FINANCE 201: TOPIC 1

TUTORIAL 1.1
SUGGESTED SOLUTIONS
1. The Capital Budgeting/Investment Decision: Link with Non-Current Assets in the Balance Sheet.
The Capital Structure/Financing Decision: Link with Equity and Liabilities (permanent) in the
Balance Sheet.
The Working Capital Management Decision: Link with Current Assets and Current Liabilities in the
Balance Sheet.
2. In the corporate form of ownership, the shareholders are the true owners of the firm. The
shareholders elect the directors of the company, who in turn appoint the firms management. This
separation of ownership from control in the corporate form of organisation is what causes agency
problems to exist. Management may act in its own or someone elses best interests, rather than those
of the shareholders. If such events occur, they may contradict the goal of maximising the share price
of the equity of the firm.
3.
4.
(a) Such organisations frequently pursue social or political missions; so many different goals are
conceivable. One goal that is often cited is revenue minimisation; i.e., provide whatever goods
and services are offered at the lowest possible cost to society. A better approach might be to
observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate
goal is to maximise the value of the equity.
(b) It is not a very precise objective. Several actions that are not desirable can be done to achieve
this objective such as deferring maintenance, letting inventories run down. It is not clear whether
this goal refers to net accounting profits or earnings per share. This goal does not tell us what the
appropriate trade-off is between current and future profits. This goal disregards risk (a trade-off
exists between return (cash flow and risk). Profits do not necessarily result in cash flows
available to shareholders
(c) An argument can be made either way. At the one extreme, we could argue that in a market
economy, all of these things are priced. There is thus an optimal level of, for example, ethical
and/or illegal behaviour and the framework of share valuation explicitly includes these. At the
other extreme, we could argue that these are non-economic phenomena and are best handled
through the political process. A classic (and highly relevant) thought question that illustrates this
debate goes something like this: A firm has estimated that the cost of improving the safety of
one of its products is R30 million. However, the firm believes that improving the safety of the
product will only save R20 million in product liability claims. What should the firm do?
5. In the corporate form of ownership, the shareholders are the owners of the firm. As most companies
have multiple shareholders, it would prove impractical for all of these owners to run their company.
Hence the shareholders elect the directors of the company, who in turn appoint the firms
management to manage the company on the shareholders behalf. This separation of ownership from
control is what causes agency problems to exist. Management may act in its own best interests,
rather than those of the shareholders. If this occurs, they may contradict the goal of maximising the
share price of the firm and agency costs are incurred. These agency costs can be direct or indirect.
Direct agency costs are incurred by firms to prevent or minimize agency problems e.g the cost of
employing independent auditors to monitor management. Direct costs would also include the

wasteful expenditure of management on the trappings of power e.g. a corporate jet or luxurious
offices. Indirect agency costs refer to lost investment opportunities to the firm due to risk-aversion or
a slow response on the part of management.
Some of the ways in which market forces can minimize these costs:
Market forces can reduce the problem: shareholders can use their voting power to put
pressure on or replace underperforming management. Institutional investors (such as life
insurance companies, unit trusts and pension funds) could be particularly effective here.
These can exert pressure on management to perform by communicating their concern to the
board. They often threaten to exercise their voting rights or liquidate their holdings if the
board does not respond positively to their concerns.
The threat of hostile takeover also acts as a deterrent acquirers look for poorly-managed
firms to take over and this threat motivates managers to act in owners best interests.
Competitive job market also serves to keep management on their toes.
6. The market is not even weak-form efficient. It is therefore more than likely inefficient.
7. Yes. Weak-form efficiency is a subset of semi-strong form efficiency (refer to concentric circle
diagram). Publicly available information would include historical information.
8. The EMH asserts that well-organised capital markets are efficient for all practical purposes. In such
efficient markets then, assets are fairly priced. Ignoring trading costs, on average, such investors
merely earn what the market offers; the trades all have a zero NPV (benefit = cost). If trading costs
exist, then these investors lose by the amount of the costs. Thus on average the typical market
participant cannot continuously earn excessive profits from a particular trading strategy. This does
not mean, however, that a certain few investors cannot outperform the market over a particular
investment horizon as, although few and far between, there will be some mis-priced shares in the
market from time to time. Some investors are particularly good at identifying such shares and may
do well for a period of time and get plenty of media attention. We dont read about the scores of
those who fail over the same time period, however.