An Overview of Financial Management

10 Principles in Finance
1st Principle - Risk and Return Trade Off - We won’t take on additional risk unless we expect to
be compensated with additional return; The more risk an investment has, the higher will be its
expected return; Expected Return vs. Actual (Required) Return

2nd Principle - Time Value of Money- A peso received today is worth more than a peso received
in the future; Economics: Opportunity cost of passing up the earning potential of a peso today
Without this 2nd principle, it is impossible to evaluate projects with future benefits and costs in a
meaningful way.

3rd Principle - Cash | Not Profits | is King- It is cash flows, not profits, that are actually received
by the firm and can be reinvested Cash flows and accounting profits may not occur together
Concern: Money on hand – when we can invest it and start earning interest on it and when we
can give back to shareholders in the form of dividends

4th Principle - Incremental Cash Flows - It is only what changes that counts
The difference between the cash flows if the project is taken on versus what they will be if the
project is not taken on; Guiding Rule whether a Cash Flow is Incremental or Not: Look at the
company with and without the new product

5th Principle - The Curse of Competitive Markets - Why it is hard to find exceptionally profitable
projects; Corporate Philosophy: Capitalize on market imperfection by product differentiation and
cost leadership; Competition forces you to innovate and to explore other possibilities

6th Principle - Efficient Capital Markets - The markets are quick and the prices are right
These are markets in which the values of all assets and securities at any instant in time fully
reflect all available information; Efficient Market: It has something to do with the speed by
which information is impounded into security prices
7th Principle - The Agency Problem - Managers won’t work for the firm’s owners unless it is in
their best interest; The agency problem results from the separation of the management and the
ownership of the firm; Prevention: Put an incentive structure that aligns the interests of
managers and shareholders

8th Principle - Taxes Bias Business Decisions- The cash flows we consider are the after-tax
incremental cash flows to the firm as a whole; Government realizes taxes can bias business
decisions and uses taxes to encourage spending in certain ways the government can use taxes as
a tool to direct business investments

9th Principle - All Risk Is Not Equal - Some risk can be diversified away and some cannot;
Process of diversification and risk reduction; Stand-alone asset vs. portfolio of assets

10th Principle - Ethical Behavior Means Doing the Right Things | But Ethical Dilemmas Are
Everywhere in Finance - People have set of values which forms the basis for personal judgments
about what is the right thing to do; Unethical behavior eliminates trust and without trust,
businesses cannot interact; Beyond the question of ethics is the question of social responsibility