The Ten Axioms

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The Ten Axioms. The Foundations of Financial Decision Making. Aug 27, 2012. 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

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The Ten Axioms

The Foundations of Financial Decision Making

Aug 27, 2012

• 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 net 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 – 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
• 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