10 Principles - Basics of Financial Management

TEN (10)
PRINCIPLES
Basics of Financial Management
By: Keown et. al, Principles and Applications of Financial Management
1. The Risk-Return Trade Off
2. Time Value of Money
3. Cash-Not Profit-Is King
4. Incremental Cash Flows
5. The Curse of Competitive Markets
6. Efficient Capital Markets
7. The Agency Problem
8. Taxes Bias Business Decisions
9. All Risk is not Equal
10. Ethical Behavior is doing the right thing, and
ethical dilemmas are everywhere in finance
PRINCIPLE 1: The Risk-Return Trade Off
“We won’t take on additional risk unless we expect to be compensated with additional return”
■ Investment alternatives have different amounts of risk and expected returns. Investors
sometimes choose to put their money in risky investments because these investments
offer higher expected returns. The more risk an investment has, the higher will be its
expected return
PRINCIPLE 2: Time Value of Money
“A dollar received today is worth more than a dollar received in the future.”
■ A fundamental concept in finance is that money has a time value associated with it: A
dollar received today is worth more than a dollar received a year from now. Because we
can earn interest on money received today, it is better to receive money earlier rather
than later. In economics courses this is the concept of opportunity cost of passing up the
earning potential of dollar today.
■ In this text, we focus on the creation and measurement of wealth. If the benefits
outweighs the costs, the project does not create and wealth should be rejected.
– Without recognizing the existence of the time value of money, is is impossible to
evaluate projects with future benefits and costs in a meaningful way.
PRINCIPLE 3: Cash-Not Profits-is King
■ In measuring wealth or value, we will use cash flows, not accounting profits, as a
measurement tool.
– We will be concerned with when the money hits our hand, when we can invest it
and start earning interest on it, and when we can give it back to the shareholders
in the form of dividends.
■ It is the cash flows, not profits, that are actually received by the firm and can be
reinvested.
– Accounting profits, however, appear when they are earned rather than when the
money is actually in hand. As a result, a firm’s cash flows and accounting profits
may not be the same.
■ Example: A capital expense or purchase of a new equipment or, is depreciated over
several years, with annual depreciation subtracted from profits. However, the cash,
associated with this expense generally occurs immediately. Therefore, cash inflows and
outflows involve the actual receiving and payout of money – when the money hits or
leaves your hands. As a result, cash flows correctly reflect the timing of the benefits
and costs.
PRINCIPLE 4: Incremental Cash Flows
“Its only what changes that counts”
■ In making business decisions, we are concerned with the results of those decisions:
– What happens if we say “yes” versus what happens if we say “no”?.
■ The incremental cash flow is the difference between the cash flows if the project is
taken on versus what they will be if the project is not taken on.
■ What is important is that we think incrementally.

– Our guiding rule in deciding whether a cash flow is incremental is to look at a
company with and without the new product. In fac, we will take this incremental
concept beyond cash flows and look at all consequences from all decisions on an
incremental basis.
PRINCIPLE 5: The Curse of Competitive Markets
“Why it’s hard to find exceptionally profitable projects”
■ It is much easier evaluating profitable projects than finding them. If an industry is

generating large profits, new entrants are usually attracted. The additional competition
and added capacity can result in profits below the required rate of return.
■ The key to locating profitable investment projects is to first understand how and where
they exist in competitive markets.
PRINCIPLE 6: Efficient Capital Markets
“The markets are quick and the prices are right”
■ To understand what causes stocks to change in price, as well as how securities such as
bonds and stocks are valued or priced in the financial markets, it is necessary to have an
understanding of the concept of efficient markets
■ Efficient Market is a market in which the values of all assets and securities at any instant
in time fully reflect all available public information.
■ An efficient market is characterized but a large number of profit-driven individuals who

act independently. In addition, new information regarding securities arrives in the market
in a random manner.
– Given this setting, investors adjust to new information immediately and buy and sell
the security until they feel the market price correctly reflects the new information.
PRINCIPLE 6: Efficient Capital Markets (cont’d)
“The markets are quick and the prices are right”
■ Under the efficient market hypothesis, information is reflected in security prices

appropriately reflect the expected earnings and risks involved and thus the true value of
the firm
■ The implications of the efficient markets are:
– First, the price is right. Stock prices reflect all publicly available information regarding the value of the
company. This means we can implement our goal of maximization of shareholder wealth by focusing on
the effect each decision should have on the stock price if everything else were held constant. That is, over
time good decisions will result in higher stock prices and bad ones, lower stock prices.
– Second, earnings manipulations through accounting changes will not result in price changes. Stock splits and other
changes in accounting methods that do not affect cash flows are not reflected in the prices. Market prices reflect expected
cash flows available to shareholders.
■ It is indeed reassuring that prices reflect value. It allows, us to look at prices and see
value reflected in them. While it may make investing a bit less exciting, it makes
corporate finance much less certain.
PRINCIPLE 7: The Agency Problem
“Managers won’t work for owners unless its in their best interest”
■ Results from the separation of management and the ownership of the firm.
– For example, a large firm may run by professional managers who have little or no
ownership in the firm. Because of this separation of the decision makers and
owners, managers may make decisions that are not in line with the goal of
maximization of shareholder wealth.
■ Agency Problem also results form conflicts of interests between the manager (the
stockholder’s agent) and the stockholders.
■ We will spend considerable time monitoring the managers and trying to align their interests
with shareholders. Managers can be monitored, by auditing financial statements and
managers’ compensation packages. The interests of managers and shareholders can be
aligned by establishing management stock options, bonuses, and prerequisites that ate
directly tied to how closely their decision coincide with the interest of the shareholders. I
■ The agency problem will persist unless an incentive structure is set up that aligns the
interest of managers and shareholders. In other words, what’s good for shareholders
must also be good for managers.
PRINCIPLE 8: Taxes Bias Business Decisions
■ Incremental Cash flows considered in evaluating process should be after-tax
incremental cash flows to the firm as a whole.
■ When we evaluate new projects, we will see income taxes playing a significant role.
When the company is analyzing the possible acquisition of a plant or equipment, the
returns from the investment should be measured on an after-tax basis. Otherwise, the
company will not truly be evaluating the true incremental cash flows generated by the
project.
PRINCIPLE 9: All Risk is Not Equal
“Some risk can be diversified away, and some cannot”
■ For most projects and assets, some risk can be eliminated through diversification,
whereas some risk cannot. This will become an important distinction. We should realize
that the process of diversification can reduce risk, and as a result, measuring a project’s
or an asset’s risk is very difficult. A project’s risk changes depending on whether you
measure it standing alone or together with other projects the company may take on.
PRINCIPLE 10: Ethical Behavior
“is doing the right thing, and ethical dillemas are everywhere in finance”
■ Ethical behavior means “doing the right thing”. A difficulty arises, however, in
attempting to define “doing the right thing”. The problem is that each of us has his or
her own set of values, which forms the basis for our personal judgments about what is
the right thing to do.

10 Principles - Basics of Financial Management

Uploaded by

Copyright:

Available Formats

10 Principles - Basics of Financial Management

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

10 Principles - Basics of Financial Management

Uploaded by

Copyright:

Available Formats

TEN (10)

■ What is important is that we think incrementally.

■ It is much easier evaluating profitable projects than finding them. If an industry is

■ An efficient market is characterized but a large number of profit-driven individuals who

■ Under the efficient market hypothesis, information is reflected in security prices

You might also like