The final stage in the interview process for an Assistant Financial Analyst at Caledonia Products involves a test of your understanding of basic financial concepts. You are given the following memorandum and asked to respond to the questions. Whether or not you are offered a position at Caledonia will depend on the accuracy of your response.
To: Applicants for the position of Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: A test of your understanding of basic financial concepts and of the Corporate Tax Code.
Please respond to the following questions:
1. What are the differences between the goals of profit maximization and maximization of shareholder wealth? Which goal do you think is more appropriate?
2. What does the risk-return trade-off mean?
3. Why are we interested in cash flows rather than accounting profits in determining the value of an asset?
4. What is an efficient market and what are the implications of efficient markets for us?
5. What is the cause of the agency problem and how do we try to solve it?
6. What do ethics and ethical behavior have to do with finance?
7. Define (a) sole proprietorship, (b) partnership, and (c) corporation.
Profit Maximization versus Maximization of Shareholder Wealth
"Profit maximization as a process that companies undergo to determine the best output and price levels in order to maximize its return" (Investorwords, 2010). "In computing the profit maximization levels one can use total cost-total revenue method or the marginal cost-marginal revenue method" (Investorwords, 2010). In contrast, the maximization of shareholder wealth is usually assumed as the goal of the organization. In some case though, the maximizing of shareholder wealth can turn organizations into providing the quickest return which results in only short-term gains. In analyzing shareholder wealth one should not just look at the profits it is giving but the overall value (Ross, Westerfield, & Jaffe 2005). Contrary to popular belief I believe that creating the best value in the process of profit maximization will give returns to shareholders not only in the short-term but in the long-term. Therefore creating the best value to maximize returns in profit maximization will keep the organization healthy for the long-term. When one tends to focus on shareholder wealth their judgment can become clouded and only maximize shareholder returns for the short-term.
The risk-return trade-off means "that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns" (Investopedia, 2010). The idea of the risk-return trade-off is a concept that organizations need to apply to understand how attractive their investment is. Due to the principle of the risk-return trade-off it is wise to diversify ones investments to ...
The solution discusses the goal of profit maximization and maximization of shareholder wealth.