10 Axioms of Financial Management
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.
5. Curse of Competitive Markets
It’s hard to find and maintain exceptionally profitable projects. High profits attract
competition.
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
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
8. Taxes Bias Business Decisions
Because cash is king, we must consider the after-tax 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
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.
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