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GB6030 FUNDAMENTALS OF FINANCE
LECTURE NOTES SPRING 2011
10 AXIOMS OF FINANCE
1. Role of financial management in the firm?
Making decisions that either maintain or create economic value
or wealthFor example, when to invest, what to invest in, when to
borrow, when to buy, when to sell, etc.
Goal of firm maximization of shareholder/stakeholder
wealthDefine shareholder, stakeholderWhy is profit not the
goal?
Timing of profits can be manipulated year to year (fraud)
Long term success may require short term risk, spending Timing
of cash flow versus profit recognition
Maximization of shareholder wealth involves:
Decisions which maximize value of common stock
Decisions which are for the good of all shareholders
Bad decisions decrease value/wealth
2. Legal forms of business organizations
Sole proprietorship
Partnership
Corporation Separate legal entity
Owners are common stock shareholders
Shareholders elect board of directors
Directors represent shareholders, hire management
Shareholder liability limited to amount invested
Can transfer ownership by selling stockBenefits of the Corporate
form of business:
Ease of raising capital based on assets, value of firm
Limited liability of investors (cant be sued)
Ease of transfer of ownership (can get out whenever they want)
Investors can choose any level of ownership (No. of shares)Role of
the financial manager in a Corporation
Treasurer (Finance) versus Controller (Accounting)
3. Federal Income Taxation
Must be considered when making business decisions
Consult tax experts for impact criteria
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Computing taxable income and taxes owed; J & S Corporatetax
table Other tax considerations
Putting it all together
4. Ten axioms/Bases for good business decisions
1. Risk-Return trade off
The more risk, the more return required and vice-versa
I.e., horse race example, junk bonds
2. Time value of money
A dollar received today worth more than a dollar received in the
future
Bus. Decisions require knowledge of present and future value of
investment returns
I.e., a 21 year old invests $12K @10%, at age 65, worth over $1
million
3. Cash is King (not profits)
Cash can be spent (profit is a paper number)
Cash does not equal profit depr., borrowing, issue stock,
invest, dividend pymts, etc.
4. Considerincremental cash flow only
Its only what changes that counts, i.e. diff between cash flow
with and without the project
I.e., new model brief case
5. Curse of the competitive market
High profits are hard to find and maintain
Competition will find a way
Competitive advantage can be maintained by:
Differentiation quality; name Kleenex, Xerox; Patents; service;
advertising
Lower cost Scale; Off shore mfrg; downsize; technology; i.e.
PCs, Cell phones
6. Efficient Capital Markets
The markets are quick and the prices are right
Information is instantly reflected in the stock price
Can the prices ever be wrong? Yes, if info is wrong, or market
hype
7. Agency problem who is management working for?
Incentives must ensure interests of management and shareholder
the same
If not, management focus is on the short term
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Solutions stock options, grants
8. Taxes bias business decisions
Value of investment measured by PV ofafter-tax cash flows
Taxes represent negative cash flow; i.e. 10% return = 6% after
tax if rate is 40%
9. Not all risk is equal
Some risk can be diversified away, some cannot
Diversification can help
10. Ethical dilemmas are everywhere in finance
Ethical behavior means doing the right thing
Ethical errors tend to end careers
Loss of public confidence very hard to repair
Social responsibility of firms to stakeholders The good -
Bristol Meyers Squibb; The bad Johns Manville; the ugly Florida
election,
Ford/Firestone, Enron
Is it wrong to tell a lie?
