10 Axioms of Financial Management

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!

Monetary policy[edit]
Further information: Monetary policy

Central banks implement monetary policy by controlling the money supply through several mechanisms.
Typically, central banks take action by issuing money to buy bonds (or other assets), which boosts the
supply of money and lowers interest rates, or, in the case of contractionary monetary policy, banks sell
bonds and take money out of circulation. Usually policy is not implemented by directly targeting the
supply of money.

Banks continuously shift the money supply to maintain a targeted fixed interest rate. Some banks allow
the interest rate to fluctuate and focus on targeting inflation rates instead. Central banks generally try to
achieve high output without letting loose monetary policy create large amounts of inflation.

Conventional monetary policy can be ineffective in situations such as a liquidity trap. When interest
rates and inflation are near zero, the central bank cannot loosen monetary policy through conventional
means. Central banks can use unconventional monetary policy such as quantitative easing to help
increase output. Instead of buying government bonds, central banks implement quantitative easing by
buying other assets such as corporate bonds, stocks, and other securities. This allows lower interest
rates for a broader class of assets beyond government bonds. In another example of unconventional
monetary policy, the United States Federal Reserve recently made an attempt at such a policy
with Operation Twist. Unable to lower current interest rates, the Federal Reserve lowered long-term
interest rates by buying long-term bonds and selling short-term bonds to create a flat yield curve.
Fiscal policy[edit]
Further information: Fiscal policy
Fiscal policy is the use of government's revenue and expenditure as instruments to influence the
economy. Examples of such tools are expenditure, taxes, debt.

For example, if the economy is producing less than potential output, government spending can be used
to employ idle resources and boost output. Government spending does not have to make up for the
entire output gap. There is a multiplier effect that boosts the impact of government spending. For
instance, when the government pays for a bridge, the project not only adds the value of the bridge to
output, but also allows the bridge workers to increase their consumption and investment, which helps
to close the output gap.

The effects of fiscal policy can be limited by crowding out. When the government takes on spending
projects, it limits the amount of resources available for the private sector to use. Crowding out occurs
when government spending simply replaces private sector output instead of adding additional output to
the economy. Crowding out also occurs when government spending raises interest rates, which limits
investment. Defenders of fiscal stimulus argue that crowding out is not a concern when the economy is
depressed, plenty of resources are left idle, and interest rates are low.[citation needed]

Fiscal policy can be implemented through automatic stabilizers. Automatic stabilizers do not suffer from
the policy lags of discretionary fiscal policy. Automatic stabilizers use conventional fiscal mechanisms
but take effect as soon as the economy takes a downturn: spending on unemployment benefits
automatically increases when unemployment rises and, in a progressive income tax system, the
effective tax rate automatically falls when incomes decline.
Comparison[edit]

Economists usually favor monetary over fiscal policy because it has two major advantages. First,
monetary policy is generally implemented by independent central banks instead of the political
institutions that control fiscal policy. Independent central banks are less likely to make decisions based
on political motives.[22] Second, monetary policy suffers shorter inside lags and outside lags than fiscal
policy. Central banks can quickly make and implement decisions while discretionary fiscal policy may
take time to pass and even longer to carry out.[22]