Simbala, Andi Te’a Mari O.

BSAc 1

10 Axioms of Financial Management

1. The risk-return trade-off

- Higher returns are demanded for risky business.
- We won’t take on additional risk unless we expect to be compensated with additional return. The greater the risk, the
greater the expected return.
2. The time value of money
- A dollar received today is worth more than a dollar received in the future because money can be invested to generate
returns.
- A dollar received today is worth more than a dollar received tomorrow because a dollar received today can earn a
day’s interest by tomorrow.
3. Cash is the king
- Expenses are paid in cash and cash can be reinvested to generate more returns. Accrual accounting recognizes the
transaction when they occur rather than when they paid which results in timing difference between profit and cash
flows. A business should pay attention to cash flow because the continuation of a business is dependent on cash
flows.
- Accounting profit or loss frequently does not coincide with the actual transfer of money. The first rule of running any
business: Do not run out of cash.
4. Incremental cash flows
- The decision on whether to invest in a project should be based on the project's impact on cash flows. The project
investment decision is based on whether the cash flow increases or decreases.
- It’s only what changes that counts. Think incrementally. How will a decision change the cash flow of the company?
5. Curse of competitive markets
- It is hard to find and maintain Highly profitable projects because highly profitable projects attract competition.
- Why it’s hard to find exceptionally profitable projects? Success attracts competition. Competition lowers profits.
6. Efficient capital market
- Security prices are a reflection of all information available in the market. Efficient capital market theory states it is
impossible for investors to buy undervalued security or sell security at inflated prices because of the security trade at
a fair price.
- The markets are quick and the prices are right. Security prices adjust very quickly and appropriately to new
information.
7. The agency problem
- Managers are not the owners of a company and they may make business decisions that hurt the company in the long
run. Manager's self-interest such as cutting research and development costs in order to improve profit in the short
run may conflict with the business's long term goals.
- Managers won’t work for owners unless it’s in their best interest. Most people will work harder for themselves than
they will for someone else.
8. Taxes business bias
- The impact of tax on cash flow is to be factored when making business decisions because the tax reduces cash
flows. The government uses tax incentives to encourage investments.
- Decisions using cash flows must always use after-tax cash flows.
9. All risks are not equal because some risk can be diversified while some cannot be diversified
- Specific risk which is unique to the industry can be diversified while market risk cannot be diversified.
- Total risk is a combination of firm-specific risk, which can be diversified away, and market risk, which cannot be
diversified away. (But see the futures markets.)
10. Ethical behavior means doing the right thing
- Un ethical behavior erodes public trust and business which cannot gain trust of customers cannot maximize
shareholders' wealth
- Businesses that are not trusted by other businesses or by customers will not maximize the wealth of stockholders.
Perhaps the primary goal of firms should address stakeholders and not just stockholders.