8 Axioms of Finance Professor Paul Bolster Axioms 1&2 We won’t take on additional risk unless we expect to be compensated with additional return. Ri = Rf + i(Rm – Rf) <= Capital Asset Pricing Model A dollar received today is worth more than a dollar received in the future. Present value < Future Value as long as interest rates are positive Example: Present Value of $1000 to be received in 1 year if interest rate is 7.5% $1000/(1.075) = $930.23 Axiom 3 Cash, not profit, is king! Note that Axioms 1, 2, and 3 together allow us to value any asset! Example: Project X will generate a net cash inflow of $10,000 (prob=50%) or $20,000 (prob=50%) next year. The project must earn a 10% return. What’s the most we should bid for the rights to Project X? Value of asset = Present value of expected future cash flows it will generate! Axiom 4 Incremental Cash Flows: It’s only what changes that counts Example: Vanilla coke! Axiom 5 The Curse of Competitive Markets. It is very difficult to find profitable projects! New, profitable industries attract new entrants Result? Profits decline to a level where they are comensurate with the industry risk level Old, unprofitable industries experience consolidation Result? Prices and profit levels rise for remaining competitors Axiom 6 Capital Markets quickly reflect new information as changes in prices Financial markets are very efficient! News released in today’s Wall Street Journal has already been incorporated into stock prices. Axiom 7 Managers won’t work for owners unless it is in their best interest “Agency problem” Managers have different incentives than owners example: John Dorrance, chairman of Campbell Soup, passed away in 1989. Stock price went up 15% the next day. Stock ownership and stock options: + and -? Axiom 8 All risk is not equal. Some risk can be diversified away and some can not. Example: Equal investment in a sunscreen project and an umbrella project will diversify the portion of revenue risk due to weather. Example: Part of Apple Computer’s risk is due to risk in future economic conditions (nondiversifiable). Part of Apple’s risk is due to unique events that affect only Apple. An investor can diversify this source of risk by holding many stocks

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# 10 Axioms of Finance