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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 Ten Axioms

The Foundations of Financial Decision Making

Aug 27, 2012

1 the risk return trade off
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
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
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
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
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
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
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
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
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
10. Ethical Behavior Means Doing the Right Thing
  • Ethical Dilemmas are everywhere in finance; just read the news (Enron, Madoff, etc.)
  • 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! i.e., Japan nuclear disaster