The Ten Axioms
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.
Brief case example
5. Curse of Competitive Markets
It’s hard to find and maintain exceptionally profitable projects
High profits attract competition
How to keep very profitable projects
Product differentiation (Kleenex, Xerox)
Low cost (Costco, Honda)
Service and quality (Mercedes, Lexus)
Give examples for each of the above
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
Example: announcing a stock split
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
Example, cutting Research and Development costs on new products to maximize current income
Pay for performance; stock options
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
Examples : investment tax credit and environmental credits reduce taxes; purchase of Prius
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
Example: drilling for oil wells
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
- all stakeholders!
