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Date Posted: 12:05:32 08/25/02 Sun
Author: Dr. DaDalt
Subject: Re: Question # 6 Chapter 1
In reply to: Christopher 's message, "Re: Question # 6 Chapter 1" on 20:05:44 08/24/02 Sat

Actually, Christopher is close. He's got part of the answer. Let's see if I can provide the other part.

Chapter 1 is trying to get across several key points.

The first is that the value of any financial asset (like a stock) is based on the expected future cash flows you would recieve from owning it. More specifically, there are three elements to the valuation process: 1) How much cash will you receive (the higher the expected future cash flow, the greater the value); 2) How risky is the expected cash flow? (the safer the perception of the riskiness invloved, the more you would be willing to pay for a dollar of expected future cash); 3) The timing of the cash flow (the further it is in the future, the less you would be willing to pay today for $1 of future cash.

The second idea is that profits are not the same as cash. The answer below (from Christopher) are keying on this second element. Because of accrual accounting, you can have higher profits without any more cash.

However, based on my earlier comments, even if profits WERE the same as cash, maximizing them would not be equivalent to maximizing shareholder value. Consider the following example (used in my sections): suppose you had a machine that produced $100 each year forever with no risk (i.e. it's guaranteed). How much would you pay for it?

Now consider another machine that pays out an expected cash flow of $101 per year. However, the actual payout could be either $1,010 or $0 each year. Each year, there is a 10% chance that it will pay out $1,010 and a 90% chance of a $0 payout. So, the expected cash flow is $101. Most people wouln't pay more for this machine than for the "safe" $100 payout.

So, in summary, the answer would be "profits ain't cash, and even if they were, you still have to consider the timing and riskiness of the cash"

Hoep this helps.




>>Can you explain me Question #6.
>>Profit maximization is not the same as shareholder
>>value maximization. How is it possible that profit
>>maximization may not lead to stock price maximization?
>
>
>I'm not sure that i have this completely correct, but
>i think it goes something like this...
>Profits can be enormous on paper, but (for instance)
>they could be composed entirely of bad debt, owed by a
>company named Enron, for example...Thus their profits
>might be up but anyone who reads the footnotes would
>not pay the market price for this company, because
>they would know that the accounts receivable are not
>worth anything and consequently the stock price is
>incorrectly valued. So you can maximize profits on
>paper without addin any real value to the company.

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