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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. 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

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

  2. 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

  3. 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)

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. 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’

  10. 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

  11. 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

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