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8 Axioms of Finance

8 Axioms of Finance. Professor Paul Bolster. Axioms 1&2. We won’t take on additional risk unless we expect to be compensated with additional return. R i = R f +  i (R m – R f ) <= Capital Asset Pricing Model A dollar received today is worth more than a dollar received in the future.

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8 Axioms of Finance

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  1. 8 Axioms of Finance Professor Paul Bolster

  2. Axioms 1&2 • We won’t take on additional risk unless we expect to be compensated with additional return. Ri = Rf + i(Rm – Rf) <= Capital Asset Pricing Model • A dollar received today is worth more than a dollar received in the future. • Present value < Future Value as long as interest rates are positive • Example: Present Value of $1000 to be received in 1 year if interest rate is 7.5% • $1000/(1.075) = $930.23

  3. Axiom 3 • Cash, not profit, is king! • Note that Axioms 1, 2, and 3 together allow us to value any asset! • Example: Project X will generate a net cash inflow of $10,000 (prob=50%) or $20,000 (prob=50%) next year. The project must earn a 10% return. What’s the most we should bid for the rights to Project X? • Value of asset = Present value of expected future cash flows it will generate!

  4. Axiom 4 • Incremental Cash Flows: It’s only what changes that counts • Example: Vanilla coke!

  5. Axiom 5 • The Curse of Competitive Markets. • It is very difficult to find profitable projects! • New, profitable industries attract new entrants • Result? Profits decline to a level where they are comensurate with the industry risk level • Old, unprofitable industries experience consolidation • Result? Prices and profit levels rise for remaining competitors

  6. Axiom 6 • Capital Markets quickly reflect new information as changes in prices • Financial markets are very efficient! • News released in today’s Wall Street Journal has already been incorporated into stock prices.

  7. Axiom 7 • Managers won’t work for owners unless it is in their best interest • “Agency problem” • Managers have different incentives than owners • example: John Dorrance, chairman of Campbell Soup, passed away in 1989. Stock price went up 15% the next day. • Stock ownership and stock options: + and -?

  8. Axiom 8 • All risk is not equal. Some risk can be diversified away and some can not. • Example: Equal investment in a sunscreen project and an umbrella project will diversify the portion of revenue risk due to weather. • Example: Part of Apple Computer’s risk is due to risk in future economic conditions (non-diversifiable). Part of Apple’s risk is due to unique events that affect only Apple. An investor can diversify this source of risk by holding many stocks

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