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Corporate goals; Equity Account

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13. You may have heard big business criticized for focusing on short-term performance at the expense of long-term results. Explain why a firm that strives to maximize stock prices should be less subject to an overemphasis on short-term results than one that simply maximizes profits.

14. We claim that the goal of the firm is to maximize current market value. Could the following actions be consistent with that goal?
a) The firm adds a cost of living adjustment to the pensions of its retired employees.
b) The firm reduces its dividend payment, choosing to reinvest more of its earnings in the business.
c) The firm buys a corporate jet for its executives.
d) The firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5.

15. Explain why each of the following may not be appropriate corporate goals
a) Increase market share:
b) Minimize costs:
c) Under price any competitors
d) Expand profits

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1. The authorized share capital of the Alfred Cake Company is 100,000 shares. The equity is currently shown in the company's books as follows {see attachment}

Common Stock ($1.00 par value) $60,000
Additional paid-in capital 10,000
Retained earnings 30,000
Common equity 100,000
Treasury stock (2,000 shares) 5,000
Net common equity 95,000

a. How many shares are issued?
b. How many are outstanding?
c. How many more shares can be issued without the approval of shareholders?

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Solution Summary

Answers questions on
1) Firm goals: Short-term performance vs. long-term results; actions consistent maximization of current market value; appropriate corporate goals.
2) Equity Account- calculates number of shares issued, number outstanding and the number of shares can be issued without the approval of shareholders.

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13. You may have heard big business criticized for focusing on short-term performance at the expense of long-term results. Explain why a firm that strives to maximize stock prices should be less subject to an overemphasis on short-term results than one that simple maximizes profits.

Answer:
The value of any publicly traded firm is determined by the financial markets. The market value of the firm will increase only when the firm makes decisions that maximize the usefulness of its assets. When the firm makes such decisions it creates value which is recognized by the market and the share price and consequently the market value of the firm increases.

The process of valuation of the company which determines the share price is based on

1) the timing of the expected cash flows and

2) the risk associated with the cash flows.

The firm is valued by discounting the cash flows by a discount rate that takes into account the risk involved. Value adding decisions are therefore those which are taken in a risk reward framework.

A firm which strives to maximize the share price would focus on improving cash flows by taking only those investment decisions that generate cash flows which compensate adequately the risks taken.

Thus managers that strive to maximize stock price take decisions most likely to increase the company's competitive, organizational and financial strength over time. Thus they would not take short term decisions that impair the firm's prospects in the long run as the market takes into account all the cash flows (and not only short term cash flows while valuing firms and therefore the share price) . The market values future earning and cash flows and the risks associated with these cash flows along with current earnings and cash flows when arriving at the share price.

In contrast, the goal of profit maximization does not capture the risk effects and fails to consider the timing of the benefits. Added to these are the facts that the variations in definitions of profit cause measurement problems and inflation and ...

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