Accounting concepts and applications

Accounting

Goals of the Firm. 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 price should be less subject to an overemphasis on short-term results than one that simply maximizes profits.

For a company that maximizes profit, the best result is always the one that produces the most profit in the current period. With this strategy, having two periods of high profit and two periods of low profit is as good as having four periods of medium growth, assuming that the former produces the same overall result.

In the case of a company striving to maximize stock price, the same is not true. Instead, four periods of medium growth is better than two periods of low and two periods of high. The reason for this is that stock price is determined by the perceived value of the shares. For investors to see value in the shares, they need to be assured of ongoing results. This is achieved by consistency, not by dramatic swings, even if the high swings are impressive.

This explains why a firm striving to maximize profits must focus more on the short-term, while a firm striving to maximize stock price is better to focus on long-term consistency.

2. Goals of the Firm. 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.

This action would not be consistent with the goal of increasing market value because it is adding an expense, but not one with a resulting benefit for potential shareholders.

b. The firm reduces its dividend payment, choosing to reinvest more of earnings in the business.

This action could be consistent with the goal of increasing market value if it is perceived as an action that is likely to increase the value of the company.

c. The firm buys a corporate jet for its executives.

This action would not be consistent with the goal of increasing market value because it does not increase the perceived value of the company.

d. The firm drills for oil in a remote jungle. The chance of finding oil is only 1 in 5.

This action would be consistent with the goal of increasing market value because regardless of the outcome, it can be perceived as potential value for investors.

3. Goals of the Firm. Explain why each of the following may not be appropriate corporate goals:

a. Increase market share.

Increasing market share may not be an appropriate strategy if the cost to do so is not justified by resulting profits. This includes recognizing that increasing market share means increasing production, which in turn has resulting costs. If an organization does not have the ability to meet higher demands, efforts to increase market share may not be able to meet their potential. In addition, an effective market share strategy may require the cash flow to support it.

Increasing market share may also not be the best strategy to increase profits. For example, serving a small percentage of the entire market with a niche product they are willing to pay for will create a greater profit margin per customer. To reach a large percentage of the market, an undifferentiated product may be required, which customers will not pay a high price for. If the increased number of sales at a lower profit margin does not create more profits overall than a low level of sales at an increased profit margin, than increasing market share may not be the best strategy.

b. Minimize costs.

A minimizing cost strategy is not likely to be a good strategy if the specific market is not driven by cost. For example, a technology company might depend on new innovations for its success. In this case, minimizing costs will not produce added value and so is not an effective strategy.

c. Underprice any competitors.

The profit that is made from a product is determined by its price. Underpricing any competitors is not an effective strategy if the increasingly low prices diminish profit margins.

This may be an effective strategy if the buying decisions of customers are based almost exclusively on price. If not, it may be a better strategy to focus on distinguishing the product or service by some feature that appeals to customers. This strategy gives a company a competitive advantage that will attract customers regardless of price. In turn, this allows companies to set the price that is needed for a suitable profit level.

d. Expand profits.

Expanding profits may not be an effective strategy if the focus on profits causes a company to neglect the aspects that make it successful. For example, a focus on expanding profits may lead to a focus on cutting costs. If this occurs, reduced costs can lead to reduced quality. The end result can be a loss of customers and a loss of profit. In this way, efforts to increase profits can actually result in a reduction of profits.

4. Corporate Financing. Financial markets and intermediaries channel savings from investors to corporate investment. The savings make this journey by many different routes. Give a specific example for each of the following routes.

a. Investor to financial intermediary, to financial markets, and to the corporation.

A private investor invests money in a term deposit offered by a bank, which acts as the financial intermediary. The financial intermediary uses the money as part of its share fund. The shares purchased provide money to the corporation that issues the shares.

b. Investor to financial markets, to a financial intermediary, and to the corporation.

A private investor purchases shares, which moves their savings into the financial markets. After the shares increase in value, the investor utilizes a broker to sell the shares. A percentage of the sale flows to the broker, who acts as the financial intermediary. The broker uses the income to invest capital in a new company, which flows money to the new corporation.

c. Investor to financial markets, to a financial intermediary, back to financial markets, and to the corporation.

A private investor purchases shares, which moves their savings into the financial markets. After the shares increase in value, the investor utilizes a broker to sell the shares. A percentage of the sale flows to the broker, who acts as the financial intermediary. The broker invests the income they received in financial markets. The shares purchased provide money to the corporation that issues the shares.

5. Equity Accounts. 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:

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?

The common stock figure shows that 60,000 shares have been issued at $1.00 per share.

b. How many are outstanding?

The treasury stock figure shows that 2000 shares were bought back. This means that there are 58,000 shares outstanding (60,000 stock issued - 2,000 stock bought back = 58,000 stock outstanding).

c. How many more shares can be issued without the approval of shareholders?

As described, the authorized share capital is 100,000 shares. Therefore, 100,000 shares can be issued without the approval of stockholders. Since 60,000 have already been issued, an additional 40,000 shares can be issued without the approval of shareholders.

6. Financing Terms. Fill in the blanks by choosing the appropriate term from the following list: lease, funded, floating-rate, eurobond, convertible, subordinated, call, sinking fund, prime rate, private placement, public issue, senior, unfunded, eurodollar rate, warrant, debentures, term loan.

a. Debt maturing in more than 1 year is often called funded debt.

b. An issue of bonds that is sold simultaneously in several countries is traditionally called a (n) eurobond.