more information about the
company than shareholders. This can lead to a lack of transparency and hinder
shareholders' ability to make informed decisions.

5. Short-Termism:

 Managers may prioritize short-term gains over long-term value creation, especially if
their compensation is tied to short-term performance metrics.

6. Managerial Entrenchment:

 Managers may take actions to entrench themselves in their positions, potentially to the
detriment of shareholder value. For example, they might resist changes proposed by
activist investors.

Effective corporate governance structures, including an independent board of directors, transparency,

and mechanisms to align managerial and shareholder interests, are crucial for mitigating agency
problems and ensuring that the management serves the best interests of the owners.

Question 07 – Primary versus Secondary Markets [LO3]

You’ve probably noticed coverage in the financial press of an initial public offering (IPO) of a
company’s securities. Is an IPO a primary market transaction or a secondary market
transaction?

An Initial Public Offering (IPO) is a primary market transaction.

In an IPO, a company issues its shares to the public for the first time, allowing it to raise capital directly
from investors. The company sells newly issued shares to investors, and the funds generated from the
sale go to the company, not to existing shareholders. This process is part of the primary market because
it involves the issuance of new securities and the company receives the proceeds from the sale.

Once the shares are initially sold in the IPO, they can be bought and the company receives the proceeds
from the sale.

Question 08 – Not-for-Profit Firm Goals [LO2]

Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital,
perhaps). What kinds of goals do you think would be appropriate?

In a not-for-profit organization, such as a hospital, the financial manager would still have important
responsibilities, but the goals would differ from those of a for-profit business. The primary focus would
be on sustaining the organization's mission, serving the community, and ensuring financial stability to
continue providing services. Here are some appropriate goals for the financial manager in a not-for-
profit hospital:

1. Mission Alignment:

 Ensure that financial decisions align with the organization's mission and the provision of
high-quality healthcare services to the community.

2. Financial Stability:

 Maintain financial stability to ensure the organization's ability to deliver healthcare

services consistently over the long term.

3. Cost-Effective Operations:

 Implement cost-effective operational strategies to maximize the impact of available

resources on patient care and community services.

4. Community Benefit:

 Focus on delivering benefits to the community, such as providing charity care,

community outreach programs, and other services that contribute to the public welfare.

5. Compliance and Accountability:

 Ensure compliance with relevant regulations and standards, fostering accountability and
transparency in financial reporting and resource allocation.

6. Strategic Planning for Community Needs:

 Engage in strategic financial planning to address the healthcare needs of the community
effectively, considering factors such as demographics, socio-economic conditions, and
health trends.

7. Fundraising and Grant Management:

 Develop and manage fundraising initiatives and grants to support the organization's
financial needs and fund specific community-oriented healthcare projects.

8. Patient Access and Affordability:

 Work towards enhancing patient access to healthcare services and exploring ways to
make healthcare more affordable for the community, potentially through financial
assistance programs.

9. Quality of Care:

 Allocate resources to maintain and improve the quality of healthcare services provided,
focusing on patient outcomes, safety, and satisfaction.

10. Collaboration with Stakeholders:

  Foster collaboration with various stakeholders, including government agencies, donors,
healthcare professionals, and community organizations, to enhance the organization's
impact.

In a not-for-profit setting, financial goals are intertwined with the broader mission and social impact of
the organization. Success is measured not only in financial terms but also in the positive contribution
made to the community and the achievement of the organization's charitable objectives.

Question 09 – Goal of the Firm [LO2]

Evaluate the following statement: Managers should not focus on the current stock value
because doing so will lead to an overemphasis on short-term profits at the expense of long-
term profits.

The statement "Managers should not focus on the current stock value because doing so will lead to an
overemphasis on short-term profits at the expense of long-term profits" reflects a perspective often
associated with the criticism of short-termism in corporate decision-making. Let's evaluate this
statement:

Points in Favor:

1. Long-Term Value Creation:

 Focusing solely on current stock value might encourage managers to prioritize short-
term gains over the long-term health and sustainability of the company. Long-term
profits, driven by strategic investments and sustainable business practices, are crucial
for sustained growth.

2. Investor and Stakeholder Trust:

 Constantly chasing short-term stock performance may erode trust among investors and
other stakeholders. A long-term perspective can build confidence and foster stronger
relationships with shareholders, customers, employees, and the community.

3. Risk of Short-Term Manipulation:

 An exclusive focus on current stock value might tempt managers to engage in short-
term financial engineering or manipulation to boost stock prices temporarily, which can
be detrimental to the company's overall health.

Counterarguments:

1. Market Signals and Investor Confidence:

 Current stock value often reflects the market's assessment of a company's performance
and future prospects. A healthy stock value can signal investor confidence, attract
capital, and provide resources for long-term investments.

2. Shareholder Value Maximization:

  For publicly traded companies, there is a fiduciary responsibility to maximize
shareholder value. While short-termism can be an issue, neglecting current stock value
entirely may not align with the duty to create shareholder wealth.

3. Capital Allocation and Strategic Planning:

 Monitoring current stock value can guide managers in making informed decisions about
capital allocation, strategic planning, and assessing the success of past decisions. It
provides a feedback loop for management actions.

4. Market Expectations:

 Companies are often evaluated based on their ability to meet or exceed market
expectations. While balancing short-term and long-term goals is essential, managing
current stock value is part of meeting these expectations.

Conclusion:

The statement underscores the need for a balanced approach. While obsessively focusing on short-term
stock fluctuations can lead to detrimental practices, entirely ignoring current stock value may overlook
important signals and hinder a company's ability to attract investment. Striking the right balance
between short-term considerations and long-term value creation is key. This involves aligning strategic
decisions with the organization's overall goals and creating sustainable value for shareholders and other
stakeholders over time.

Question 10 – Ethics and Firm Goals [LO2]

Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding
unethical or illegal behaviour? In particular, do you think subjects like customer and employee
safety, the environment, and the general good of society fi t in this framework, or are they
essentially ignored? Think of some specific scenarios to illustrate your answer.

The goal of maximizing the value of stock can potentially conflict with other goals, particularly when it
comes to ethical considerations, social responsibility, and the well-being of various stakeholders,
including customers, employees, and society at large. However, it is increasingly recognized that
sustainable and ethical business practices can contribute to long-term value creation. Let's explore this
in more detail:

### Potential Conflicts:

1. **Customer and Employee Safety:**

- Conflict: A company might compromise on product safety or workplace conditions to cut costs and
maximize short-term profits.

- Alignment: Prioritizing customer and employee safety can contribute to brand trust and long-term
profitability by avoiding legal issues, negative publicity, and potential harm to individuals.
2. **Environmental Responsibility:**

- Conflict: Ignoring environmental regulations or engaging in practices that harm the environment
might seem profitable in the short term.

- Alignment: Embracing sustainable and eco-friendly practices can enhance the company's reputation,
reduce regulatory risks, and attract environmentally conscious consumers.

3. **General Good of Society:**

- Conflict: A company may engage in practices that have negative societal impacts (e.g., exploitation of
communities, labor issues) to maximize profits.

- Alignment: Contributing positively to society through ethical practices, philanthropy, and community
engagement can enhance brand reputation and build long-term relationships.

### Specific Scenarios:

1. **Scenario - Product Safety:**

- Conflict: Cutting corners in quality control to reduce costs and increase short-term profits, risking
harm to consumers.

- Alignment: Investing in robust quality control processes, ensuring product safety, and building a
reputation for reliability can lead to sustained customer trust and loyalty.

2. **Scenario - Labor Practices:**

- Conflict: Exploiting workers to minimize labor costs, leading to ethical and legal issues.

- Alignment: Fair labor practices, including competitive wages and safe working conditions, can
contribute to employee satisfaction, productivity, and long-term organizational success.

3. **Scenario - Environmental Impact:**

- Conflict: Disregarding environmental regulations to avoid immediate costs associated with eco-
friendly practices.

- Alignment: Adopting sustainable practices can enhance the company's image, attract
environmentally conscious consumers, and mitigate long-term environmental risks.
4. **Scenario - Community Engagement:**

- Conflict: Ignoring the needs and concerns of local communities in pursuit of short-term profits.

- Alignment: Engaging with and positively contributing to local communities can foster goodwill,
reduce regulatory risks, and enhance the company's social license to operate.

### Balancing Act:

While short-term financial goals may create tensions with ethical considerations and social
responsibility, there is a growing understanding that sustainable business practices align with long-term
value creation. Companies are increasingly adopting Corporate Social Responsibility (CSR) initiatives and
Environmental, Social, and Governance (ESG) criteria to integrate ethical, social, and environmental
considerations into their decision-making processes. Balancing financial objectives with ethical and
social responsibility can lead to more resilient, trusted, and enduring businesses.

Question 11 – Agency Problems [LO4]

Suppose you own stock in a company. The current price per share is $25. Another company
has just announced that it wants to buy your company and will pay $35 per share to acquire
all the outstanding stock. Your company’s management immediately begins fighting off this
hostile bid. Is management acting in the shareholders’ best interests? Why or why not?

The question of whether management is acting in the shareholders' best interests when resisting a
hostile takeover bid can be complex and depends on various factors. Let's explore the perspectives on
both sides:

### Arguments Supporting Management's Actions:

1. **Maximizing Long-Term Value:**

- Management may argue that they are acting in the long-term interests of shareholders. They may
believe that the current offer undervalues the company's true worth, and by resisting the bid, they are
preserving shareholder value for the future.

2. **Strategic Vision:**

- The company's management might have a strategic vision for the business that they believe will
result in higher shareholder value over time. They may resist the takeover to execute their long-term
plans and deliver greater returns to shareholders.
3. **Concerns about Synergy and Integration:**

- Management may be concerned about the potential negative impact of the acquiring company's
strategy on the existing business, including issues related to culture, employee morale, and operational
integration.

### Arguments Against Management's Actions:

1. **Shareholder Value Maximization:**

- Shareholders may argue that accepting the higher acquisition offer is in their immediate financial
interest, as it provides an opportunity to sell their shares at a premium.

2. **Hostile Bid Premium:**

- Shareholders might view the hostile bid as an opportunity to realize an immediate gain, as the offer
price of $35 per share is significantly higher than the current market price of $25 per share.

3. **Market Dynamics:**

- Some shareholders may believe that management is acting in its own interest rather than that of the
shareholders by resisting a bid that could be financially beneficial.

### Considerations for Shareholders:

1. **Fairness of the Offer:**

- Shareholders should assess whether the $35 per share offer is fair and reasonable based on the
company's current performance, future prospects, and the market environment.

2. **Communication and Transparency:**

- Management's communication about the reasons for resisting the bid should be transparent and
well-justified, providing shareholders with a clear understanding of the decision.

3. **Alternative Strategies:**

- Shareholders should evaluate whether management has presented alternative strategies or plans
that demonstrate a credible path to creating value equal to or exceeding the proposed acquisition offer.
In summary, the question of whether management is acting in the shareholders' best interests in
resisting a hostile bid depends on the specifics of the situation, the strategic vision of the company, and
the perceived value of the acquisition offer. Shareholders should carefully evaluate the arguments
presented by both management and potential acquirers to make informed decisions about their
investment.

Question 12 – Executive Compensation [LO3]

Critics have charged that compensation to top managers in the United States is simply too
high and should be cut back. For example, focusing on large corporations, Ray Irani of
Occidental Petroleum has been one of the best-compensated CEOs in the United States,
earning about $54.4 million in 2007 alone and $550 million over the 2003–2007 period. Are
such amounts excessive? In answering, it might be helpful to recognize that superstar athletes
such as Tiger Woods, top entertainers such as Tom Hanks and Oprah Winfrey, and many
others at the top of their respective fields earn at least as much, if not a great deal more.

The question of whether executive compensation, particularly for top managers, is excessive is a matter
of ongoing debate. Opinions on this matter can vary, and different stakeholders may have different
perspectives. Here are some points to consider:

### Arguments for High Executive Compensation:

1. **Market Forces:**

- Proponents argue that executive compensation is determined by market forces. Companies compete
for top talent, and the compensation packages are structured to attract and retain high-caliber
executives.

2. **Performance-Based Pay:**

- Many executive compensation packages include performance-based components, such as stock

options and bonuses tied to specific targets. Advocates argue that this aligns the interests of executives
with shareholders and encourages better performance.

3. **Global Competition:**

- In an increasingly globalized business environment, companies may argue that they need to offer
competitive compensation to attract executives who can lead the organization effectively, especially in
industries where talent is scarce.
4. **Complex Roles and Responsibilities:**

- The argument is made that top executives are responsible for complex decision-making that can
significantly impact the success or failure of a large organization. The high compensation reflects the
level of responsibility and expertise required for the role.

### Arguments Against High Executive Compensation:

1. **Income Inequality:**

- Critics argue that excessively high executive compensation contributes to income inequality, creating
a significant gap between the earnings of top executives and the average worker.

2. **Lack of Accountability:**

- Some critics contend that high compensation packages are often not directly tied to company
performance and can be awarded even when companies underperform. This may indicate a lack of
accountability in the executive pay structure.

3. **Comparison with Other Countries:**

- The U.S. has often been cited as having higher executive pay compared to other developed countries.
Critics argue that more restraint in executive compensation would align the U.S. with global norms.

4. **Shareholder Value:**

- Skeptics question whether the high compensation for executives always correlates with increased
shareholder value. In cases where excessive pay is not justified by performance, it may be seen as
detrimental to shareholder interests.

### Comparisons with Other Professions:

- **Entertainment and Sports:** The comparison with top athletes and entertainers is often made to
justify executive compensation. Critics argue that executive roles are fundamentally different from
entertainment or sports roles and should not be subject to the same compensation structures.

In conclusion, whether executive compensation is considered excessive depends on one's perspective

and values. It is a complex issue that involves considerations of market dynamics, company
performance, societal values, and fairness. Public discussions and debates on this topic continue, and
corporate governance practices are evolving to address concerns related to executive compensation.