Ten Axioms of
Financial
Management
Lecture
st
1
– Risk & Return Trade Off
nd
2
– Time Value of Money
rd
3 – Cash – Not Profits – is King
th
4 – Incremental Cash Flows
th
5 – The Curse of Competitive Markets
th
6 – Efficient Capital Markets
th
7 – The Agency Problem
th
8 – Taxes Bias Business Decisions
th
9 – All Risk is Not Equal
th
10 – Ethical Behavior Means Doing the Right Thing but Ethical
Dilemmas are Everywhere in Finance
1st Principle: The RiskReturn Trade-Off
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We won’t take on additional risk unless we expect to be
compensated with additional return
The more risk an investment has, the higher will be its
expected return
Expected Return vs. Actual (Required) Return
2nd Principle: The Time
Value of Money
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A peso received today is worth more than a peso received in
the future
Economics: Opportunity cost of passing up the earning
potential of a peso today
nd
Without this 2 principle, it is impossible to evaluate projects
with future benefits and costs in a meaningful way.
3rd Principle: Cash – Not
Profits – Is King
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It is cash flows, not profits, that are actually received by the
firm and can be reinvested
Cash flows and accounting profits may not occur together
Concern: Money on hand – when we can invest it and start
earning interest on it and when we can give back to
shareholders in the form of dividends
4th Principle: Incremental
Cash Flows
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It is only what changes that counts
The difference between the cash flows if the project is taken
on versus what they will be if the project is not taken on
Guiding Rule whether a Cash Flow is Incremental or Not: Look
at the company with and without the new product
5th Principle: The Curse of
Competitive Markets
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Why it is hard to find exceptionally profitable projects
Corporate Philosophy: Capitalize on market imperfection by
product differentiation and cost leadership
Competition forces you to innovate and to explore other
possibilities
6th Principle: Efficient
Capital Markets
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The markets are quick and the prices are right
These are markets in which the values of all assets and
securities at any instant in time fully reflect all available
information
Efficient Market: It has something to do with the speed by
which information is impounded into security prices
7th Principle: The Agency
Problem
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Managers won’t work for the firm’s owners unless it is in their
best interest
The agency problem results from the separation of the
management and the ownership of the firm
Prevention: Put an incentive structure that aligns the interests
of managers and shareholders
8th Principle: Taxes Bias
Business Decisions
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The cash flows we consider are the after-tax incremental cash
flows to the firm as a whole
Government realizes taxes can bias business decisions and uses
taxes to encourage spending in certain ways
The government can use taxes as a tool to direct business
investments
9th Principle: All Risk Is
Not Equal
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Some risk can be diversified away and some cannot
Process of diversification and risk reduction
Stand alone asset vs. portfolio of assets
10th Principle: Ethical
Behavior Means Doing the
Right Thing, But Ethical
Dilemmas are Everywhere
in Finance
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People have set of values which forms the basis for personal
judgments about what is the right thing to do
Unethical behavior eliminates trust and without trust, businesses
cannot interact
Beyond the question of ethics is the question of social responsibility