Integrative Problem (Page 27)

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Integrative Problem (Page 27)

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
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Over time, good decisions will result in higher stock prices and bad ones, lower stock prices. Second, earnings manipulations through accounting changes will not result in price changes. Stock splits and other changes in accounting methods that do not affect cash flows are not reflected in prices. Market prices reflect expected cash flows available to shareholders. Thus, our preoccupation with cash flows to measure the timing of the benefits is justified.

5. What is the cause of the agency problem and how do we try to solve it?

The cause of the agency problem is conflicts of interest between the manager (the stockholder’s agent) and the stockholders. It is also results from the separation of management and the ownership of the firm. These problems may interfere with the implementation of the firm’s goals, which is to maximize the shareholder’s wealth. For instance, a large firm may be run by professional managers who have little or no ownership in the firm. Because of this separation of the decision makers and owners, managers may make decisions that are not in line with the goal of maximization of shareholder wealth. They may approach work less energetically and attempt to benefit themselves in terms of salary and perquisites at the expense of shareholders. We can try to address these issues in several ways. Managers can be monitored by auditing financial statements and managers’ compensation
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