Fundamentals of Financial Management (Concise 6th Edition)

10 Part 1 Introduction to Financial Management

1-5 INTRINSIC VALUES, STOCK PRICES,

AND EXECUTIVE COMPENSATION

As noted in the preceding section, stock prices are based on cash " ows expected in

future years, not just in the current year. Thus, stock price maximization requires

us to take a long-run view of operations. Academics have generally assumed that

managers adhere to this long-run focus, but it is now clear that the focus for many

companies shifted to the short run in recent years. To give managers an incentive

to focus on stock prices, stockholders (acting through boards of directors) awarded

executives stock options that could be exercised on a speci! ed future date. An

executive could exercise the option on that date, receive stock, immediately sell it,

and earn a pro! t. The pro! t was based on the stock price on the option exercise

date, which led some managers to try to maximize the stock price on that speci! c

date, not over the long run. That, in turn, led to some horrible abuses. Projects that

looked good from a long-run perspective were turned down because they would

penalize pro! ts in the short run and thus lower the stock price on the option exer-

cise day. Even worse, some managers deliberately overstated pro! ts, temporarily

boosted the stock price, exercised their options, sold the in" ated stock, and left

outside stockholders “holding the bag” when the true situation was revealed.

Enron and WorldCom are examples of companies whose managers did this, but

there were many others.

Other companies have also used aggressive but legal accounting practices that

boosted current pro! ts but lowered pro! ts in future years. For example, knowing

that an asset would be usable for only 5 years, management might depreciate it

over a 10-year life. This reduces reported costs—and raises reported income—for

the next 5 years but raises costs and lowers income during the following 5 years.

SEL

F^ TEST What is management’s primary goal?

What do investors expect to receive when they buy a share of stock? Do in-

vestors know for sure how much they will receive? Explain.

Based just on the name, which company would you expect to be riskier—

General Foods or South Seas Oil Exploration? Explain.

When Boeing decides to invest $5 billion in a new jet airliner, are its manag-

ers certain of the project’s e# ects on Boeing’s future pro" ts and stock price?

Explain.

Who would be better able to judge the e# ect of a new airliner on Boeing’s

pro" ts—its managers or its stockholders? Explain.

Would all Boeing stockholders expect the same outcome from a given new

project, and how would those expectations a# ect the stock’s price? Explain.

a more stable industry, had a narrower price range—from $42 to $52. Investors can

predict future results for Wal-Mart more accurately than for Apple; thus, Wal-Mart

is thought to be less risky. Also, some projects are relatively straightforward and

easy to evaluate and, hence, not very risky. For example, if Wal-Mart were considering

a proposed new store, the revenues, costs, and pro! ts for this project would be eas-

ier to estimate than for an Apple project related to a new voice-activated computer.

The success or lack thereof of projects such as these determine the stock prices of

Wal-Mart, Apple, and other companies.