10 Axioms of Financial Management The Ten Axioms The Foundations of Financial Decision Making 1. The Risk-Return Trade-off The more risk an investment has, the higher its expected return should be If you bet on a horse, you want greater odds on the long shot If you invest in a risky business (Semiconductor, oil wells, junk bonds), you should demand a greater return Every decision you make should be evaluated for risk 2. The Time Value of Money A dollar received today is worth more than a dollar received in the future If you receive a dollar today, you can invest it and earn more Because of inflation, a dollar you receive today will buy more than a dollar you receive in the future So the sooner you get the money, the better The sooner you invest your money, the better (i.e. retirement) 3. Cash is King You can not spend “profit” or “net income”. these are paper figures only Cash is what is received by the firm and can be reinvested or used to pay bills Cash flow does not equal net income; there are timing differences in accrual accounting between when you record a transaction and when you receive or pay the cash 4. Incremental Cash Flows it’s onlY the increase or decrease in cash that really counts it’s the difference between cash flows if the project is done versus if the project is not done Consider all related cash flows, i.e., equip., inventory, etc. Brief case example 5. Curse of Competitive Markets it’s hard to find and maintain exceptionallY profitable projects High profits attract competition How to keep very profitable projects Product differentiation (Kleenex, Xerox) Low cost (Costco, Honda) Service and quality (Mercedes, Lexus) Give examples for each of the above 6. Efficient Capital Markets The markets are quick and the prices are right Information is incorporated into security prices at the speed of light! Assuming the information is correct, then the prices will reflect all publicly available information regarding the value of the firm Example: announcing a stock split 7. The Agency Problem Managers are typically not the owners of a company Managers may make decisions that are in their best interests and not in line with the long term best interests of the owners Example, cutting Research and Development costs on new products to maximize current income Pay for performance; stock options 8. Taxes Bias Business Decisions Because cash is king, we must consider the aftertax cash flow on an investment The tax consequences of a business decision will impact (reduce) cash flow Companies are given tax incentives by the government to influence their decisions Examples : investment tax credit and environmental credits reduce taxes; purchase of Prius 9. All Risk is Not Equal Some risk can be diversified away and some cannot don’t put all Your eggs in one basket Diversification creates offsets between good results and bad results Example: drilling for oil wells 10. Ethical Behavior Means Doing the Right Thing Ethical Dilemmas are everywhere in finance; just read the news (back date stock options, Madoff) Unethical behavior eliminates trust, results in loss of public confidence Shareholder value suffers and it takes a long time to recover Social responsibility means firms have to be responsible to more than just owners - all stakeholders!
