End-of-Chapter Question Solutions
CHAPTER 1: FINANCIAL GOALS AND CORPORATE GOVERNANCE
Corporate goals: shareholder wealth maximization. Explain the assumptions and objectives of the
shareholder wealth maximization model.
The Anglo-American markets are characterized by a philosophy that a firm's objective should follow the
shareholder wealth maximization (SWM) model. More specifically, the firm should strive to maximize the return
to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. Alternatively,
the firm should minimize the risk to shareholders for a given rate of return.
The SWM model assumes as a universal truth that the stock market is efficient. The share price is always
correct because it captures all the expectations of return and risk as perceived by investors. It quickly incorporates
new information into the share price. Share prices, in turn, are deemed the best allocators of capital in the macro
The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that
the firm’s shares bring to a diversified portfolio. The total operational risk of the firm can be eliminated through
portfolio diversification by the investors. Therefore, this unsystematic risk, the risk of the individual security,
should not be a prime concern for management unless it increases the prospect of bankruptcy. Systematic risk,
the risk of the market in general, cannot be eliminated. This reflects risk that the share price will be a function of
the stock market.
Corporate goals: corporate wealth maximization. Explain the assumptions and objectives of the corporate
wealth maximization model.
In contrast to the SWM model, Continental European and Japanese markets are characterized by a philosophy
that a corporation's objective should be to maximize corporate wealth. Thus a firm should treat shareholders on
a par with other corporate inte