8 Axioms of Finance
Professor Paul Bolster
Axioms 1&2
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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
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A dollar received today is worth more than a dollar received in the
future.
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Present value < Future Value as long as interest rates are positive
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Example: Present Value of $1000 to be received in 1 year if interest rate is 7.5%
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$1000/(1.075) = $930.23
Axiom 3
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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
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Incremental Cash Flows: It’s only what
changes that counts
Example: Vanilla coke!
Axiom 5
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The Curse of Competitive Markets.
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It is very difficult to find profitable projects!
New, profitable industries attract new entrants
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Result? Profits decline to a level where they are
comensurate with the industry risk level
Old, unprofitable industries experience
consolidation
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Result? Prices and profit levels rise for remaining
competitors
Axiom 6
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Capital Markets quickly reflect new
information as changes in prices
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Financial markets are very efficient!
News released in today’s Wall Street Journal has
already been incorporated into stock prices.
Axiom 7
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Managers won’t work for owners unless it
is in their best interest
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“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
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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