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Ten Axioms that Form the Foundations of Financial Management

We’ll finish this introductory lecture by going over ten axioms of financial management. As we move through this course, we’ll return to these axioms again and again. So what follows is, in a sense, a quick preview of things to come.

Axiom 1: The risk-return trade-off—We won’t take on additional risk unless we expect to be compensated with additional return

As a financial manager, your job will revolve around risk-return trade-offs. How much risk does a project entail? How big a return might we get on our investment? Does the potential return justify the level of risk?

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If someone asks you to take on additional risk without offering additional return, they’re asking you to give something for nothing.

Axiom 2: The time value of money—A dollar received today is worth more than a dollar received in the future

Compare the value of a dollar received today with a dollar received five years from now. A dollar received today can be invested. A dollar received five years from now cannot. So a dollar received now exceeds the value of a dollar received five years from now by the return on investment we expect to receive over a five year period.

Axiom 3: Cash—not profits—Is king

Future profits cannot be invested. They cannot be paid to shareholders in the form of dividends. In contrast, cash can be used immediately to forward the goals of the firm. That is why cash, not profit, in hand is king.

Axiom 4: Incremental cash flows—It’s only what changes that counts

Every time you make a decision, you face two possible outcomes. What happens if you say yes? What happens if you no? The incremental cash flow is the difference between the company’s cash flow if a project is taken on versus the cash flow if the project is rejected. This difference represents the true impact of the decision.

Axiom 5: The curse of competitive markets—Why it’s hard to find exceptionally profitable projects

You’re a financial manager. You identify a promising market that has not been exploited by your competitors. You recommend that your company enter the market. As expected, the market proves exceptionally lucrative.

Unfortunately, that’s not the end of the story. Your competitors notice your success. They enter the market, pushing supply up and prices down. Now you have to invest in extensive advertising just to maintain your market share. What had been an exceptionally profitable project is now only an average performer.

How do you avoid this outcome?

You can try to differentiate your product in some key way that insulates you from competition. If your product is better in a way that cannot be easily copied, you might be able to maintain your pre-competition price.

You could also try to achieve a lasting cost advantage over the competition. If you can make your product for less, you can maintain your pre-competition profit margin.

Axiom 6: Efficient capital markets—The markets are quick and the prices are right

In an inefficient market the flow of information is slow and uneven. Stock prices in such markets are heavily influenced by the efforts of investors to take advantage of information discrepancies. In contrast, an efficient market is one in which the value of all assets and securities at any instant in time fully reflect all available information. In efficient markets, given enough time, good decisions will result in higher prices for our stock and bad decisions will result in lower prices for our stock.

Axiom 7: The agency problem—Managers won’t work for the owners unless it’s in their best interest

Your goal is to do everything you can to help the firm maximize shareholder value. At least that’s what you tell people at work. Actually, your goal is maximize your own wealth. Maximizing shareholder wealth is just a means to an end. This discrepancy between the firm’s goal and the goals of its managers is called the agency problem. Many firms try to overcome the agency problem by tying the financial compensation of managers to the achievement of the firm’s goals.

Axiom 8: Taxes bias business decisions

Part of your job is to weigh the costs and benefits associated with particular decisions. The government uses this fact to shape business behavior. For example, if the government wanted businesses to start recycling programs, it might offer a tax credit to organizations that do so. On the other hand, if it wanted certain firms to reduce the amount of pollution they produce, it might tax them on the basis of pollution output.

Axiom 9: All risk is not equal—Some risk can be diversified away, and some cannot

Sometimes you can reduce your overall risk by diversifying, by dividing your resources among several projects. Here’s how it works. Let’s say you have $1,000 to invest in the stock market. You identify twenty stocks that have a 10% chance of dramatically increasing in value. If you invested all of your money in one stock, you would have to be very lucky to pick a winner. However, if you divided your money among several stocks, you could significantly increase your chances of investing in a big money maker.

Axiom 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance

Business is about finding and exploiting advantages. That’s the nature of competition. Given this, it’s not surprising that individuals and organizations often feel the temptation to create advantages where they don’t exist, in short, to cheat. However, the temptation to cheat should be balanced by a knowledge of the consequences of getting caught. A business that is caught engaging in unethical conduct can lose the trust of other businesses and the confidence of the public. When this happens, further operations become impossible.

Is the extraordinary compensation offered to some chief executives justified, or is it a spectacular example of the agency problem?

Lecture Notes End





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